How a Founder's Earnout Turned Into Ordinary Income Instead of Capital Gain

How a Founder's Earnout Turned Into Ordinary Income Instead of Capital Gain

This case study is an illustrative, anonymized composite based on patterns common in earnout disputes. It is not a description of a specific client engagement, and no outcome described here is promised or guaranteed.

An earnout taxed as ordinary income instead of capital gain almost never comes down to the size of the payment. It comes down to one clause, and in this case it was fifteen words long.

The founder had built a specialty services business over eleven years and sold it to a strategic buyer. Structure was familiar: a majority of the price at closing, and a two-year earnout tied to revenue retention. She had negotiated hard on the revenue targets and the measurement definitions, which was the right instinct applied to the wrong risk.

The clause she did not negotiate said the earnout was forfeited if she was no longer employed by the buyer at the end of the measurement period.

What She Thought She Had Bought

Her understanding, which is the standard founder understanding, was that the earnout was part of the purchase price.

Deferred, contingent, uncertain, but still purchase price. Which would mean long-term capital gain on the way in, recognized as the payments arrived, taxed at preferential rates, and no employment taxes on any of it. The seller-side arithmetic she had run at signing assumed exactly that.

Her separate employment agreement with the buyer paid her a salary that was, in her words, fine. Not generous. Fine.

That combination is the fact pattern.

Why the Forfeiture Clause Turned the Earnout Into Ordinary Income

The distinction between purchase price and compensation turns on a single question: is the buyer paying for the business, or for the seller's continued services.

A contingent payment that a seller forfeits by leaving is not paying for the business. The business was already transferred at closing. What the payment is contingent on is her showing up, and that is the definition of compensation for services.

Forfeiture on termination is the strongest single indicator in the analysis. It is not the only factor, and no factor is dispositive on its own. But it is the one that is hardest to argue around, because the agreement itself states the condition in plain language.

The below-market salary made it worse rather than better. When a seller receives a salary that is low relative to the role and an earnout that is large, the natural reading is that the earnout is carrying part of the compensation. A market-rate salary alongside the earnout is one of the few facts that pushes the other direction.

What Earnout Ordinary Income Treatment Actually Cost

Three separate costs, and the rate difference was the smallest of them.

Item	Purchase price treatment	Compensation treatment
Federal rate	Long-term capital gain rates	Ordinary rates
Employment taxes	None	Applies, both halves in effect
Withholding	None	Buyer withholds from each payment
Buyer's position	Added to basis in the acquired assets	Deductible as compensation

The employment tax layer is the one that surprises people. Above the Social Security wage base the Medicare components still apply, and the additional Medicare tax on high earners applies too, so the marginal cost is real even at large numbers.

The withholding was the immediate cash problem. She had planned her estimated payments around receiving gross earnout installments and paying tax later. Instead the buyer withheld from each payment, which was the correct treatment and a genuine cash flow surprise in a year she had already committed the money.

And note the last row. The buyer preferred compensation treatment, because a deduction now is worth more than basis in an intangible amortized over fifteen years. The buyer's tax interest and the seller's are directly opposed in an earnout, and only one party's counsel was thinking about it.

The Two Rules That Applied Even to the Part That Stayed Capital

The portion of the deal that was genuinely purchase price came with its own mechanics, and they are worth knowing because they surprise sellers in every deal, not just recharacterized ones.

It was a contingent payment sale. A contingent payment sale is one where the total selling price cannot be determined by the end of the tax year of sale, which is exactly what a revenue-based earnout produces. That changes how the contract price and gross profit percentage are computed. When there is no fixed ceiling on the payments, basis recovery follows the rules in Reg. 15a.453-1(c) rather than the simple gross profit percentage a fixed-price installment sale uses.

Part of every later payment was interest. Deferred payments carry imputed interest under section 483 or section 1274, with the adequacy of stated interest measured against the applicable federal rate. If the agreement is silent on interest, the rules supply it anyway, and the imputed portion is ordinary interest income rather than gain. Sellers routinely model an earnout as if 100% of a later payment is capital gain. It never is.

There was one rule the deal was small enough to avoid. The interest charge on deferred tax applies when the sales price exceeds $150,000 and the total balance of nondealer installment obligations arising during and outstanding at the close of the tax year exceeds $5 million. Above that line, a seller pays interest to the government on the tax being deferred, which erodes most of the reason for deferring. Her balance stayed under it. A larger deal would not have.

What Could Not Be Fixed After Signing

Nothing about the character of the payments.

