Including an earn-out provision in a corporate sale transaction can be an effective way to ensure a smooth and efficient transfer of a company. However, it may also introduce significant tax challenges. As such, it’s important to approach the inclusion of such a provision with careful consideration.
Earn-Out in M&A Transactions
In M&A negotiations, the focus is often on agreeing on the purchase price. A common provision is that the seller, in addition to receiving a fixed purchase price, is entitled to an "earn-out" payment. This payment is contingent on achieving predefined performance targets after the transaction has closed. This provision motivates the seller to remain involved post-closing to ensure the company’s continued success. Earn-out arrangements are often paired with temporary employment or service agreements between the company and the individual seller.
However, it’s crucial to understand that including (and paying out) an earn-out can lead to unexpected tax consequences. Therefore, the parties should prepare for these issues in advance and structure their transaction accordingly.
Taxation of the Purchase Price – 15% Personal Income Tax
When the parties agree on a fixed purchase price, the tax implications for the individual seller are relatively predictable. The difference between the sale price and the acquisition cost of the shareholding—i.e., capital gains—is subject to a 15% personal income tax (PIT). Additionally, a limited social contribution tax (SCT) liability may arise if the seller has not otherwise paid the social contribution tax on an annual income amounting to 24 times the minimum wage.
Earn-Out: Not Necessarily Capital Gains
Once the parties agree on an earn-out, the taxation of the purchase price becomes more complex. Under a lesser-known rule in the Personal Income Tax Act, a conditional variable portion of the purchase price is not taxed as capital gains but as “other income.” This classification means that, in addition to the 15% PIT, a 13% SCT liability applies to the earn-out payment. If the buyer is considered a payer, they bear the SCT liability; if the buyer is a foreign entity, the individual seller is responsible for it.
In its guidance, the tax authority has clarified what constitutes a variable purchase price component. If the parties agree on a fixed future payment contingent upon achieving a target (e.g., if the sold company’s EBITDA reaches 1,000, the seller is entitled to a 100-unit earn-out), this is not considered a variable purchase price. However, even in such cases, complications can arise: the tax must be calculated at the time of the sale as though the earn-out condition will be met, with the possibility of reclaiming tax later if the condition is not fulfilled. Thus, the individual seller must pay tax on a future, potentially unrealized income, which they may later need to recover.
On the other hand, if the future purchase price can have multiple outcomes (e.g., an earn-out of 1,000 for an EBITDA of 10,000 and 1,500 for an EBITDA of 20,000), it is classified as “other income.” Similarly, an earn-out tied to a percentage of a performance indicator (e.g., the seller is entitled to 10% of EBITDA as an earn-out) falls into this category. In all these cases, the earn-out qualifies as other income and is subject to SCT.
When Earn-Out Becomes Employment Income
The parties could face even worse consequences if the tax authority reclassifies the earn-out payment as employment income based on their agreement. In this case, the seller must not only pay the 15% PIT but also an 18.5% social security contribution, in addition to an unlimited 13% SCT liability. If there is a clear link between the earn-out payment and the seller’s employment obligation (e.g., the seller commits to working for the company during the earn-out period, and the earn-out appears to be compensation for that work), the basis for reclassification is strong.
How Can This Be Avoided?
These reclassification and over-taxation issues arise only if the seller is an individual. If the seller is a company, the earn-out amount, like the fixed purchase price, is added to the corporate seller's taxable income and taxed accordingly.
Even individuals initiating a sale process need not be alarmed. They have the option to transfer their shareholding to a holding company or place it in a trust before the transaction. This approach not only resolves the earn-out-related issues but also allows the sale to remain tax-exempt until the proceeds are distributed to the individual seller. In the case of a trust, complete tax exemption is possible, provided that the seller genuinely intends to engage in trust management and does not withdraw the proceeds within five years.