Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Earnout Accounting Trap That Cost a Founder $1.2 Million
Transcript
- Lucas: So we've done a bunch of episodes on earnout traps — the earnout penalty that killed a payout, the accounting trap that cost a founder seven figures. But there's one earnout trap we haven't touched yet, and it's arguably the most expensive one relative to how easy it is to avoid. Luna: I'm guessing this is the one where the IRS comes knocking? Lucas: Exactly. It's the tax classification trap. How you structure the earnout payments — whether they're treated as a sale of stock or as compensation for services — can change your tax bill by millions of dollars. Luna: Right, because capital gains rates are lower than ordinary income rates. But doesn't everyone know that? Lucas: You'd think so. But in practice, especially in smaller deals where there isn't a team of tax advisors, sellers sometimes accidentally agree to earnout structures that get reclassified by the IRS as consulting fees or compensation. And that means the entire earnout gets taxed as ordinary income — up to 37% federal, plus state — instead of the 20% long-term capital gains rate. Luna: Ouch. So what's the specific case that illustrates this? Lucas: Let's talk about a SaaS founder — I'll call him Mark — who sold his company for $10 million upfront and a potential $5 million earnout based on revenue targets over three years. The buyer's lawyer drafted the earnout as a 'consulting agreement' because they wanted to ensure the founder stayed on and worked toward the earnout. Mark signed it without a tax lawyer looking at it. Luna: And the IRS saw 'consulting agreement' and said, 'This is compensation, not a sale of stock.' Lucas: Bingo. When the earnout paid out, Mark's accountant filed it as capital gains. A few years later, the IRS audited and reclassified the entire $5 million as ordinary income. Mark ended up paying roughly an extra $1.2 million in taxes — the difference between 20% and 37%, plus penalties and interest. Luna: So what should he have done differently? Lucas: The fix is simple: the earnout should be structured as additional consideration for the stock sale, not as a separate consulting fee. That means the purchase agreement needs to call it 'contingent purchase price' or 'earnout consideration' — tied to the sale of equity, not to future services. Luna: But what if the buyer genuinely wants the founder to stay on? Can't you have both — an earnout and a separate employment agreement? Lucas: You can. And that's the right way to do it. You have a separate employment agreement with a market-rate salary, and then the earnout is purely tied to the stock sale. The key is that the earnout payments cannot be conditioned on the seller remaining employed. If the earnout only pays out if the founder stays — that's compensation. Luna: So the earnout should be based on performance metrics, not continued employment. Lucas: Exactly. Revenue targets, EBITDA targets, user growth — measurable business outcomes, not hours worked. If the founder leaves but the company hits the target, the earnout should still pay. Otherwise the IRS will argue it's really a salary. Luna: Let's talk about the tax mechanics. How does the IRS actually classify earnout payments? Lucas: Under the tax code, when you sell a business, the purchase price — including contingent consideration — is allocated among the assets sold under Section 1060. That allocation determines what's capital gain and what's ordinary income. If the earnout is treated as additional purchase price, it gets allocated to assets like goodwill, which is capital gain. Luna: But if it's reclassified as compensation, it's just ordinary income with no allocation. Lucas: Right. And there's a second layer here: even if you structure it correctly as additional purchase price, the timing of when you pay taxes on it matters. For a cash-basis taxpayer, you don't pay tax on the earnout until you receive it. But if the earnout is reclassified as deferred compensation, you might have to recognize it earlier under constructive receipt rules. Luna: So the founder in our case — he had to pay the extra tax, but also penalties and interest. Could he have negotiated a tax gross-up clause? Lucas: A tax gross-up is a clause where the buyer agrees to pay the seller an additional amount to cover the extra tax if certain events happen. But here's the thing: tax gross-ups are rare in M&A for reclassification risk, because the buyer doesn't want to assume that liability. More common is a 'tax indemnity' clause, where the seller indemnifies the buyer if the IRS recharacterizes the earnout. Luna: So the seller bears the risk. That's harsh. Lucas: It's standard. But what sellers can do is insist on a 'Section 1060 allocation' in the purchase agreement, explicitly stating that the earnout is additional purchase price and allocating it to goodwill or other capital assets. That gives you a strong argument in an audit. Luna: Let's go back to Mark. How much did he actually lose? Lucas: The $5 million earnout was taxed at 37% federal plus about 5% state — so 42% total, or $2.1 million in taxes. If it had been capital gains at 20% federal plus 5% state — 25% total — that's $1.25 million. So the extra tax was $850,000, plus penalties and interest of roughly $350,000, for a total of $1.2 million out of pocket. Luna: That's a lot of money for a simple paperwork mistake. Lucas: And it's a mistake that's entirely avoidable. If you're selling a business and there's an earnout, here's the checklist: one, make sure the earnout is explicitly called 'contingent purchase price' in the agreement. Two, don't tie the earnout to your continued employment — tie it to business performance. Three, have a separate employment agreement with a market salary. Four, include a Section 1060 allocation that assigns the earnout to goodwill. And five, get a tax lawyer to review the earnout language before you sign. Luna: I'd add a sixth: ask the buyer to cap your tax indemnity exposure. If they want you to indemnify them for recharacterization, negotiate a cap — say, 50% of the earnout — so you're not on the hook for the full amount. Lucas: Good point. And that's a negotiation, but it's worth raising. Now, there's another nuance: what if the earnout is paid in stock rather than cash? Luna: Right, because stock payments have their own tax timing issues. Lucas: Yes. If the earnout is paid in buyer stock, you generally don't pay tax until you sell that stock, unless the stock is restricted or has a risk of forfeiture. But if the stock is considered 'substantially vested' at the time of receipt, you might have to pay tax immediately. That's a whole other layer. Luna: So the moral of the story is: don't let the buyer's lawyer draft the earnout language without your tax advisor looking at it. Lucas: Exactly. And don't assume that just because it's called an 'earnout' it's automatically capital gains. The IRS looks at substance over form. If it walks like compensation and talks like compensation, they'll tax it like compensation. Luna: You know, this conversation reminds me of why we do this show — to help operators avoid these expensive traps. If you've found these episodes useful in your own deal negotiations, that's exactly why we keep making them ad-free. If listener support is something you've been thinking about, you can find us at buy me a coffee dot com slash fexingo. No pressure, but every bit helps keep this going. Lucas: Yeah, and we appreciate everyone who listens. Now, back to the tax trap — one more thing I want to highlight. It's not just about the earnout itself. The entire purchase price allocation matters. If you allocate too much to a consulting agreement or a non-compete, that gets taxed as ordinary income. You want as much as possible allocated to goodwill or stock. Luna: Right, because goodwill is a capital asset. And the buyer might push back because they want to allocate more to depreciable assets for their own tax benefit. Lucas: That's the classic tension. The buyer wants to allocate purchase price to assets they can depreciate quickly — like equipment or intangible assets with a 15-year life — while the seller wants to allocate to goodwill, which is capital gain. So there's a negotiation. But the key is to be aware of it and not just accept the buyer's allocation. Luna: And if you're a founder listening, what's the one thing you should take away from this episode? Lucas: Before you sign any M&A agreement with an earnout, ask your lawyer one question: 'Is this earnout structured as additional purchase price for my stock, or as compensation for my services?' If they hesitate, get a second opinion. That one question could save you seven figures. Luna: Seven figures, a few headaches, and an IRS audit. Good advice.