Reduce The Cost Of An Earn Out By Up To 40%

investor profile

June 24, 2021

by an investor from Rensselaer Polytechnic Institute in Connecticut, USA

Here's an idea I've been modeling:

When buying a company using an earn out, structure it as a consulting contract to the former owner. This makes the payments an expense to you which is pretax money and reduces the cost of the earn out by up to 40% (or whatever your tax rate is). The former owner can then use a Defined Benefit Plan or Solo 401`(K) to shelter the income from taxes until they withdraw the funds.

It's a potential win-win.

Thoughts?

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Reply by an intermediary
from The University of Chicago in Chicago, IL, USA
As an M&A Intermediary, I have structured deals where earn-out is an expense to the buyer and OI to seller. Seller can shelter taxes if income is below taxable thresholds or if shareholder funds a DB plan with earn-out $. The amount that can be contributed to DB plan is determined by many factors including seller's age and pre-sale W2 compensation (I believe 3 years average). In order for this to work, earn-out has to be paid to a company (X) owned by selling shareholder(s). X can be OldCo or a NewCo. Earn-out payments cannot be made directly to shareholder(s). Shareholder then becomes employee of X and takes W2 salary from X. As mentioned earlier by others, there is FICA cost to seller. Further, to be legit, such earn-out has to be paid for "services" of the selling shareholder. This could create problems with SBA financing. There are few non-service ways (like royalty) to structure earn-out so buyer can expense it and is not a payment for shareholder service.

In theory, buyer should pay a higher price if earn-out is structured as an expense to buyer for the tax benefit associated with expensing. If earn-out is not an "expense" to buyer but an "additional purchase price", then the earn-out is additional goodwill. Such additional GW is tax deductible over 15 years from the date of earn-out payment in an Asset purchase; it has no tax benefit in a Stock purchase.

My software (www.BVXpress.com) has the option of treating earn-out as an expense or as an additional purchase price, and it treats each differently if the deal is an Asset purchase or a Stock purchase.
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Reply by a searcher
from INSEAD in Brussels, Belgium
Not sure it would work for two reasons: (i) the reason you point out - it is not really tax efficient for the owner because in the end they will always have to pay "salary" level taxes on it and not CGT which can be optimized in numerous ways (you would have to check the fiscal impact, but I think you have a max contribution into 401k) and (ii) you will need to pay social security contributions which will gross up the amount paid so you will not be saving 40% but rather >20% in my view. So net-net not sure it works out, but maybe someone will see it differently. This also assumes that you structure your consulting contract with performance thresholds so that the payouts are not certain (i.e., to mimic an actual earnout).
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