Staying Alert for Tax Traps in Earn-Outs: Buyers and sellers using an earn-out to close a deal must be aware of the potential for an income tax backlash.

Dealmakers usually treat an earn-out as a last resort to close a transaction with an otherwise unbridgeable pricing gap between the buy and sell sides. Payments based on future results of the target company have a history of contentiousness in structuring terms, choosing a metric for measuring performance, and actually distributing the additional cash or stock when it comes due. Buyers and sellers are usually less aware, however, that earn-outs may cause significant tax problems if they are not set up correctly. For example, if the transaction is reported under the installment method, earn-out payments are not taxable until the seller receives them after the deal has closed. 1 However, the tax treatment can vary significantly under the installment method. Because earn-outs are appearing more frequently to resolve negotiating deadlocks in the difficult m&a market, this article illustrates how the tax treatment can vary significantly based on the terms and the timing of the payments. I recommend that sellers and their advisers always consider the tax consequences of earn-outs to avoid adverse tax consequences. Although, earn-out payments are not taxable to the seller until they are received, the installment method prescribes special rules for allocating the tax basis in the assets being sold to earn-out payments. 2 Moreover, different tax basis allocation rules apply depending on the terms of the earn-out. Thus, the terms of an earn-out can affect the character and timing of the seller’s gain and/or loss when the payments are received. If the earn-out has a stated maximum amount, that sum is included in the total price paid for the assets for purposes of allocating the tax basis. For purposes of calculating the taxable gain, the tax basis of the assets is allocated to each payment received by the seller in proportion to the amount of the payment over the total price, which includes the maximum earn-out amount. For example, assume Paul owns all of the stock of Elmo Corp. with a basis to Paul of $20 million. On Jan. 1, 2004, Paul sells this stock to Luke under an agreement calling for 15 annual payments equal to 5% of Elmo’s earned income in the immediately preceding fiscal year. Each payment provides for adequate stated interest. The agreement specifies that the maximum amount (exclusive of interest) payable to Paul shall not exceed $60 million. Therefore, the gross profit ratio is two-thirds – or a gross profit of $40 million divided by the $60 million contract price. On Jan. 1, 2005, Paul receives a payment of $3 million (not including interest) under the agreement. Under the installment method, Paul must report $2 million as a gain attributable to the sale and $1 million as recovery of basis – a $3 million payment divided by the $60 million maximum stated amount times the $20 million tax basis. As the example illustrates, this methodology assumes that the stated maximum earn-out amount will be received. This assumption can result in the deferral of basis recovery and the corresponding acceleration in taxable gain if the stated maximum is not realized. It can even result in future capital losses to the seller if the stated maximum is not realized. If a stated maximum selling price cannot be determined, but the earn-out fixes the maximum period over which payments may be received, the seller’s basis is allocated to the taxable years in which payment may be received in equal annual increments. If the payments received in any given year do not exceed the allocable basis for that year, the seller does not get a loss but must carry forward any excess basis to the next succeeding taxable year. For example, Emma sells all her stock in Elmo Corp. to Big Bird Corp. for 10% of Elmo’s net income for each of the next five years. Emma’s basis in her stock in Elmo Corp. is $5 million. Since the sales price is indefinite and the maximum selling price is not ascertainable from the terms of the agreement, her basis is recovered ratably over the period during which payments may be received under the contract. Emma would recover $1 million in basis in each of the five years after closing, or a $5 million basis divided by a fixed period of five years. Assume then that Emma receives the following payments (excluding interest): $2.1 million, $1.8 million, $1.4 million, $1.5 million, and $1.3 million in post-deal years one through five, respectively. Emma would report a gain attributable to the sale as follows: year one, $1.1 million; year two, $800,000; year three, $400,000; year four, $500,000, and year five, $300,000. If Emma had only received $800,000 in the first year, the entire amount would be tax-free because of the $1 million basis allocable to that year. The excess $200,000 would be added to the basis allocable to the second year when Emma would have basis of $1.2 million for purposes of calculating the taxable gain on the payments received that year. Finally, if the earn-out does not specify a maximum