Earn-outs with continued employment purchase price or compensation

Contingent payments are a common part of an M&A transaction. However, the tax treatment of the contingent payments will depend on the facts of the agreement and can impact both buyer and seller. When engaging in acquisitions involving contingent payment transactions such as earn-out payments, whether an equity deal or asset deal, it is critical to identify as early as possible whether the payments represent (i) deferred purchase price, eligible for installment sale treatment, (ii) payments as compensation for continued employment, or (iii) payments for a non-compete covenant. 

A buyer and seller unable to agree on a purchase price often include contingent payment clauses such as earn-outs. For example, if the seller asks $100 million for the business and the buyer is only willing to pay $85 million, they may agree to a fixed price of $85 million plus an earn-out to pay up to an additional $15 million, contingent on the occurrence of certain earnings, sales, or other income-based metrics. But aside from the realization of one of these milestones, the contingency sometimes also depends on other factors, such as the continued employment of the owner-employees.                        

In acquisitions in which the owner-employees played an integral part in the operation of the acquired business, the buyer and owner-employees sometimes execute a non-compete covenant in connection with the acquisition. In such a situation, the parties must determine whether to treat the non-compete covenant as part of the purchase of the business goodwill, or rather as a separate compensatory arrangement. This determination can significantly change the tax treatment to both the owner-employees and buyer, as discussed in this article.

In some acquisitions, the buyer seeks more than a non-compete; the buyer desires the continued provision of services by the owner-employees. Accordingly, the buyer may include a provision in the purchase agreement that requires the owner-employees to remain employed by the company until a specified date to be eligible to receive earn-out payments. In such a scenario, earn-out payments are made only if both (i) specified income-based milestones are achieved, and (ii) the owner-employees remain employed. Such a provision is intended to incentivize owner-employees to remain with the company post-acquisition.

Under such a scenario, the question arises whether the proper characterization of these earn-out payments is deferred purchase price or compensation for services.

Tax treatment under each approach

Distinctions between treatment as purchase price versus as compensation include:

• If the payments are deferred purchase price, the owner-employees generally recognize capital gain or loss on the receipt of the payment (although in the case of an asset purchase, some of the gain or loss could be ordinary, such as amounts related to depreciation recapture and inventory). The buyer capitalizes the payments into the tax basis of the acquired equity (or assets, in the case of an asset purchase).
• If the payments are compensation for services, the owner-employees recognize ordinary income and the buyer receives an ordinary business deduction. Additionally, the buyer is required to withhold and pay applicable withholding taxes on all compensation. Finally, the payments may be subject to the section 280G deduction limitation on excess parachute payments and the section 409A nonqualified deferred compensation rules.

Preferences of sellers and buyers include:

• Sellers generally prefer to emphasize the element of deferred purchase price, as compensation for services is taxed at ordinary income rates while purchase price payments are generally taxed at capital gains rates and are not subject to payroll tax.
• Buyers generally prefer to emphasize the element of compensation for services, for non-tax motivations, as buyers generally focus on ensuring the success of the acquired business; tying the earn-out to continued services is intended to accomplish that goal. Additionally, payments of compensation are immediately deductible, while payment for purchase price must be capitalized.

Background law

Depending on the individual facts, earn-outs with employment contingencies may result in treatment as deferred purchase price or as compensation for services.

The earn-outs may result in treatment as purchase price. Under general tax principles, the tax character of a subsequent event can be tied to an earlier transaction based on the origin of the claim doctrine, first set forth in Arrowsmith v. Commissioner, 344 U.S. 6 (1952). In Arrowsmith, taxpayers obtained favorable capital gains treatment upon the liquidation of a corporation. They later attempted to deduct a loss stemming from an adverse legal judgment against the liquidated corporation as an ordinary business loss. The Supreme Court held that the later payment related to the earlier liquidation transaction and should be classified as a capital loss. Likewise, in the case of earn-outs with continued service contingencies, under appropriate circumstances payments in subsequent years relate to the earlier purchase of the company and should be treated as deferred purchase price.

