How earn-outs are taxed
When selling your business, understanding how earn-outs are taxed is crucial for avoiding costly mistakes. Whether you're negotiating cash, shares, or loan notes, proper planning will ensure compliance with HMRC and a positive outcome. This article discusses the key considerations involved.
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What is an earn-out? - Tax implications
An earn-out is essentially a contingent payment that the seller only receives from the buyer when specific performance targets are met. This deferred consideration can take the form of cash, shares, or loan notes. We discuss these different forms of consideration and how earn-outs are taxed further below:
Why are earn-outs are used?
An earn-out can prove useful where the buyer has not got the cash to pay the seller upfront.
Alternatively, the seller and buyer can't agree an upfront sales price as the buyer is uncertain about the future profits.
The different forms of earn-out
Establishing the correct consideration for the sale of a business isn't always straightforward. Factors like loan repayments, earn-outs and deferred consideration can complicate matters.
This was illustrated in the case of Michelle McEnroe & Miranda Newman v HMRC. As a result of confusion over the Sale and Purchase Agreement (SPA) the vendors underdeclared their sale proceeds. This resulted in dire consequences with HMRC.
Payment of earn-outs in cash
As mentioned previously, the earn-out can take many forms. Where the earn-out consists of a deferred cash consideration the position is as follows:
Earns-out paid as shares
When you receive an earn out as shares the tax treatment is different from the above.
Where the sale (deferred or not) consists of the buyer issuing you with its own shares, any capital gain can be deferred. This will be until the shares received from the earn out are exchanged for cash, or different shares as part of a company restructure.
Payment of earn-outs as loan notes
If your earn out is paid as loan notes, a proportion of the gain can also be deferred until the loan notes are redeemed.
As it may not be possible to claim Business Asset Disposal Relief at a later on the earn out, you can therefore elect in both cases to have the whole sale consideration taxed in the same year.
The structuring of an earn-out
An earn-out can be structured in many different ways. These are subject to negotiation but dependent on the parties’ short-term intentions which can be conflicting.
A buyer will want to retain the seller to ensure a smooth transition and use their expertise. They also may want to tie the seller in for a period to prevent competition.
Conversely a seller may want a clean break and a short-term gain. They may lose interest if they have to continue on in the business.
Negotiating an earn-out
When you're negotiating an earn-out, flexibility and clarity are important. You should therefore consider the following in your negotiations:
Summary - points for consideration
If you are looking to preserve Business Asset Disposal Relief, deferring and managing the risk of bad debts, you may prefer to structure a sale or earn-out in cash terms.
You could also consider convertible shares instead of loan notes for deferral in order to claim Business Asset Disposal Relief on the earnout.
Ultimately any earnout agreement should be carefully drafted to ensure the terms balance your short-term gains and long-term risk.
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And if you'd like to know how we can help you with all of this, or with anything else, feel free to give us a call on 01202 048696 or email us at richard@tfaaccountants.co.uk.
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