Capital Gains vs. Ordinary Income: Earnout Tax Guide

Earnouts in M&A deals can be taxed in two ways: capital gains (15-20%) or ordinary income (up to 37%). The tax treatment depends on how the earnout is structured:

Capital Gains Tax: Applies when earnouts are tied to business performance metrics (e.g., revenue, EBITDA). Lower tax rates.
Ordinary Income Tax: Applies when payments are linked to personal services or employment. Higher tax rates plus payroll taxes.

Key takeaway: Proper structuring and documentation can save you thousands in taxes. Work with tax professionals to ensure compliance and reduce liabilities.

Quick Comparison

Aspect	Capital Gains Treatment	Ordinary Income Treatment
Maximum Tax Rate	20%	37%
Additional Taxes	3.8% Net Investment Income Tax	Payroll taxes
Qualifying Criteria	Business performance metrics	Linked to personal services
Payment Structure	Part of purchase price	Compensation for services

Carefully plan earnouts to maximize after-tax proceeds.

Tax Differences: Capital Gains vs. Ordinary Income

Capital Gains Tax Basics

Earnouts classified as part of the sale price, rather than as payment for services, are generally taxed at capital gains rates of 15% or 20%. For high-income earners, an additional 3.8% net investment income tax may apply, making it essential to carefully plan taxes for larger deals.

Ordinary Income Tax Basics

If earnouts are treated as compensation for services, they are taxed at ordinary income rates, which can go as high as 37%, and are also subject to payroll taxes. This often happens when the earnout depends on the seller's continued role or personal performance after the sale.

Tax Rate Comparison Table

Aspect	Capital Gains Treatment	Ordinary Income Treatment
Maximum Tax Rate	20%	37%
Additional Taxes	3.8% Net Investment Income Tax	Social Security and Medicare taxes
Qualifying Criteria	Business performance metrics (e.g., revenue, EBITDA)	Tied to personal service or employment
Payment Structure	Part of purchase price	Compensation for ongoing services
Tax Impact Example	$2M earnout = $476K tax ($400K + $76K NIIT)	$2M earnout = $740K tax + payroll taxes

The tax treatment of earnouts depends on how they are structured and what performance metrics are used. For example, an earnout tied to the company reaching $25 million in revenue would likely qualify for capital gains treatment. On the other hand, an earnout contingent on the seller staying on as CEO for three years would fall under ordinary income.

Careful structuring can help sellers reduce taxes and maximize their net earnings while staying within IRS rules. Understanding how the IRS classifies earnouts is key to navigating these distinctions effectively.

IRS Rules for Earnout Taxation

Key Tax Classification Factors

The IRS uses specific criteria to decide whether earnout payments fall under capital gains or ordinary income. The focus is on the economic substance of the deal - what's actually happening financially, not just how the agreement is worded.

Here are some key factors:

Earnouts based on company-wide performance metrics (like revenue or EBITDA) are more likely to be treated as capital gains.
Payments tied to continued employment are typically classified as ordinary income.
The timing of payments, especially how they align with employment terms, can influence the classification.

IRS Guidelines

The IRS has clear guidelines to help classify earnouts for tax purposes. These focus on the actual purpose of the earnout, not just its description in contracts.

Classification Element	Capital Gains Treatment	Ordinary Income Treatment
Performance Metrics	Company-wide financial targets	Individual performance goals
Payment Conditions	Independent of employment	Linked to employment
Duration	Unrelated to employment term	Aligned with employment period
Purpose	Part of the purchase price	Compensation for services

"The characterization of an earnout affects the buyer, too. An earnout that's treated as compensation is immediately deductible. On the other hand, the earnout must be capitalized and amortized over time if it's considered a deferred payment on the purchase price." - GRF CPAs & Advisors

Proper classification requires thorough documentation of performance metrics, accurate tax reporting, and evidence to support the chosen classification.

Experts at Phoenix Strategy Group recommend involving tax professionals early in the process to ensure earnouts are structured correctly. This groundwork is essential for reducing tax liability, a topic covered in the next section.

Tax Planning for Earnouts

How to Qualify for Capital Gains Treatment

When structuring earnouts, the goal is often to qualify for capital gains tax rates, which range from 15-20%, instead of the much higher ordinary income rates (up to 37%). To increase the likelihood of capital gains treatment, consider these strategies:

Tie earnouts to broad company financial metrics, like revenue or EBITDA, instead of individual performance.
Define clear performance goals that aren't connected to personal contributions.
Properly document the earnout as part of the purchase price and not as compensation.
Keep the earnout period separate from any employment agreements.

