Earnout Tax Treatment: Sale Price or Pay for Staying On?

Are earnouts taxed as capital gains or as wages?

An earnout paid for your shares is part of the sale price, so it is usually capital gain, reported year by year as the money arrives. An earnout paid for your work after the sale is pay for services, taxed as wages. Publication 525 says pay for personal services is income, shown on Form W-2, while Publication 537 treats later payments of sale price as installment sale income.

The stakes are large. Most long-term capital gain is taxed at federal rates up to 20%, may owe the 3.8% net investment income tax, and may be excluded under QSBS. Wages are taxed at ordinary rates, carry Social Security tax of 6.2% (on wages up to $184,500 a year) and Medicare tax of 1.45% on your side, plus 0.9% Additional Medicare Tax on high wages, and never qualify for QSBS.

No rule in the Code or regulations sorts earnouts into one bucket. The agreement's terms, and how the buyer reports the payment, are the starting point, and the answer turns on facts. Your case is not simple if any payment depends on you staying employed, if you hold options as well as shares, or if you moved states after closing.

Gather the merger or purchase agreement, your employment or consulting agreement, every earnout payment notice, and each Form W-2 and Form 1099-B from the buyer or its paying agent.

Earnout vs retention bonus: which terms make it pay?

Terms that tie the money to your continued work point to wages; terms that tie it to the shares you sold point to sale price. Negotiating those terms is a job for your deal lawyer before signing; the tax result follows what was signed.

Payments on options are compensation even when paid on the same schedule and terms as the shareholders' earnout. Treasury's section 409A regulations call these transaction-based compensation and let them follow the shareholders' schedule for up to five years after the sale. For option cash-outs generally, see taxes when your startup is acquired.

Can I report earnout payments as they come in?

Yes, by default. A sale whose total price cannot be known by the end of the sale year is a contingent payment sale, and it is reported on the installment method unless you elect out (26 CFR 15a.453-1(c)(1)). The closing cash and each later earnout payment carry part of your gain and part of your basis.

Conditions that change this:

• Publicly traded stock. If the shares you sold traded on an established securities market, the installment method is not available and all payments are treated as received in the sale year (26 U.S.C. 453(k)).
• A fixed amount in escrow or a holdback. That is not a contingent earnout; see escrow and holdback payments.
• Large deferred sales. Interest on the deferred tax can apply when the sale price is over $150,000 and installment obligations that arose in the year and remain unpaid at year-end total more than $5,000,000 (26 U.S.C. 453A). The statute leaves the treatment of contingent payments to regulations, so measuring an earnout against that threshold needs professional judgment.

Gain that was long-term in the sale year stays long-term in later years (Publication 537).

How is basis spread when the earnout has a cap, only an end date, or neither?

Basis is spread by one of three rules, set by what the agreement fixes at the end of the sale year (26 CFR 15a.453-1(c)(2) to (4)). Most startup earnouts have a cap, so the first rule is the usual one.

If the normal rule would substantially and inappropriately delay your basis recovery, you can ask the IRS for a ruling to use another reasonable method. The request must be filed before the due date, with extensions, of the return for the year you receive the first payment, and you must show basis would come back at least twice as fast (26 CFR 15a.453-1(c)(7)).

Is part of each earnout payment interest?

Often, yes. When some payments are due more than one year after the sale, part of a payment due more than six months after it can be treated as interest (26 U.S.C. 483). For a contingent earnout payment, this split applies even if the agreement states adequate interest (26 CFR 1.483-4(a)).

For a contingent payment, the principal part is the payment discounted back to the sale date at the applicable federal rate; the rest is interest, taxed as ordinary income in the year you receive it (26 CFR 1.483-4). The interest is not sale price, so it also lowers the gain and the capped price used in the basis rules above (26 CFR 15a.453-1(c)(2)(ii)).

Can I elect to report the expected earnout now instead?

Yes. You can elect out of the installment method and report the earnout in the sale year by reporting the sale on Form 8949 instead of Form 6252. The deadline is the sale-year return due date, including extensions; if you filed on time without electing, you have six months after the original due date to elect on an amended return (Publication 537). Revoking needs IRS consent (26 U.S.C. 453(d)).

