You’re selling your business and as part of the deal you’ll stay on in a managerial role for three years. You’ll then be paid an additional sum based on the profits made over that period. How should you structure the payment to avoid tax traps? Our Senior Tax Manager Brona MacDougall provides advice on the traps and tips.
If you sell a business in which you’ve played a key role it’s quite common for the buyer to want to keep you on board for at least for a short while. The buyer may partly link the amount they’ll pay for the business to its future performance to encourage your commitment. The wording of this type of agreement, known as an ‘earn out’, requires careful drafting to avoid tax traps.
What are the proceeds of sale?
The capital gain or loss from the sale of an asset, say your business, is the difference between what it cost you and the proceeds you’ll receive. However, calculating the capital gains tax (CGT) position for an earn out is not as straightforward because the final proceeds aren’t known until after the earn out period. To work out the gain the amount payable at the later date must be estimated.
In 2000 David started a business from scratch. In March 2019 he signed a contract to sell the business. He’ll stay with the business as an employed manager. David receives £500,000 on completion of the sale plus an amount equal to 25% of the average annual profits, to the extent they exceed a base figure, in the three years to 31st March 2022, but not to exceed £400,000.
In our example the terms of the contract have triggered a trap. Because it specifies a maximum there’s no need to estimate the future profits to work out the proceeds, instead the maximum is used. This means David’s gain will be worked out assuming he will receive £900,000. A trap also applies if a minimum is specified.
Where possible, avoid including a maximum or minimum figure in a contract in relation to earn out proceeds. To the extent that any part of the proceeds are payable more than 18 months after the contract date, you can elect to pay any corresponding tax by instalments.
Capital gains or income tax?
While tackling the CGT position of an earn out is tricky, there is a more fundamental trap to avoid when wording a contract. If the value of the earn out amount is expressed or implied to depend on the individual’s performance during the earn out period, HMRC can argue that the additional payment is earnings rather than a capital payment. The risk is potentially high as the maximum CGT rate payable on an earn out is 20% whereas income tax is up to 45%. Furthermore, if the earn out is taxed as employment income it will be liable to Class 1 NI employers’ and employees’ contributions.
Make sure that the contract doesn’t indicate in any way that the earn out payment relates to the seller’s future role in the business. Make it clear that it relates only to the value of the business being sold/bought.
If part of the price depends on future profits, don’t mention minimum or maximum amounts, if you do you’ll be taxed on them, at least initially, rather than the actual sum you receive. Don’t indicate that future payments are linked to your performance in the business or it could be taxed as income rather than capital.