Make a deal
Are you interested in selling (or buying) a business interest in Texas? The gap between how much the buyer is willing to pay and how much the seller expects to receive can be bridged by incorporating creative options into the purchase agreement.
A portion of the sales price is typically withheld in an escrow account or paid from future operating cash flow with an earnout, but only if certain predetermined financial benchmarks are achieved. An earnout allows a seller with optimistic sales projections to achieve a higher selling price by bearing some risk that the business will perform as expected. On the flip side, an earnout lowers the risk that the buyer will overpay for a company that doesn’t achieve its projections.
However, there are some disadvantages to earnouts. When the earnout is due, the parties may disagree about how to verify financial performance, and earnouts also bring complicated tax issues to the negotiating table. For instance, will earnout payments be considered compensation for services or as additional sales proceeds? The seller and buyer have competing interests on this matter.
When and if earnout payments are treated as compensation, the seller reports them as ordinary income, which is taxed at a higher rate than capital gains. The seller also owes employment taxes on the income (or self-employment tax if not an employee of the seller). The buyer gets a deduction for any amount treated as compensation or the amount paid to the seller as consulting fees. The buyer will also be responsible for the payroll taxes associated with such payments, to the extent any earnout payment is treated as compensation
If earnouts are treated as additional sales proceeds (not as compensation), the seller may qualify for (lower) capital gains treatment. But the buyer receives only an increased tax basis in his or her investment.
Also, if the earnout payment isn’t made before year end, complex tax rules could apply. The rules differ depending on whether there’s a determinable maximum selling price and/or a fixed payment period.
Sellers of certain eligible property can recognize the tax gains or profits from installment sales proportionately over time under the installment method of reporting the transaction. Since the installment method also gives the buyer a fully stepped-up basis in the acquired property, they can take depreciation deductions based on the purchase price, even though the full amount wasn’t exchanged at closing.
When the buyer has limited access to bank financing, installment sales can be advantageous in getting a deal done. In effect, the seller is financing the deal and bears some default risk.
Installment sales can also save tax for the seller if tax rates fall. Conversely, they can be costly if tax rates increase. Another tax consideration for sellers is that depreciation recapture must be reported as gain in the year of the sale — even if it exceeds the installment payment the seller receives that year.
However, be aware that not all transactions are eligible for the installment method. For example, inventory sales and transactions involving related parties are ineligible.
Consulting agreements and restrictions
The seller can serve as an employee or consultant to facilitate the change in management after closing. Continued involvement by the seller with the business can minimize disruptions, reduce turnover, and build trust with long-term employees, suppliers and customers.
Conversely, the seller could use his or her business contacts and specialized knowledge to start a competing business. If so, the buyer should consider adding restrictive covenants — such as noncompete or nonsolicitation provisions — to the purchase agreement that prevent the seller from: 1) diverting business opportunities from the company, 2) working for any competitors within a negotiated distance of the business, or 3) soliciting the company’s employees to leave the business to work for the seller or any affiliated entity.
Negotiating in advance how much of the purchase price to allocate to consulting agreements and restrictive provisions, is quite helpful. These allocations will have tax and financial reporting consequences, so it’s important to get the allocations right.
A valuation specialist can help you understand the financial implications of creative deal terms, because negotiating the optimal deal structure takes time, patience and financial know-how.