Demand for dealerships remains very strong, even as market conditions softened last year due to declining earnings and uncertainty.1 In spite of declines, dealership profits remain more than twice as high as before the pandemic. Dealers have reacted to higher interest rates by putting more cash into acquisitions. One buy-sell trend our professionals at FORVIS have seen becoming more prevalent recently is the earnout provision. This article will examine details of the provision, its potential benefits, and its accounting and tax treatments.
Earnout Provisions
An earnout provision is part of a negotiation between a buyer and a seller in which part of the purchase price is paid if certain targets or metrics are achieved. An earnout is typically based off of gross profit or adjusted net income/earnings before interest, taxes, depreciation, and amortization (EBITDA), usually over one to three years, depending on the negotiation.
Earnouts may be a good tool to use if a seller is reluctant to sell because of expected future performance. They also may be beneficial if the seller is continuing in some capacity with the company and is motivated to see it perform well.
With earnouts, a seller may maintain some interest in the business. Here are a couple of earnout examples that our professionals have witnessed in the market:
- $10 million paid on closing day; if two years after the closing date the company had a net income of $3 million, the seller would earn an additional $1 million
- $50 million paid on closing day; if two years later EBITDA was less than $55 million, the seller would receive an additional $9 million payout; if EBITDA was between $55 million and $60 million, an extra $15 million; and if EBITDA was more than $60 million, an extra $20 million
Buyers also may benefit from earnouts because they are not obligated to pay as much for lower performance. Companies engaging in earnout provisions should be aware of the accounting and tax treatments detailed below.
GAAP Accounting Treatment
Based on guidance in Accounting Standards Codification 05-10-55-24, one of the first things to determine is whether the earnout is classified as seller compensation or purchase price consideration. If it’s compensation, the earnout would be an expense and recorded via equity. However, if it’s consideration, the earnout would be measured at fair value at the date of acquisition.
Authoritative guidance provides several examples and indicators. In one example involving continuing employment of the seller, if the seller stays on as a key employee but the additional earnout compensation is forfeited if the seller is no longer employed, then this would indicate the earnout should be considered compensation cost. However, if the contingent payment is not affected by employment termination, the payment is additional consideration rather than compensation. And if the earnout is considered additional consideration, it would need to be measured at fair value.
Federal Tax Treatment
For the buyer, if the earnout is treated as compensation cost, it would be immediately deductible. If it was additional consideration, it would be capitalized and amortized over time.
For the seller, if the earnout is treated as compensation cost, it could be subject to ordinary income rates, which can be as high as 37%. If it was part of consideration paid, it would be taxed at maximum capital gain rates of 20% (plus a potential additional 3.8% net investment income tax), and it would potentially qualify for an installment sale treatment in which the seller would not pay tax on that portion until the cash was received.
Be aware that there may be state tax implications outside of this article’s scope.
How FORVIS Can Help
Our Dealerships Practice provides a variety of services for dealerships nationwide, ranging from tax compliance and planning to assurance and consulting. We work with clients throughout the dealership life cycle. If you have any questions regarding earnouts or need assistance, please reach out to a professional at FORVIS.
- 1“The Haig Report® Q3 2023,” haigpartners.com.