Allocating earn-outs among sellers + earn-out taxes?

September 14, 2021

by a searcher from University of California, Los Angeles - UCLA Anderson School of Management in London, UK

Is there a mechanism to allocate an earn-out in a sale disproportionately amongst the selling shareholders and still have it treated as capital gains?

For example: Two sellers A and B, each a 50% shareholder, but we want 75% of the earn-out to go to seller A and 25% to seller B.

Also, what fiscal year would the earn-out be taxed based on? i.e. suppose the deal is done this year and the earn-out is paid next year, and that there is also a tax increase next year, which tax rate is the seller paying on the earned portion of the deal?

Thank you.

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Reply by a professional
from University of Sydney in Sydney NSW, Australia

I can only comment from an Australian perspective and like what a lot of the others have said, the answer will be very fact dependent. As to the first part of your question, I suspect where you will end up is that the securities the sellers hold in the entity being sold will need to have a special class issued to accommodate the disproportionate allocation of the earnout proceeds. As a general rule, as the ownership is 50/50 without accommodating this through the legal mechanics of the rights attaching to the capital structure it is difficult to not share proceeds in proportion. As to the second part of your question, provided a number of conditions are satisfied in relation to the terms under which the earnout is agreed, it is possible that the earnout proceeds are only brought to account for tax purposes as and when they are received. For example, if the sale occurs in Year 1 and the earnout is paid in Year 3, the earnout is taxed as a capital gain attributable to Year 1 but the tax is only payable in Year 3.

Reply by a professional
from University of Minnesota in Minneapolis, MN, USA

Slow to respond here, but I like the creative thinking on the deal. I think ^redacted‌ identified a key issue we don't know from your post - whether you are buying equity direct from the owners or the assets of a company. Since the structure you're proposing is ostensibly to benefit a Seller (or one of Seller's owners), perhaps it's worth proposing to the benefiting Seller that you are open to any structure that works, but the Seller that benefits is probably in the best position to analyze the deal with a knowledgeable tax advisor and bring a proposal to you to consider (rather than making you carry his water). From my perspective, the person benefiting is in the best position to get the straight answer they are looking for, and also foot the bill on any related research! Good luck, and if it works out, maybe post a follow-up to educate us on what went down? Thanks!!

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