Earnout Payments: Tax as Compensation vs. Capital Gains

Earnout payments in business sales can be taxed as compensation (ordinary income) or capital gains (lower tax rates). Here's what you need to know:

Compensation Taxation: Up to 37% federal tax, plus employment taxes like FICA (7.65%). Example: A $1,000,000 earnout could leave less than 55% after taxes.
Capital Gains Taxation: 15–20% federal tax, plus 3.8% Net Investment Income Tax (NIIT) for high earners. Example: A $1,000,000 earnout taxed at 20% leaves around 76%.
Key Factors: Payments tied to employment are taxed as compensation, while payments based on business performance may qualify as capital gains.

Quick Comparison

Aspect	Compensation	Capital Gains
Federal Tax Rate	Up to 37%	15–20%
Additional Taxes	7.65% FICA	3.8% NIIT (if applicable)
Timing	Taxed when received	Can defer using installments
Basis of Taxation	Entire payment	Gain above cost basis

To reduce taxes, structure earnouts based on business performance, not employment, and ensure contracts clearly define payments as part of the purchase price.

How Earnouts Are Taxed

The way earnouts are taxed can significantly impact the seller's final proceeds. Here's a breakdown of the differences between taxation as regular income and as capital gains.

Taxation as Regular Income

If earnout payments are classified as compensation, they face federal tax rates of up to 37%. On top of that, employment taxes like the 7.65% FICA tax (covering Social Security and Medicare) apply, along with state and local taxes - or self-employment tax, if relevant. For example, a $1,000,000 earnout treated as compensation could leave the seller with less than 55% after taxes.

Taxation as Capital Gains

Capital gains are taxed at lower rates compared to regular income. Long-term capital gains are taxed at 15% to 20%, depending on income, with an additional 3.8% Net Investment Income Tax (NIIT) potentially applying to high earners.

Here's a simplified comparison of the two tax treatments:

Tax Component	Taxed as Compensation (Regular Income)	Taxed as Capital Gains
Federal Income Tax Rate	Up to 37%	15–20%
Additional Taxes	About 7.65% FICA	3.8% NIIT (if applicable)
Total Potential Tax	Around 44.65%	Approximately 18.8–23.8%

For a $1,000,000 earnout taxed at a 20% capital gains rate (plus 3.8% NIIT, if applicable), the seller could retain roughly 76% of the payment.

The experts at Phoenix Strategy Group can help structure earnout agreements to reduce tax burdens while staying compliant with IRS regulations.

What Determines Tax Classification

The IRS evaluates several factors to decide if earnout payments are taxed as capital gains or compensation income. These factors include employment ties, how payments are distributed among shareholders, and the terms of the agreement. Knowing these details can help structure deals in a way that aligns with preferred tax outcomes.

Employment Requirements

If earnout payments are tied to the seller’s continued role in the company, the IRS often treats them as compensation income. For example, if a seller is required to stay in a leadership position, the payments are likely to be considered compensation.

To support capital gains treatment:

Link payments to the company’s overall performance, not individual roles
Ensure payments are not dependent on employment status
Use company-wide goals as the basis for payments instead of personal achievements

Payment Distribution

The way payments are distributed among shareholders plays a big role in tax classification. If payments align with the original equity ownership, they are more likely to be treated as part of the purchase price rather than compensation.

Distribution Characteristic	Likely Capital Gains	Likely Compensation
Recipient Group	All shareholders based on ownership %	Only working shareholders
Payment Timing	Fixed schedule or milestone-based	Linked to employment periods
Basis of Distribution	Business performance metrics	Individual performance metrics

The next step is to examine how payment terms influence tax treatment.

Payment Terms

Payment terms are a key factor in determining how earnout payments are taxed. Payments based on objective performance metrics, without adjustments for employment status, generally lean toward capital gains treatment. On the other hand, reductions tied to employment termination suggest compensation income.

To support capital gains treatment:

Use objective financial metrics as the basis for payments
Clearly tie payments to the purchase price of the business
Ensure payments are unaffected by employment status

Phoenix Strategy Group advises structuring earnout agreements to focus on the business sale rather than future services. This approach aligns with capital gains treatment while staying within IRS guidelines.

When Earnouts Are Taxed

The timing of tax payments for earnouts depends on whether they’re classified as compensation or capital gains. This distinction plays a key role in cash flow planning and tax strategy. Here’s a closer look at how the timing works for each.

