If you’re planning on buying a business, you may encounter a contract with an earnout provision. This contractual arrangement provides the seller with additional payments if certain financial milestones are met. In other words, the future payments to the seller will depend on how the company performs after the sale. Performing a due diligence assessment before entering into the agreement is also essential.
Because earnout arrangements require a different approach to taxes, it’s important for both the buyer and seller to agree to an earnout provision before finalizing the transaction. If you buy a business with such an agreement, you must consider tax requirements for the contingent payments if the agreed-upon financial terms are met, as the assets or stocks you purchase may be indeterminable by the end of the tax year.
Regardless of whether you purchase a company’s assets or its stock, you receive a no tax basis for the contingent payments until they become fixed. Additionally, you may need to make cash payments in order to be entitled to this basis under the “economic performance rules”. This is why proactively completing a due diligence assessment for the transaction and its corresponding earnout provision is so important.
Starting With Contingent Payments
When the buyer takes contingent payments into consideration for tax purposes, a portion of each payment must usually be treated as interest, which can often be deducted on the purchaser’s federal income tax return. If the interest rate of your earnout deal is too low for the IRS, imputed interest rules may need to be considered, and complex calculations may be required to discover how much of each payment must be treated as interest, as well as how much should be treated as principal.
The amount of every contingent payment that is treated as principal usually creates an additional tax basis for the acquired assets or stock, causing the buyer’s tax basis to rise gradually. When the tax regulations treat the transaction as an asset purchase, this “rolling” approach makes it more difficult to calculate depreciation and amortization deductions for the acquired assets.
To further complicate things, when the “residual method rules” apply to a transaction treated as an asset purchase (under Section 1060 of the Tax Code), the increased basis amounts from contingent payments are often allocated to intangible assets that must be amortized over 15 years (called Section 197 intangibles). Because of these complications, performing your own due diligence assessment may not be enough. You may require help from a professional who is familiar with an earnout provision.
Two Additional Considerations
1. In an asset purchase transaction, how the purchase price is allocated to the assets being bought and sold can be critical for both buyer and seller. In most cases, the buyer allocates as much of the cost as possible to temporary, short-term assets, such as inventory and receivables. On the other side of the coin, the seller will typically allocate as much of the price as possible to low-taxed capital gain assets, such as land or structures.
2. When completing a due diligence assessment, carefully consider whether you want to use an existing legal entity or a new entity to acquire the desired assets or stock. This issue can involve both legal liability concerns and tax considerations, which is why having an experienced earnout provision professional on your side is helpful.
The Writing on the Wall
It’s clear that the tax rules and legal implications for purchasing a business that includes an earnout provision can get quite complicated. Additionally, the terms of an earnout arrangement may have positive or negative tax consequences for the buyer and the seller.
Consequently, it may be necessary to compromise tax goals in order to find a deal that satisfies both parties. Often, the tax results can be more advantageous for you, the buyer, depending on the structure of the arrangement. To ensure ideal results, always perform a due diligence assessment by speaking with a qualified professional before signing a contract, especially those that include an earnout provision. For more information and to get assistance with your business purchase, please contact us today.