That is the uncomfortable finding. The analysis was correct, the documentation supported the buyer's treatment, and the agreement said what it said. There was no amendment available that would retroactively change the character of payments made under a clause both parties had signed. Attempting to recharacterize after the fact, with a buyer who has already taken deductions, is a fight with a counterparty who has every incentive not to help.

What was fixable was forward-looking and modest. The estimated tax planning got corrected. The second-year installment was modeled properly, with the interest component broken out. The retirement plan contribution capacity that compensation income actually creates, which capital gain does not, was used deliberately rather than discovered late. Small offsets against a large problem.

The Three Questions Worth Asking Before You Sign

Ask what happens to the earnout if you leave, and understand that the answer determines the tax character. If it is forfeited, expect compensation treatment and price the deal that way.

Ask whether your salary during the earnout period is market rate for the role you are actually doing. A low salary next to a large earnout is the pattern that invites the question in the first place.

And ask the buyer's counsel directly how the buyer intends to treat the payments for tax purposes. Both sides file returns. If they are inconsistent, one of you is going to have a problem, and the party with the deduction usually has the stronger paper trail.

For the earlier stage of this, see 6 Things to Settle Before You Sign a Letter of Intent to Sell Your Business. For the mechanics of payments over time, What Is an Installment Sale and How Is It Taxed covers the framework.

Who Does This Kind of Work

The valuable work here happens before signing, and it is unglamorous: reading the contingent consideration section of a draft agreement with a tax question in mind rather than a business one.

OLarry is a nationwide, California-based private client tax firm founded in 2024, now a team of 39, holding a CPA credential and serving clients in all 50 states. The practice describes itself as private client tax strategy built for emerging wealth through ultra high net worth individuals, and its published service lines include mergers and acquisitions, tax planning and strategy, international tax services, estate planning, and tax resolution and IRS representation.

OLarry has 7 verified client reviews on Sam's List as of 2026-09-04. Each review is submitted by an individual who identifies as a client of the firm and rates it on communication, subject-matter knowledge, and overall satisfaction. Reviews reflect those individual experiences, do not represent an endorsement by Sam's List, and are not indicative of future results.

The relevant detail for an earnout question is that the M&A service line and the individual tax work sit in the same firm. An earnout is simultaneously a deal term and a line on a personal return, and the recharacterization risk lives precisely in the gap between the two. A transaction advisor who does not prepare the 1040, and a preparer who never sees the draft agreement, can each do their job correctly and still let this through.

The honest constraints. Published minimums are $1 million in income and $1 million in revenue, which puts the firm out of reach for smaller deals, and fees run $2,500 to $50,000 a year or $200 to $650 an hour. It is also a young firm, founded in 2024, so ask directly about the depth of transaction experience behind the M&A service line. And a tax firm is not a substitute for transaction counsel, who is the person who can actually negotiate the clause that caused this.

The most useful thing to know is a timing point rather than a firm recommendation: the same review costs the same money before signing and is worth far more. To compare firms, browse the Sam's List accountant directory and read what actual clients wrote before you get on a call.

Frequently Asked Questions

When is an earnout treated as compensation instead of purchase price? Generally when the payment is compensating the seller's continued services rather than paying for the business. The strongest single indicator is forfeiture: if the seller loses the earnout by leaving before the measurement period ends, the payment looks like pay for services. A below-market salary alongside a large earnout points the same direction. No single factor decides it, but forfeiture on termination is the hardest to argue around.

How much more does compensation treatment cost than capital gain? More than the rate difference alone. Ordinary rates replace long-term capital gain rates, employment taxes apply where they would not have, and the buyer withholds from each payment rather than paying it gross. The withholding is often the more disruptive part, because it changes cash flow in the year of payment rather than just the total.

What is a contingent payment sale? A sale where the total selling price cannot be determined by the end of the tax year in which the sale occurs, which is what a revenue-based or earnings-based earnout creates. It uses different rules to compute the contract price and gross profit percentage than a fixed-price installment sale, and where there is no stated maximum price, basis recovery follows Reg. 15a.453-1(c).

Is any part of an earnout payment treated as interest? Generally yes. Deferred payments are subject to imputed interest under section 483 or section 1274, measured against the applicable federal rate, so a portion of each later payment is ordinary interest income rather than gain even when the agreement says nothing about interest. Modeling an earnout as entirely capital gain overstates the after-tax result.

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About the author: Kimberly Green is the cofounder of Sam's List, where business owners and high earners find vetted CPAs, financial advisors, and fractional CFOs. She's met one-on-one with 400+ financial professionals and writes from the real data behind thousands of client-advisor matches. Ask her anything about finding an accountant - she's heard it all, including the questions people are afraid to ask.