Income Tax Timing

Earnouts treated as compensation are taxed in the year they’re received, similar to a salary or bonus. Sellers report these payments as ordinary income for that tax year.

Capital Gains Timing

For earnouts classified as capital gains, taxes can often be deferred using the installment sale method. This allows sellers to spread their tax liability over several years, making it easier to manage cash flow.

To make the most of these timing differences, Phoenix Strategy Group advises structuring earnout agreements with clear payment schedules and performance metrics. This approach helps sellers maintain steady cash flow while ensuring the tax treatment aligns with their goals, avoiding any surprise liabilities.

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Tax Treatment Comparison

How earnouts are taxed can greatly affect the amount you keep from an M&A transaction.

Side-by-Side Tax Comparison

Here’s a quick breakdown of how earnout payments are taxed under two different treatments:

Aspect	Compensation Treatment	Capital Gains Treatment
Tax Rates	Ordinary income rates and employment taxes	Lower long-term capital gains rates
Medicare/Additional Taxes	May trigger Medicare surtax above certain thresholds	May trigger net investment income tax above certain thresholds
Tax Basis	Entire payment taxed as ordinary income	Only gain above cost basis is taxable
Payment Timing	Tax due when payment is received	May allow for deferring tax liability
Deductibility	Buyer can deduct as a business expense	Not deductible for the buyer
Social Security/Medicare	Subject to payroll taxes	Not subject to payroll taxes

This comparison highlights the importance of planning ahead when structuring earnouts. Taxing earnouts as compensation leads to a much heavier tax burden, cutting into your net proceeds.

Phoenix Strategy Group recommends starting the planning process early to design earnout agreements that minimize tax impact and maximize your returns.

How to Plan for Better Tax Results

Deal Structure Tips

Getting the structure of an earnout right requires careful planning from the start. To set yourself up for success, consider these strategies:

Focus on metrics tied to overall company performance, not individual achievements.
Set clear financial goals, such as revenue or EBITDA targets.
Avoid linking earnouts to continued employment or personal services.
Structure payments as adjustments to the purchase price, based on how the business performs.

The goal is to show that earnouts are deferred purchase price adjustments - not hidden compensation. These choices impact how clear and effective your contract will be, which brings us to the next point.

Contract Language

The way your contract is written plays a big role in ensuring the right tax treatment. To avoid confusion or misclassification, your agreement should:

Clearly state that earnout payments are part of the purchase price.
Avoid mentioning future services or employment requirements.
Use straightforward formulas to calculate earnouts based on business metrics.
Keep employment agreements separate from earnout provisions.
Stick to terminology that aligns with purchase price adjustments.

Clear and precise contract language makes it easier for advisors to fine-tune the details of your deal.

Professional Help

Since tax treatment depends heavily on your deal’s structure and wording, working with experts can help you achieve better outcomes. Phoenix Strategy Group specializes in guiding businesses through the complexities of M&A deals.

"PSG and David Metzler structured an extraordinary M&A deal during a very chaotic period in our business, and I couldn't be more pleased with our partnership." - Lauren Nagel, CEO, SpokenLayer

Here’s how expert advisors can assist:

Provide guidance on structuring and documenting your deal.
Help you plan strategically to maximize after-tax proceeds.
Support you during negotiations.
Align finance and revenue teams effectively.
Prepare your business for a smooth exit.

Key Points to Remember

Here’s a concise breakdown of the main takeaways:

Understanding the tax implications of earnouts is critical for getting the most out of M&A transactions. Whether payments are taxed as compensation or capital gains can have a big effect on your after-tax income.

Key factors affecting earnout classification:

Employment ties: Avoid linking payments to ongoing employment.
Payment distribution: How and when payments are made matters.
Contract terms: Precise language in the agreement is crucial.

Ensure the purchase agreement clearly states that earnouts are part of the purchase price. Avoid any references that tie payments to future services or employment.

Earnout structuring tips:

Base earnouts on business performance metrics, not personal achievements. This helps ensure payments are treated as part of the purchase price rather than as compensation.

Timing considerations to keep in mind:

Capital gains may qualify for installment sale treatment, spreading tax liability over time.
Compensation income is taxed as it’s received, impacting cash flow planning.

Working with seasoned advisors, such as Phoenix Strategy Group, can help you structure agreements that align with your tax goals and optimize your overall exit strategy.