Electing out means you report the fair market value of the earnout right as sale proceeds in the sale year, and that value can never be less than the value of the shares sold minus the other consideration you received. Treating the sale as "open" until the earnout is paid is allowed only in rare and extraordinary cases where the value cannot reasonably be found (26 CFR 15a.453-1(d)).

Electing out may help when you have capital losses in the sale year to absorb the gain, or expect higher rates in later years. It costs you tax on money you may never receive. How later payments that differ from the value you reported are taxed is not spelled out in the installment regulations, so it is a decision for professional judgment before the deadline.

What if the earnout is never paid, or is paid in buyer stock?

A missed target lowers the gain still to be reported; it does not undo the closing-year gain. Under a capped earnout, once the maximum can no longer be reached, you recompute the share of gain for payments from that year on. If the buyer's obligation becomes worthless, unrecovered basis becomes a loss on the sale in the year the worthless-debt timing rules allow (26 CFR 15a.453-1(c)(2)). A capital loss above your gains is deductible against other income only up to $3,000 a year.

An earnout paid in buyer stock is generally a payment equal to the stock's fair market value when you receive it (Publication 537). If the deal qualified as a tax-free reorganization, the extra shares may also be tax-free except for the part treated as interest (26 CFR 1.483-4, Example 2). Whether your deal qualifies is covered in taxes when your startup is acquired.

How do QSBS and state tax apply to later earnout payments?

QSBS can cover earnout gain on qualifying shares, but the per-issuer cap is shared across years. Gain excluded in earlier years reduces the cap of $10,000,000 for older stock, or $15,000,000 for newer stock, that is left for later payments. The alternative cap of ten times basis counts the basis of shares sold during the year, so check how it applies to a payment received in a later year. Whether your shares qualify is covered in QSBS for founders and early employees.

State tax is a separate question. A state where you lived at closing may still tax payments received after you move: see moving to another state before selling startup shares. Some states do not follow the federal QSBS exclusion: see state tax on QSBS gains.

Which forms show earnout payments: W-2, Form 1099-B or Form 6252?

Form 6252 reports the sale under the installment method, and you file it for the sale year and every later year of the agreement, including the final payment year, even a year with no payment (Publication 537; About Form 6252). Its gain carries to Schedule D.

A Form 1099-B amount rarely matches what the installment method reports for the year. How to reconcile it on Form 8949 is covered in escrow and holdback payments.

Example

All figures are illustrative, in US dollars. Interest is left out to keep the figures simple; in a real deal, part of each later payment may be interest.

An earnout with a cap

A founder sells shares with a basis of $400,000 for $4,000,000 at closing plus up to $2,000,000 over three years if revenue targets are met. The stated maximum price is $6,000,000, so gross profit is $5,600,000 and each dollar received is about 93.3% gain.

• Sale year: $4,000,000 received, $3,733,333 gain.
• Year 2: $800,000 received, $746,667 gain.
• Year 3: $700,000 received, $653,333 gain.
• Year 4: $500,000 received, $466,667 gain.

Total gain is $5,600,000, reported on Form 6252 each year.

An earnout tied to staying

A co-founder's $1,000,000 "earnout" is forfeited if she quits before the second anniversary of closing, and sellers who leave get nothing. It is likely pay for services: taxed as wages in the year paid, on Form W-2 with withholding, and outside both her installment sale and QSBS.

The target is missed

Same deal as the first example, but the earnout is one payment after year 2, between $0 and $2,000,000 depending on revenue.

• Sale year: $4,000,000 received at 93.3%: $3,733,333 gain, $266,667 of basis used.
• Year 2: revenue falls short and only $500,000 is paid. The maximum drops to $4,500,000, so the share of gain is recomputed for this payment: $500,000 minus the remaining $133,333 of basis gives $366,667 gain.

Total gain is $4,100,000: the $4,500,000 actually received minus the $400,000 basis. The sale-year return is not amended.

Different for you?

• Part of the price sits in escrow or a holdback for a fixed amount: see escrow and holdback payments after a startup sale.
• You also received buyer stock at closing, or options were cashed out: see taxes when your startup is acquired.
• You moved, or plan to move, before the earnout is paid: see moving to another state before selling startup shares.
• You are counting on QSBS for the earnout gain: check QSBS for founders and early employees.
• You sold a small owner-run business paid over time: see selling your business.
• The earnout depends on your staying employed, or you are weighing an election out before the deadline: these turn on judgment about the agreement; get individual tax help.