Under other circumstances, the payments are more akin to compensation for services. The Code defines “wages” broadly to include ‘‘all remuneration. . . for services performed by an employee ...’’ (emphasis added). Section 3401(a). The regulations elaborate: ‘‘The name by which the remuneration for services is designated is immaterial. Thus, salaries, fees, bonuses, commission on sales or on insurance premiums, pensions, and retired pay are wages within the meaning of the statute if paid as compensation for services performed by the employee for his employer.’’ Reg. section 31.3401(a)-1(a)(2). Other compensation provisions likewise have broad scopes, including Reg. section 1.61-2 (compensation for services), and section 83 (property transferred for the performance of services). Under these provisions, in appropriate circumstances, earn-outs with continued service contingencies should be treated as wages instead of deferred purchase payments.

So how do we determine the correct treatment?

Under general federal tax principles, the correct treatment of payments depends on the objective intention of the parties involved. In Comm'r v. Duberstein, for example, after a business owner transferred a Cadillac to his business associate for vague reasons, the question arose as to whether the transfer constituted a taxable payment for business information or a non-taxable gift. The Supreme Court held the transfer was a taxable payment and stated that the critical consideration is the transferor's intention—“the dominant reason that explains his action in making the transfer”—and that each scenario must be considered on a case-by-case basis. 363 U.S. 278 (1960).

One case that considered a variation of this question is Lane Processing Trust v. United States, in which an employee-owned business sold assets and distributed the proceeds to the owner-employees. The right to the proceeds, however, was contingent upon the continued employment of the owner-employees, and the precise amount earned by each owner-employee depended on the owner-employee’s place of employment, length of employment, and job classification. The court held that these payments constituted wages, as 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 court held that the payments more closely aligned with compensation for services than with deferred purchase price. 25 F.3d 662 (8th Cir. 1994).

A key factor courts consider is whether the amount of the payments represent reasonable compensation for the services provided. In Yelencsics v. Comm'r, for example, in which the sole shareholder of an acquired corporation received payments contingent on a consultation arrangement, the court held the amount resembled reasonable consulting payments and should be treated as such. 74 T.C. 1513 (1980). Similarly, in Estate of Morris v. Comm'r, the court held that payments to the sole shareholder of an acquired corporation for consultation services, although entered into to enable the buyer to retain a valuable customer list, most resembled compensation and should be treated as such. 46 T.C.M. 993 (1983). Where, however, the payments exceeded reasonable compensation for services provided, courts have been less likely to treat the payments as compensation. In Freeport Transp., Inc. v. Comm'r, for example, the court held that payments termed as “wages” were disproportionate to reasonable compensation and should be treated as purchase price payments. 63 T.C. 107 (1974).

However, establishing a payment could represent reasonable compensation is not the only dispositive factor. See, e.g., Twin City Tile and Marble Co., 32 F2d 229 (8th Cir. 1929), aff'g 6 B.T.A. 1238 (1927) (where employee-owners received a monthly salary increase equal to a percentage of their shares, court considered all factors and held payments were dividends even though the amounts received could have been reasonable compensation).

Fact-specific considerations

In line with the above, tax practitioners must look to the facts of the individual case to determine whether the payments more closely resemble employment compensation or deferred purchase price. Considerations include:

1. Where the amount of the earn-out is similar to typical employment compensation, the payments likely represent employment compensation. Where, however, the amount of the earn-out is far in excess of typical and reasonable employment compensation, it may be deferred purchase price.
2. Where the earn-out for all owners is subject to the continued employment of only a few key owner-employees, the argument for deferred purchase price treatment is stronger. In assessing this, it is important to understand how many owners there are in total, how many owner-employees remain employed by the company post-acquisition, and whose services are specifically tied to the earn-out.
3. Where the earn-out for all owners is reduced when each owner-employee terminates employment, the argument to treat the payments as deferred purchase price is stronger. If, for example, the termination of each of twenty owner-employees reduces earn-out payable to all owners by 5%, it may be appropriate to treat the payments as contingent payments for a workforce asset. The termination of each employee thus reduces purchase price allocable to the workforce asset. (If, however, the owner-employees entered into side agreements stating that one who terminates employment must compensate the others for their attendant loss of earn-out, the validity of this approach is diminished.)

