Ordinary Income versus Capital Gains and the Tax Treatment of Earn-Outs

A capital gain occurs when one sells or exchanges a capital asset at a price higher than its basis (its purchase price plus commissions and the cost of improvements net of depreciation). Similarly, a capital loss occurs when an asset is sold for less than its basis. Gains and losses (like other forms of capital income and expense) are all measured in nominal terms – that is, unadjusted for inflation.

Ordinary Income includes any gain from the sale or exchange of property that is not a capital asset.  Any gain from the sale or exchange of property that is treated or considered as ordinary income shall be treated as gain from the sale of property that is not a capital asset.  Ordinary Losses include any loss from the sale or exchange of property that is not a capital asset. Any loss from the sale or exchange of property that is treated or considered as ordinary loss shall be treated as loss from the sale of property that is not a capital asset.

An earn-out is a business arrangement in the sale of a business and/or the sale of business assets where the buyer makes an additional payment to the acquired company’s former owner in the event that certain earnings benchmarks are met.  Earn-outs are based on the acquired company’s potential future earnings.  Depending upon how the sale of business agreement is structured, the earn-out is either considered to be part of the purchase price, thereby taxed at a capital gains rate, or considered to be compensation income to the seller as an employee, thereby taxed at the ordinary income rate.

Always consult a tax attorney when entering into a sale of business or sale of business assets transaction.

** This article is intended to be used for solely educational and informational purposes and is not to be understood as legal advice or any offer to provide legal advice.