Service-related earnouts: contingent purchase price vs. compensation.

• Author: Delgado, Robert W.

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), available at tinyurl.com/ms2rzlx). As a result, a buyers 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...