Quick Summary
Earnouts are common in M&A transactions, allowing buyers to reduce upfront risk by making part of the purchase price contingent on the seller’s future performance. How that contingent payment is taxed depends heavily on how the earnout is structured, and the difference between capital gains treatment and ordinary income treatment can represent a significant portion of the seller’s after-tax proceeds. Understanding the tax mechanics before signing is not optional; it is one of the highest-value decisions in the entire deal process.
If you have received a letter of intent that includes an earnout provision, you have encountered one of the most tax-sensitive components in a business sale transaction. Earnouts are not simply a financing mechanism. They are a tax event with characteristics that are determined by the structure of the agreement, not by what either party intended.
Exit planning is at its most valuable in this exact window: before the deal structure is set, when a tax attorney can still influence outcomes. Once the earnout is documented and the deal is signed, the tax treatment is largely determined by the terms on paper.
This article explains how earnouts are taxed, what makes the difference between favorable and unfavorable treatment, and what a seller should be thinking about before they agree to the structure a buyer is proposing.
What an Earnout Is
An earnout is a provision in a purchase and sale agreement that entitles the seller to receive additional consideration after closing, provided that the acquired business meets specified performance targets during a defined post-closing period. Earnouts are used frequently in transactions where there is a valuation gap: the buyer and seller disagree on what the business is worth, and the earnout bridges that disagreement by making part of the price conditional on future results.
From the seller’s perspective, an earnout represents a promise of future money tied to a business they no longer control. From the buyer’s perspective, it reduces upfront exposure by shifting some of the purchase price to a contingency that the business has to earn.
The earnout is common in technology, healthcare, services, and any sector where a significant portion of value is tied to intangible factors like customer relationships, proprietary processes, or key personnel.
The Core Tax Question: Capital Gains or Ordinary Income?
The central tax issue with an earnout is character: will the payments be treated as capital gains, or will they be taxed as ordinary income?
At current federal rates, the difference between long-term capital gains treatment and ordinary income treatment can be approximately 20 percentage points on a federal basis, before accounting for the 3.8% net investment income tax and state taxes. On an earnout payment of several million dollars, that difference is material.
The character of an earnout payment is not determined by what either party calls it in the agreement. It is determined by what the payment is actually compensating.
When earnouts are taxed as capital gains: If the earnout is structured as contingent purchase price tied to the performance of the business, and the seller is not providing ongoing services to the buyer after closing, the earnout payments are generally treated as additional consideration for the sale of the business. Properly structured, they receive capital gains treatment and, in some cases, installment sale treatment that spreads the tax liability over the period in which the payments are received.
When earnouts are taxed as ordinary income: If the earnout is structured in a way that ties payments to the seller’s personal services after the closing, to employment milestones, or to a formula that looks and functions like a compensation arrangement, the IRS will treat the payments as ordinary compensation income rather than capital gains. The buyer may prefer this structure because compensation payments are deductible, while capital payments are not. That preference creates a direct conflict of interest between buyer and seller that is almost never made explicit during negotiations.
The Personal Services Trap
The most common way that earnouts shift from capital gains to ordinary income is through their connection to the seller’s continued personal services.
Consider a scenario where the seller agrees to remain as CEO for two years post-closing and the earnout is payable based on EBITDA during those two years. On its face, this looks like performance-based contingent purchase price. But if the buyer’s primary argument for the earnout is that the business’s performance is inseparable from the seller’s personal involvement, a court or the IRS may find that the earnout is functionally compensation for those services.
The more closely the earnout payment is tied to actions that the seller personally takes post-closing, the more likely that ordinary income treatment applies.
This matters especially when a seller is being asked to sign an employment or consulting agreement alongside the purchase and sale agreement. The structure of those agreements, how compensation is allocated between the employment arrangement and the earnout, and the conditions under which each becomes payable all affect how the IRS characterizes the earnout.
Installment Sale Treatment and Open Transaction Doctrine
When earnout payments are properly structured as contingent purchase price, two additional tax concepts come into play: installment sale treatment and the open transaction doctrine.
Under installment sale treatment, a seller who receives payments over multiple tax years does not recognize all of the gain in the year of sale. Instead, each payment received is allocated between return of basis and gain, and the gain portion is recognized in the year the payment is received. For a seller with significant accrued capital gains, this can substantially reduce the tax burden in any single year.
The open transaction doctrine applies when the total amount of the earnout payments cannot be determined at the time of the sale with reasonable certainty. Under this doctrine, the seller first recovers their basis in the sold assets before recognizing any gain. This can be highly favorable when payments arrive over time and the seller has significant basis to recover.
Navigating between installment sale treatment and open transaction treatment requires deliberate structuring. The IRS has specific positions on when each applies, and the agreement language needs to reflect those positions accurately.
Imputed Interest
One additional tax issue that arises with earnouts is imputed interest. When a contingent payment will be made in future years, the tax law treats part of that payment as interest, even if the agreement does not characterize it that way. The imputed interest is taxed as ordinary income rather than capital gains.
The applicable federal rate published by the IRS is used to calculate the imputed interest component. Sellers who do not account for this in their planning will often be surprised to find that a portion of an earnout payment they expected to be taxed at capital gains rates is actually ordinary income.
What Can Be Done Before Signing
The window for influencing the tax treatment of an earnout is before the letter of intent is signed, or at minimum before the purchase and sale agreement is finalized. Once the terms are documented and agreed upon, the structure is largely locked.
The actions that a tax attorney can take during deal negotiation include:
- Reviewing the proposed earnout structure for personal services traps and advising on how to restructure the formula or conditions to support capital gains treatment.
- Coordinating the employment and consulting agreement alongside the purchase price allocation to ensure the arrangements do not inadvertently shift earnout payments into compensation.
- Advising on purchase price allocation under Section 1060, which governs how the purchase price in an asset sale is allocated across asset classes and how that allocation interacts with earnout characterization.
- Modeling installment sale versus lump-sum treatment based on realistic projections of when earnout payments will be received and the seller’s overall tax position across those years.
- Documenting the deal intent in a manner that supports the seller’s desired tax treatment in the event of an IRS examination.
The deal team you assemble before closing determines what options remain available to you. A tax attorney who reviews the earnout structure after the term sheet is agreed upon has far less to work with than one who is involved from the beginning.
Why Sellers Often Do Not Know What They Are Agreeing To
One of the consistent findings in complex business sale transactions is that sellers focus intensely on the total purchase price and much less on the character of how that price is taxed. An earnout of $5 million that is taxed at ordinary income rates is not the same economic outcome as an earnout of $5 million taxed at long-term capital gains rates. The after-tax difference can be $800,000 or more at current rates, and that difference is determined entirely by the structure of the agreement.
Buyers are represented by sophisticated M&A counsel and tax advisors who understand these dynamics. Sellers who rely solely on M&A counsel without a dedicated tax attorney advising on the tax structure of the earnout are frequently at a disadvantage on this dimension of the deal.
Covello Tax Law’s Role in Earnout Transactions
Dustin Covello advises sellers on the tax structure of their transactions, including the earnout component, as part of Covello Tax Law’s exit planning practice. Every client works directly with Dustin. The analysis includes a review of the proposed deal structure, the employment or consulting arrangements, the purchase price allocation framework, and the multi-year tax planning considerations that extend beyond the closing date.
The goal is to ensure that every dollar of the earnout is structured to receive the most favorable tax treatment the facts support, and that the documentation behind that treatment is defensible under IRS scrutiny.
Contact Dustin for a confidential conversation about your tax strategy. Email dustin@covellotaxlaw.com or use our secure form.
