The purchase price on an acquisition of the stock or assets of a business often includes an “earn out” component. Under the earn out, additional installments of purchase price are paid if the business achieves certain agreed upon metrics. Earn outs may be paid in either cash or stock. Whenever a payment on a sale transaction is to be received in the future, a portion of that payment is taxable as interest. The buyer and the seller may have explicitly agreed that the payment obligation will accrue interest. Alternatively, if the agreement does not provide for interest, a portion of the agreed-upon payments will be re-characterized as interest under the tax code.
This consequence is unfavorable to the seller, because interest is taxable at ordinary income rates rather than the more advantageous capital gains rates. The adverse effect is compounded to the extent that gain is from the sale of stock that qualifies as “Section 1202 stock” gain on which is not subject to tax. By virtue of being re-characterized as ordinary income, the tax on that portion of the payment will go from a 0% tax rate to as high as a 37% tax rate. The recent increase in interest rates has exacerbated this problem because the portion of payments that will be re-characterized as income has increased significantly (the current short-term “applicable federal rate” has increased from 59% in February 2022 to 4.47% in February 2023).
The adverse tax consequences of interest income for the Seller may be mitigated by structuring the transaction so that buyer pays the entire purchase price – including the “earnout” – at the closing, with the former “earn out” criteria becoming criteria that if not satisfied cause the Seller to forfeit the earn-out consideration. The purchase agreement would further stipulate that any “earn-out” consideration forfeited reduces the purchase price for income tax purposes. By taking these steps, Seller avoids the interest income issue by ensuring that it received no deferred consideration (it may also have the effect of accelerating deductions for Buyer depending on the transaction structure). This construct can work even if the former earn-out funds are placed in escrow, provided that Seller is considered the owner of those funds for tax purposes throughout the escrow period. As a practical matter, this works best in acquisitions in which the consideration is paid in stock or units since the seller would need to pay tax upfront on a cash earn out (which it may forfeit) and buyers are likely to be unwilling to escrow a significant amount of cash to facilitate this tax planning for the seller.
Bottom Line: If you are selling a business (especially Section 1202 stock) and receiving buyer stock or units as consideration, rather than structuring the payment as contingent on achieving the metrics, structuring it as subject to forfeiture (in effect a “reverse earn out”)
could result in substantial tax savings.
“If at first, you don’t succeed, think how many people you’ve made happy. ” – H. Duane Black