Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Tax Gross-Up Trap in M&A Earnouts
Transcript
- Lucas: There's a clause in earnout agreements that quietly shifts 20 to 30 percent of the payout from the seller to the IRS — and most sellers don't see it coming until the tax return is due. Luna: You're talking about the tax gross-up — or rather, the lack of one. Lucas: Exactly. Let's take a concrete case. In early 2025, a mid-market software company called NexusStream was acquired for $200 million, with $50 million structured as an earnout tied to revenue retention. The sellers hit every target. They got the full $50 million. But because the purchase agreement classified the earnout as compensation for services — not as additional purchase price — the entire $50 million was taxed as ordinary income, plus payroll taxes. The sellers had modeled capital gains treatment. They ended up paying roughly 15 million more in tax than they expected. Luna: And that's the gross-up issue in a nutshell. The buyer gets a deduction for the earnout payment, but the seller gets stuck with a higher tax rate. A gross-up clause would have required the buyer to increase the payment to cover that extra tax. Lucas: Right. A gross-up essentially says: 'If the tax treatment of this earnout results in a higher liability for the seller than if it were treated as purchase price, the buyer will pay the difference.' Without that language, the seller eats the delta. In the NexusStream deal, the sellers' lawyers had actually flagged the issue in the first draft. But the buyers pushed back, arguing it was standard to treat earnouts as compensation for tax purposes. The sellers — wanting to close — conceded. Luna: And the data suggests this is not rare. A 2024 study by the M&A Research Center at Wharton looked at 600 earnout agreements from 2020 to 2023. They found that 42 percent had no gross-up language at all. Another 28 percent had what they called 'weak gross-ups' — clauses that only triggered if the IRS reclassified the earnout, not just because of the default treatment. Lucas: That's a critical distinction. A weak gross-up only kicks in after an audit. By then, the money's been distributed, the deal's closed, and the seller has to chase the buyer for reimbursement under an indemnification claim — which itself has deductibles and caps. The strongest language is upfront: the buyer agrees to gross up the earnowt payment at the time of payout, based on the difference between the seller's actual tax rate and the hypothetical capital gains rate. Luna: But is that always negotiable? I've heard buyers argue that a gross-up makes the earnout an open-ended liability — they can't predict the seller's tax situation. Lucas: It's a fair pushback. But there's a standard workaround: the seller agrees to provide a tax certification or an opinion from their accountant stating their marginal rate. The buyer then calculates the gross-up based on that rate. If the seller ends up paying less — say because they had offsetting losses — they refund the excess. It's a true-up mechanism, similar to a working capital adjustment. Luna: So it's not a blank check. It's a formula. Lucas: Exactly. And that formula should be spelled out in the agreement. I've seen deals where the gross-up was calculated as: ). So for a 40 percent rate and a $10 million earnout, the gross-up would be $6.67 million. The buyer pays $16.67 million total, the seller nets $10 million after tax. Without the gross-up, the seller nets only $6 million. Luna: That's a huge swing. And it's not just software deals. Biotech earnouts, especially those structured as contingent value rights or CVRs, have the same issue. In 2023, a gene-therapy company called RegenX had a $30 million CVR tied to FDA approval. The CVR paid out, but the tax treatment was ambiguous — the IRS later ruled it was ordinary income for the former shareholders. No gross-up clause. The investors ended up with a class-action suit against the acquirer. Lucas: Right, CVRs are often structured as taxable dividends when paid, which is ordinary income for individuals, not capital gains. And many biotech sellers are individuals — founders, early employees — who don't have the same tax planning infrastructure as institutional investors. They're the ones most hurt by the lack of a gross-up. Luna: So what should a seller do before signing? Walk us through the checklist. Lucas: Step one: model both scenarios. Have your tax advisor run the numbers assuming the earnout is treated as purchase price — capital gains — and as compensation — ordinary income plus payroll taxes. The delta is your negotiating baseline. Step two: push for explicit gross-up language in the earnout section of the purchase agreement. Don't rely on general tax indemnities. Step three: if the buyer resists, offer to cap the gross-up at a percentage of the earnout, say 25 percent, so both sides have a ceiling. Step four: consider structuring the earnout as an additional equity grant or a contingent note that can qualify as installment sale treatment under Section 453. That can preserve capital gains. Luna: And what about the buyer's perspective? Are there legitimate reasons to avoid a gross-up? Lucas: From the buyer's side, a gross-up increases the total consideration — it's an additional cost. But the buyer also gets a larger deduction, because they're paying more. In a taxable acquisition, the deduction for the earnout — whether grossed up or not — is based on the actual payment. So the net after-tax cost to the buyer might be roughly the same, especially if they're in a high tax bracket. The bigger issue is administrative complexity. The buyer has to track each seller's tax status. But in most deals, there are only a handful of key sellers — founders, top executives. For them, it's worth the effort. Luna: There's also a regulatory angle. The IRS has been looking at earnout taxation. In late 2025, they proposed new guidance under Section 409A that would treat earnouts that are contingent on the seller's continued employment as deferred compensation, triggering strict compliance rules. That could change the calculus entirely. Lucas: That's a great point. If the earnout is tied to the seller staying on as an employee, Section 409A requires the payment terms to be fixed in advance — the amount, the timing, the form of payment. If those terms aren't met, the seller faces a 20 percent penalty plus interest. A gross-up won't fix a 409A violation. So sellers need to be careful: if the earnout is partly based on continued employment, the structure has to comply with 409A from day one. Luna: And a word to the wise: get that tax certification letter from your CPA before signing. Don't rely on verbal assurances from the buyer's CFO. Lucas: Absolutely. And that's the kind of practical nuance that separates a good deal from a painful one. You know, this show exists because we believe that conversations like this — specific, no-fluff — help people make better decisions. If these conversations have moved your work forward in some small way, listener support is what keeps it ad-free. A lot of listeners have been asking how they can chip in. If it's ever crossed your mind, you can buy me a coffee dot com slash fexingo. No pressure, no upsell — just a way to keep this independent. Luna: Yeah, and it genuinely makes a difference. Every contribution goes straight into research and production. Lucas: So back to the tax gross-up. I want to give listeners one more concrete example. In 2022, a manufacturing company called Polaris Components was acquired for $500 million, with $80 million in earnouts. The earnout was structured as a 'phantom equity' plan — meaning the sellers were technically employees receiving a bonus. The purchase agreement had no gross-up. When the earnout paid out, the sellers faced an effective rate of over 50 percent — federal, state, Medicare surtax, and the net investment income tax. They ended up with about $38 million after tax instead of the $53 million they'd modeled. That's a $15 million gap — roughly 30 percent of the earnout. Luna: And the buyer? They deducted the full $80 million as compensation, saving about $20 million in taxes. So the tax burden effectively shifted from the buyer to the sellers. Lucas: Exactly. And that's the core of the issue. The tax gross-up isn't about greed — it's about fairness in allocation of tax burden. The buyer gets a deduction for the payment, so they should, in principle, be indifferent to the tax characterization. But in practice, they have no incentive to fix it unless the seller demands it. Luna: One more thing: the gross-up should also cover state and local taxes. A lot of templates only reference federal. If the seller is in California or New York, that state rate can add 10 percent or more. Lucas: Good catch. I've seen gross-up clauses that say 'all taxes imposed by any taxing authority,' which covers state and local. Others limit it to federal. Sellers should push for the broad language. And if the earnout pays out over multiple years, the gross-up should be recalculated each year based on the seller's actual effective rate for that year. Luna: Let's talk about alternatives. Some sellers try to structure the earnout as a contingent promissory note that qualifies for installment sale treatment under Section 453. That keeps the gain as capital gains, but it's complex and requires the buyer to issue a note with adequate stated interest. Lucas: Right. Another alternative is to issue a 'tax indemnity' clause — separate from the gross-up — where the buyer agrees to reimburse the seller for any incremental tax caused by the earnout being treated as compensation. That indemnity itself is taxable to the seller, so it needs to be grossed up too. It can get recursive, but it's been done. Luna: And the bottom line: if you're a seller in any deal with an earnout, assume it will be taxed as ordinary income unless you have explicit language to the contrary. Don't model capital gains into your personal financial plan without a gross-up clause. Lucas: Perfectly said. And as the IRS continues to refine its stance — the proposed Section 409A rules are expected to be finalized sometime in 2027 — the earnout landscape will shift again. Sellers who stay informed will be the ones who keep their share of the upside. Luna: And that's the kind of edge this show tries to give you. Thanks for listening.