Is there a mechanism to allocate an earn-out in a sale disproportionately amongst the selling shareholders and still have it treated as capital gains?
For example: Two sellers A and B, each a 50% shareholder, but we want 75% of the earn-out to go to seller A and 25% to seller B.
Also, what fiscal year would the earn-out be taxed based on? i.e. suppose the deal is done this year and the earn-out is paid next year, and that there is also a tax increase next year, which tax rate is the seller paying on the earned portion of the deal?
Thank you.
Allocating earn-outs among sellers + earn-out taxes?
by a searcher from University of California, Los Angeles - UCLA Anderson School of Management
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1) If the earn-out is a capital gain to seller, then you cannot split 25/75. However, in this situation, the shareholders can, without buyer involvement, have a side agreement to where buyer pays 50/50, each seller pays taxes, and then seller A gives half the after-tax amount to seller B, thus essentially achieving as-if it was a 25/75 split from buyer. (I am excluding gift taxes impact).
2) If the earn-out is a "compensation" then you can easily split it to 25/75 under the rationale that one seller works more than B.. But in this case, earn-out will be an ordinary income, not a capital gain.
3) Taxes are due when earn-out is paid or earned. However, I believe there is a provision in the code where a Seller can choose to pre-pay taxes upfront on "estimated earn-0ut".