Earn-Outs: Key Tax Considerations for Vendors

Earn-outs, often included as part of the purchase price in a share purchase agreement (SPA), involve payments contingent upon specific performance milestones for the vendors. While these arrangements offer flexibility and are commonly present when the parties cannot yet agree on a final purchase price, they also introduce complexity in their tax treatment. This post breaks down the fundamental tax considerations for earn-outs in Germany.

What Are Earn-Outs?

Earn-outs are variable purchase price components in an SPA that depend on the achievement of defined performance targets or milestones post-closing of a company acquisition. For example, a buyer may agree to pay additional amounts if the acquired company meets specific revenue or profit thresholds within a stipulated time frame.

Tax Treatment of Earn-Outs

Earn-outs impact the qualification of the seller's exit proceeds for tax purposes following the transaction. The following key aspects are crucial for the vendor:

For individuals (commonly being employed as managers post-closing):

1. Risk of Reclassification as Employment Income: If sellers transition into employee roles post-closing, there is a risk that earn-out payments might be classified as employment income, subject to payroll tax
2. ‍Mitigation Strategies: Sellers should ensure that employment contracts do not reference the earn-outs. At the same time the SPA’s wording must be drafted accurately, allowing for a qualification of the earn out portion as a consideration for the sale of shares.

For Holding entities as Sellers (Shareholding Entities):

1. Participation-Exemption on Capital Gains: Under German law (§ 8b KStG), effectively 95 % of capital gains from share sales can be tax-exempt for corporate sellers. However, this benefit may not extend to earn-outs unless they are explicitly structured as part of the original purchase price.‍
2. SPA Adjustments: It should be assured that the SPA clearly defines the earn-out portion as part of the total purchase price (i.e. retrospective purchase price adjustment).

Best Practices for Structuring Earn-Outs

1. Clear SPA Drafting:

• Define earn-outs explicitly as part of the purchase price and outline the conditions under which they are payable.

2. Minimize Payroll Tax Risks:

• Maintain a clear separation between earn-out agreements and employment contracts.

3. Seek Professional Advice:

• Tax planning for earn-outs is nuanced and requires expert guidance to align with German tax regulations.

Conclusion

Earn-outs are a powerful tool in M&A transactions but come with significant tax implications. By understanding these challenges and proactively structuring agreements, sellers can optimize their tax outcomes while maintaining compliance.

At INSIGHT TAX, we specialize in advising startups on complex transactions. Contact us to ensure your earn-out agreements are tax-efficient and aligned with your strategic goals.