selling price or a fixed period, the basis is recovered in equal annual increments over a period of 15 years. If no payment is received in any taxable year or the payment received is less than the basis allocated to the year, no loss is generally allowed. Instead, the excess basis is reallocated in level amounts over the balance of the 15-year term. Any basis not recovered by the end of the 15th year is carried forward until all basis has been recovered or the future payment obligation is determined to be worthless. Application of the Installment Method To reiterate, the tax treatment of earn-out payments when the seller receives them can vary significantly under the installment method. The following examples illustrate how identical earn-out payments can result in different tax consequences to the seller under the installment method. For example, compare the outcome in Example 1 to the outcome in Example 2. In Example 1, the earn-out provides for “pie in the sky” maximum aggregate payments totaling $60 million. It assumes that the seller has a basis in the stock of $20 million. It also sets the duration of the earn-out at five years. Finally, it assumes that the actual payments received by the seller equal $45 million and are mostly received in the early years of the earn-out term. Thus, in this example the seller does not realize the maximum aggregate earn-out amount. Example 1 summarizes the tax consequences to the seller. In Example 1, the seller is forced to recognize $30 million in gain over the five-year period, even though she only realizes $25 million in actual gain ($45 million in payments received less the $20 million basis). This imbalance is corrected by a $5 million capital loss that she can take at the end of the term. However, based on these facts, this earn-out structure has effectively accelerated the taxable gain to the seller. Furthermore, it has left the seller with a capital loss that she may not be able to utilize efficiently. In Example 2, the facts are identical except that there is no maximum earn-out amount. Example 2 summarizes the tax consequences to the seller. In Example 2, the seller recognizes $25 million in gain over the five-year period and has no residual capital loss. Of course, even a fixed-period earn-out can result in accelerated gain and offsetting (but usually not desirable) future capital loss to the seller if actual amounts received are concentrated in the early years, leaving excess basis and potential capital losses in later years. Nevertheless, compare the seller’s tax consequences in Example 1 to those in Example 2. The comparison illustrates that, although the seller receives the same payments in the same years in both examples, the seller defers a greater amount of gain in Example 2. The only differences are the terms of the earn-out. In Example 3, we vary the facts of Example 1 only to assume that the seller receives the maximum aggregate earn-out amount mostly in the early years of the arrangement. In Example 4, we use the same basic facts as those in Example 3 except the earn-out has no maximum amount, or “ceiling.” Compare the seller’s tax consequences in Example 3 to those in Example 4. A comparison illustrates that an earn-out with a maximum aggregate amount may be more favorable to the seller from a tax standpoint than an earn-out with a fixed period if the maximum amount is realized and/or most of the payments are received in the early years following completion of the sale. However, even if the seller receives the maximum aggregate amount, the timing and amounts of the earn-out payments can affect the tax treatment of the seller under different terms. To illustrate, Examples 5 and 6 differ from Examples 3 and 4 only in that the timing of the payments are reversed so that most of them are received in later years. Compare the seller’s tax consequences in Example 5 to those in Example 6. The comparison of Examples 5 and 6 illustrates that even though the seller receives the identical payments, an earn-out with no maximum aggregate amount but with a fixed period may result in more favorable tax treatment of the seller because it results in a greater deferral of taxable gain. Even though earn-out payments are generally not taxable until the seller receives them, the tax treatment of the payments can differ significantly under the installment method, depending on terms. The tax treatment is a function of: * Whether the terms provide for a maximum aggregate earn-out amount, a fixed duration, or neither; and * The timing and amount of the payments received by the seller. To the extent that sellers have the ability to control the terms of an earn-out, they should consider the tax ramifications to ensure that they are maximizing their gain deferral. Otherwise, the seller may face unexpected and costly results. End Notes: 1 See Internal Revenue Code section 453 2 See Temporary Treasury Regulation section 15A.453-1(c) Nicolas Schmelzer is a tax attorney at Shumaker Loop & Kendrick, Toledo, Ohio. He represents clients before the Internal Revenue Service, the U.S. Tax Court, and other taxing authorities.