Negotiating an earn-out fee when selling your business
If you are currently selling your business and negotiating an earn-out fee as part of the sale, this could increase the amount the buyer pays for your business.
When you sell your business, an earn-out fee is where a portion of the money you receive for the sale is based on the business’ performance after the sale.
For example, in selling your business the purchaser may agree to pay $500,000 up front and then an extra $50,000 if the business continues with its current level of sale for each of the next two years. Under this agreement, you would receive the $500,000 when you sell and then an extra $25,000 in 12 months’ time and then another $25,000 in two years’ time. The risk of course is that the business doesn’t maintain its sales and you don’t receive the extra amounts.
So how does an earn-out fee impact the tax you pay?
An earn-out fee will determine the capital gains tax (“CGT”) you may pay on the sale of your business. CGT on a business sale can be complicated, but essentially it’s the tax you pay on the profit you make selling your business.
With an earn-out, you first calculate the capital gain based on the original amount you receive. Then, if the sales are maintained and you receive the extra amounts, you need to go back and amend your tax return for each amount you receive.
Using the above example, and assuming that the capital gain equals the sale price, you would initially pay CGT on $500,000. Once the sales target is achieved and you receive the first earn-out fee, you go back and amend your original tax return to include the gain now being $525,000. When you receive the second amount, you amend the return again and the gain becomes $550,000. If the sales aren’t maintained and you don’t receive the earn-out fee, then there is no need to amend your return.
Earn-out fees are a complex issue and I suggest you consult your accountant or tax advisor before making any decisions.