Pre-acquisition planning

When provided with the opportunity to advise parties contemplating an acquisition involving continued employment of owner-employees, rather than confronting the issue after it falls into ambiguous territory, advisors can choose from one of the following approaches during the initial negotiating stages. The use of one of these approaches can enable definite treatment. Additionally, several of these approaches eliminate or mitigate the undesirable result to the owner-employees of ordinary income treatment.

1. Instead of a contingency for continued employment, a buyer can utilize a covenant not to compete to ensure the owner-employees remain with the company. The buyer would amortize the covenant over fifteen years and the owner-employees would recognize ordinary income on each payment. However, if not structured properly, a covenant not to compete entered into with continuing employees can itself raise questions as to treatment, as discussed in this article, cited above.
2. Instead of purchase price payments contingent on continued employment, a buyer can include as part of the payment package restricted equity in the buying company. The equity can be subject to forfeiture depending on both the company’s future earnings and continued employment of the owner-employees. The equity holder may be able to argue that the restricted equity has a low value due to the earn-out contingency (but not due to the continued employment contingency). Accordingly, although the equity would be treated as employment compensation under section 83, the amount taxed may be minimized by using the value at grant rather than the future value at vesting through use of a section 83(b) election which applies tax at the time of grant instead of upon the subsequent lapse of the restriction. In addition, the owner-employees may be entitled to capital gain treatment on the subsequent sale of the restricted equity. See this article for further details regarding the section 83(b) election. (Obviously, the parties would need to consider the economics of a restricted equity grant instead of a cash payment.)
3. While often difficult to implement and requiring significant analysis, a buyer can include as part of the payment package a seller note contingent on continued employment and subject to personal recourse that operates like an earn-out. The buyer may be able to make a section 83(b) election to lock in the value of the note when it is issued instead of when it subsequently vests. The receipt of payments under the note would then be taxed based upon its value at the time of grant instead of upon the subsequent lapse of the restriction.
4. The purchase agreement can expressly state that the contingent payments are compensation for services and the payments can be structured to resemble employment compensation. The parties can offset the advantage to the buyer (of an immediate deduction) and disadvantage to the owner-employees (of ordinary income treatment) by agreeing that the buyer pay a gross-up to the owner-employees. The gross-up would equal all or a portion of the differential to the owner-employees of tax on ordinary income versus capital gains.
5. The earn-out can be structured so that the earn-out for a particular owner-employee is not tied to the services of that owner-employee. As described above, the determination of purchase price versus compensation is dependent upon all factors. If the earn-out for all owners is subject to the continued employment of only a few key owner-employees, the factors weighing towards compensation are reduced.   

If, based on the factors noted above, the parties believe tax law treats the payments as purchase price payments, the purchase agreement should be drafted so as to maximize support for such treatment. For example:

1. The purchase agreement recitals and definitions should clarify that the intent of the earn-out is not compensatory in nature but rather to protect the buyer’s significant investment in the acquired business.
2. The purchase agreement should include language stating that the buyer is not paying separate consideration for the future employment and that the earn-out payments are part of the overall purchase consideration paid for the business. Such language can support the claim that the earn-out is not a separately bargained-for compensatory arrangement but is rather inseparable from the purchase price.
3. The purchase agreement should include a specific business value attributed to the contingent payments. While not binding upon the IRS, an agreement by the parties as to the value of the business represented by the earn-out payments may help to defend their treatment as part of purchase price.

Additionally, the buyer should pay owner-employees reasonable compensation for their services, apart from payments they receive due to the earn-out.

Conclusion

Taxpayers and advisers should pay close attention to earn-out clauses during the initial stages of purchase price negotiations, and should ensure the intent and substance of the arrangement control the tax treatment.