By Walter Rogers
Agreements for the sale of privately-held companies often call for part of the purchase price to be paid in the form of an earnout. The earnout provision requires the buyer to pay an additional amount in purchase price after the closing of the sale, if after the closing the company achieves certain financial results or meets certain goals. Earnouts may be described in various ways, but they usually call for one or more installments of additional purchase price to be paid to sellers when, usually in a later year or later years, the parties can determine whether or not the specified financial results have been achieved or the goals have been met.
Tax lawyers often ask sellers to consider agreeing to a cap on the earnout payments. To understand why, compare the following examples which describe the same deal with and without a cap on the earnout. (Assume the sellers do not “elect out” of the installment method of income tax accounting.)
Example – Earnout Is Subject to a Cap
Ms. A sells all the stock of X corporation to Mr. B on January 1, 2015. The stock purchase agreement provides that Mr. B will pay to Ms. A (i) $10,000,000 at closing, (ii) 10 percent of X’s net profits for 2015 in excess of a specified threshold on March 1, 2016 and (iii) cash in an amount equal to 10 percent of X’s net profits for 2016 in excess of a specified threshold on March 1, 2017, the 2016 and 2017 payments not to exceed, in the aggregate, $1,200,000. The agreement also provides that Mr. B will pay adequate interest in addition to any earnout payment. Ms. A’s basis in her stock is $2,100,000. The actual earnout payment turns out to be $1,000,000, made on March 1, 2017 with respect to 2016 net profits. X’s net profits for 2015 did not exceed the specified threshold.
Ms. A’s 2015 tax year
The maximum amount Ms. A may receive (not including interest) is $11,200,000. It is assumed that Ms. A will receive the maximum amount. Thus, Ms. A’s gross profit is $9,100,000 ($11,200,000 selling price minus $2,100,000 basis). Her gross profit ratio is .8125 ($9,100,000/$11,200,000). Of the $10,000,000 received at closing, $8,125,000 is reportable as gain attributable to the sale and $1,875,000 is recovery of basis.
Ms. A’s 2016 tax year
Ms. A receives no earnout payment in 2016 and thus has no gain or loss to report.
Ms. A’s 2017 tax year
Since it is no longer possible for Ms. A to receive the maximum amount, the gross profit ratio to be applied to the 2017 earnout payment must be recomputed. The recomputed total gross profit is $8,900,000, which equals the selling price of $11,000,000 (as adjusted to reflect the fact that the maximum earnout payment was not earned and received) minus Ms. A’s adjusted basis of $2,100,000. However, since Ms. A has already recognized $8,125,000 of gain, the gross profit for purposes of calculating the gross profit ratio to be applied to the 2017 earnout payment is $775,000. The recomputed selling price is $11,000,000, but this must be reduced to $1,000,000 in calculating the “new” gross profit ratio to reflect the receipt of $10,000,000 at closing. Accordingly, the gross profit ratio to be applied to the 2017 earnout payment is .775 ($775,000/$1,000,000). Thus, Ms. A will recognize $775,000 of gain on the receipt of the 2017 earnout payment (.775 x $1,000,000) and $225,000 is recovery of basis.
Example – Earnout Is Not Subject to a Cap
The facts are the same as in Example 1 except the stock purchase agreement does not specify any cap on the earnout payment.
Since the maximum amount that Ms. A may receive cannot be determined, Ms. A must allocate her $2,100,000 basis equally among the three years in which a payment may be received (2015, 2016 and 2017). Accordingly, $700,000 is allocated to each year.
Ms. A’s 2015 tax year
Of the $10,000,000 received at closing, $9,300,000 is reportable as gain attributable to the sale and $700,000 is recovery of basis.
Ms. A’s 2016 tax year
Ms. A receives no earnout payment in 2016 and thus has no gain or loss to report. The $700,000 of basis allocated to 2016 is carried forward to 2017.
Ms. A’s 2017 tax year
Ms. A receives an earnout payment of $1,000,000 (excluding interest) in the final payment year under the agreement. Ms. A will recognize a loss of $400,000 in 2017 ($1,000,000 payment minus [$700,000 allocation of basis to 2017 + $700,000 of basis reallocated from the 2016 tax year]). Since it is a capital loss, it cannot be carried back to offset the gain Ms. A recognized in 2015. While Ms. A can carry the capital loss forward, it can only offset future capital gain and $3,000 of ordinary income each year.
Ms. A’s tax results were significantly better in the first example when she agreed to a cap on her earnout payments. Why? Because federal income tax regulations prescribe different methods of recovering basis depending on whether or not the maximum amount of earnout payments sellers may receive can be determined. For more on calculating gain or loss on sales of privately-held stock, click here.
But how should one determine what cap to use? It is a matter of forecasting and balancing. The greater the cap, the more of seller’s basis is allocated to future earnout payments. The more of seller’s basis that is allocated to future earnout payments, the greater the gain that is allocated to the earlier tax years, and, what may be worse, the greater the risk of a capital loss at the end of the earnout period. On the other hand, the smaller the cap, the greater the chance that some portion of the earnout described by the earnout terms may be forfeited. This complicates deal making, but a more informed seller is a better bargainer and has a better chance of receiving a better tax result.
For more information about taxing the earnout, contact a Heyward Armstrong or Carl Patterson of Smith Anderson.