Earn Outs on Share Sale
An earn out is an amount payable on a sale of shares in a company linked to its performance after the sale, typically profitability.
Earn outs are back in fashion.
Earn outs were popular before the credit crunch as sellers were anxious that they did not sell too cheaply in a strong market. More recently, buyers have been keen on earn outs to ensure that they have not overpaid for a company in an uncertain market.
It is helpful to consider any earn out early in the sale process. It is possible to structure earn outs so that entrepreneurs' relief (ER) can be obtained on the full amount of consideration for the sale of the shares, including via the earn out.
The capital gains tax (CGT) on the consideration for the sale of shares that qualify for ER is 10% compared to up to 28% for consideration that does not.
It can be difficult for sellers to qualify for ER on their earn out rights. They usually cease to . have an appropriate connection with the company after they sell their shares. For example they might not be an employee or director, or own at least 5% of the shares- both usually needed for ER qualification.
Planning techniques focus on crystallising the value in the earn out right at the point of sale. One method is for the sellers to warrant the profitability of the company for the relevant period after the sale and to be entitled to the maximum amount under the earn out, payable on deferred terms with an appropriate adjustment if the warranty is breached. Another is to agree with HMRC a substantial value of the earn out right and then rely upon a generous relief which allows a loss on the earn out right to be carried back and set against the CGT payable when the shares were sold.
If you have any questions about tax relating to share sales, including earn outs please contact Nasim Sharf on firstname.lastname@example.org
This article is for general guidance only. It provides useful information in a concise form. Action should not be taken without obtaining specific legal advice.