These steps can make a big difference, but navigating the rules requires expertise to ensure compliance and maximize your tax advantages.

Why You Need Tax Experts

Earnout taxation is tricky, and getting it right means seeking advice early. Tax professionals can help structure earnouts to meet IRS requirements, document them properly as part of the purchase price, and minimize the risk of audits.

For example, Phoenix Strategy Group specializes in creating earnouts that are tax-efficient and fair for both sellers and buyers. Their process focuses on setting clear financial metrics to support capital gains treatment while preserving the overall value of the deal. Their expertise can make all the difference in achieving a favorable outcome.

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Earnout Tax Examples

Capital Gains Cases

In 2024, TechCare Solutions sold for $10 million upfront with an additional $3 million earnout tied to EBITDA targets over two years. Because the earnout was based on overall business performance and kept separate from employment agreements, it qualified for capital gains tax at 20%, instead of the higher 37% rate. This approach shows how thoughtful structuring can lead to lower taxes.

Another example comes from Industrial Components Corp's 2023 sale. They included a $5 million earnout contingent on meeting specific revenue milestones within 18 months. By documenting the earnout as part of the purchase price and ensuring it wasn’t tied to the seller’s consulting role, they secured capital gains treatment - cutting the seller's tax bill by $850,000.

Ordinary Income Cases

Earnouts tied to employment are taxed as ordinary income, as seen in the 2023 sale of Marketing Dynamics. The seller agreed to a $2 million earnout based on managing client relationships and maintaining revenue while serving as Chief Strategy Officer. Because the earnout was directly linked to personal services, the IRS classified it as compensation, resulting in a 37% tax rate plus payroll taxes.

Similarly, in 2024, Digital Solutions Group structured a $1.5 million earnout around the founder’s role as head of product development. The earnout’s connection to employment terms and project deadlines led to its classification as ordinary income.

These cases highlight how proper structuring and expert advice can make a big difference in reducing tax burdens during M&A transactions. Strategic planning is essential to avoid unnecessary tax costs.

Main Points

Understanding how earnouts are taxed is essential for business owners involved in M&A transactions. The tax rate difference - capital gains (up to 20%) versus ordinary income (up to 37%) - can have a big impact on the money you actually take home after a sale.

When earnouts are tied to metrics like revenue or EBITDA, they are more likely to qualify for capital gains tax treatment. This approach not only helps secure lower tax rates but also aligns the goals of buyers and sellers.

Earnouts are becoming a common feature in M&A deals, which makes their tax classification even more important. As highlighted earlier, structuring these agreements with clear performance metrics and thorough documentation can help minimize tax liabilities.

Action Steps

To get the best tax outcome for earnouts, consider taking these steps:

Work with tax professionals early to avoid unexpected reclassification issues. Properly linking earnouts to business performance rather than personal services is key for securing favorable tax treatment.
For more complex deals, consult specialized advisory firms. For example, Phoenix Strategy Group offers M&A support, helping with earnout structuring and tax planning.
Plan for multi-year tax implications, including state taxes and potential changes in tax laws.

Additionally, focus on these strategies to ensure compliance and tax efficiency:

Tie earnouts to clear, measurable performance metrics.
Keep them separate from employment agreements.
Use well-documented methods to determine business valuation.
Set specific timelines for performance milestones and payments.
Include detailed reporting and verification processes.

FAQs

How are earn-out payments taxed in M&A transactions?

Earn-outs tied to the purchase price and based on business performance are taxed at capital gains rates (15-20%). However, if they’re connected to employment or services, they’re taxed as ordinary income - up to 37%, plus an additional 3.8% NIIT.

What Makes the Difference?

Whether the earn-out is tied to business metrics or personal services
Separation from employment agreements
Clear valuation documentation
Defined performance timelines

"The tax rate gap between capital gains and ordinary income (up to 20%) highlights the need for strategic earn-out planning."

Structuring earn-outs with clear business-focused metrics and proper documentation can make a big difference in tax treatment. Here's a quick comparison:

Aspect	Capital Gains Treatment	Ordinary Income Treatment
Tax Rate	15-20%	Up to 37%
Additional Tax	3.8% NIIT possible	Self-employment tax may apply
Key Requirements	Linked to business performance	Connected to personal services
Documentation	Focused on business valuation	Employment-related agreements
Payment Timeline	Typically shorter term	Often longer term

Specialized advisors can help structure earn-outs to reduce tax burdens and comply with IRS rules. With the right approach, you can maximize after-tax proceeds and achieve better financial outcomes.