Service-Related Earnouts: Contingent Purchase Price vs. Compensation

Editor: Mary Van Leuven, J.D., LL.M.

Gross Income

Negotiating the purchase price on a transaction is often a point of contention between parties. As noted in a December 2013 article from the Bureau of Labor Statistics, the movement in the United States toward service-based businesses will mean that more value within existing businesses will be tied to the existing relationships of service providers and their clients (Henderson, “Industry Employment and Output Projections,” Monthly Labor Review (Dec. 2013)). As a result, a buyer’s willingness to pay is connected to its confidence in the parties’ ability to transfer existing business relationships post-closing. In many instances, the sellers of a business are also service providers who control business relationships. As a result, a portion of the consideration for the business—the “earnout”—may be based on a seller’s willingness to provide a level of service that results in the transfer of the business interest and relationships to the buyer.

Perspective

The issue that arises in these scenarios is whether the earnout is a contingent purchase price or compensation to the seller and, in certain circumstances, subject to bifurcation as both a contingent purchase price and compensation. There is an inherent tension between the two because either characterization will benefit only one party to the transaction.

From the seller’s perspective, if the seller is an individual and the earnout is characterized as compensation (including payments for future services and covenants not to compete), the payment will be subject to federal income tax rates of up to 39.6%. On the other hand, an earnout characterized as a deferred purchase price for equity or assets (including stock and goodwill) will generally be more attractive for tax purposes because it will (1) be subject to the lower capital gains rate and (2) not be subject to payroll tax. Thus, a seller would generally prefer capital gains treatment.

From the buyer’s perspective, it may be advantageous to view the earnout as compensation for services because the payment of compensation will usually generate a current tax deduction for the buyer. Nonetheless, if viewed as compensation, the earnout may also be subject to the Sec. 280G deduction limitation on golden parachute payments and would need to comply with Sec. 409A (i.e., income inclusion for nonqualified retirement plans), requiring a consideration of collateral provisions of the Code.

Factors

Several factors should be considered when determining whether service-related earnouts are contingent on purchase price or compensation, including, but not limited to:

1. Service conditions: Generally, if earnouts are conditioned on future services, then those conditions indicate compensation (see Duberstein, 363 U.S. 278 (1960)).
2. Proportionality: Consider whether the earnout payment is proportional to the sale of equity. If there is proportionality—all sellers receive the earnout based on the services provided by a minority set of owners—this indicates a return on capital and deferred purchase price. 
3. Negotiations: Actual negotiations play an important role. To the extent that the parties disagree on a purchase price and the earnout is later proposed as a means of resolving that disagreement, these facts may indicate the earnout is a deferred purchase price. 
4. Valuation: If the payment of earnouts represents reasonable value for the acquired business, then amounts paid for the earnout may represent deferred purchase price.
5. Reasonable compensation: If individuals are already paid reasonable compensation for post-closing services, then the reasonable compensation may indicate that the earnout is deferred purchase price.

When services are tied to the earn-out, the concern is that the earnout is compensation for services under Regs. Sec. 1.61-2. However, if one or more of the other factors noted above are present, then one must consider whether there is a compensatory intent and whether the origin of the claim/payment stream is the intrinsic equity value. Pertinent guidance includes the following:

• Arrowsmith, 344 U.S. 6 (1952): In Arrowsmith, two taxpayers liquidated a corporation that they co-owned and divided the proceeds equally, reporting the profits from the distributions as capital gains. In a subsequent year, a judgment against the corporation was rendered. The taxpayers paid the judgment and reported it as an ordinary business loss deduction. The Court held that those payments and the resulting deduction were capital because the claim for which the judgment was rendered related to the original liquidation. The Court reasoned that the fundamental root of taxation was the origin of the claim. Similarly, if the payment of an earnout represents nothing more than the intrinsic value of the equity an individual owned before the transaction, then Arrowsmith suggests that the origin of the earnout payments is the existing value of the shares.
• The Lane Processing Trust, 25 F.3d 662 (8th Cir. 1994): In Lane Processing Trust, an employee-owned business sold assets, and the proceeds were distributed to the employee-owners. However, the right to the distribution and the amount of the distribution were contingent upon the individuals’ being employed at the time of the transaction, their job classification, length of employment, etc. The court rejected the company’s claim that the payments were not wages and held that the payments were based on factors “traditionally used to determine employee compensation, specifically, the value of services performed by the employee, the length of the employee’s employment, and the employee’s prior wages.” As such, the payments were more closely aligned to services than equity ownership.
• R.J. Reynolds Tobacco Co., 149 F. Supp. 889 (Ct. Cl. 1957): An employer claimed payments made to certain owner-employees, under a profit distribution plan and proportionate to their shareholdings, were deductible compensation rather than dividends. The court held that the payments were not compensatory and, instead, were on account of equity ownership because:

  • The payments were in proportion to equity ownership;

  • The payments were in addition to existing reasonable compensation arrangements; and

  • In prior tax, accounting, and litigation matters, the company had treated the payments as dividends rather than compensation.

• Rev. Rul. 2007-49: In Rev. Rul. 2007-49, three rulings were issued on the following situations: (1) No “transfer” for Sec. 83 purposes occurred when new service-based restrictions imposed on vested shares caused those same shares to become “unvested”; (2) a transfer for Sec. 83 purposes did occur when an employee-shareholder exchanged substantially vested shares for unvested shares in a Sec. 368(a) reorganization; and (3) a transfer for Sec. 83 purposes also occurred when an employee-shareholder exchanged substantially vested shares for unvested shares in a taxable stock acquisition. In situation (1), Rev. Rul. 2007-49 suggests that an owner can subject existing equity to service-related conditions and retain capital gain treatment. In situations (2) and (3), the employee shareholder will maintain basis in the property and can make a Sec. 83(b) election at transfer to have any subsequent gain taxed at the capital gain rate. While not directly on point to an earnout, the ruling suggests at the very least that the intrinsic equity value is capital and that any increase in that value may (or may not) require a Sec. 83(b) election to subject any additional upside to capital gains treatment.

Conclusion

The specific facts and circumstances of an earnout will naturally drive the tax result. Although a service-based earnout condition may indicate compensation, it is important to consider other factors to fully determine the earnout’s character. With careful planning and appropriate considerations within transaction agreements, parties can capture their intent by addressing factors relevant to earnouts.

EditorNotes

Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.