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Not sure if this is an appropriate venue for this question but figured others here might end up with a similar issue at some point.

We sold a (US) business 3 years ago (in 2006 to a US acquirer) and recently were paid an earnout that was based on the performance of the company. We received no documentation from the acquirer and were told that we would not be receiving any documentation. The money was wired directly into our accounts and we did not give any Tax ID information to the acquirer (we were not asked).

1) What is the legality of reporting this on taxes? I assume we would need to do so but the lack of documentation has me questioning it. If it is not reported I can stomach paying back taxes later if indeed we're required to pay taxes on this (the amount was about $175K).

2) If it does need to be reported (as I suspect it does) my understanding is that it would be a long-term capital gain (based on some conversations with others who also received earnouts). However, I'm not sure how I am supposed to know that without documentation.

Please let me know if you have dealt with a situation like this before. I am planning to engage legal counsel if necessary but figured I would ask here before running up the legal tab.

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2 Answers

up vote 3 down vote

I am a business attorney and not a tax professional but unfortunately, all income is reportable and taxed unless you can find an exemption. I don't know of one in your scenario.

Long-term capital gains are determined by the amount of time you held your investment. So, if you sold your stock in the company during the acquisition and the date on which you were paid for your earnout was more than a year after you aquired that stock, then yes, it would likely be a long-term capital gain tax rate. That rate is lower (should be between 5 and 15% depending on your marginal tax bracket).

The other thing to consider is that sale of fixed assets in the company is taxed at ordinary rates. If you were selling something other than stock during the sale, this may be a little trickier in the reporting to the IRS. Also, there are Gain on Small Business Stock provisions in the IRS Code. Try to find someone who knows more about Sections 1202 and 1244 than I do to see if you qualify for special treatment under those provisions.

The fact that you do not have documentation characterizing the earnout doesn't change anything for the IRS. They only care about income and this sounds like income.

Good luck!

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up vote 0 down vote

This proves the truth in the old adage about nothing in life being certain - except death and taxes.

You received income so you owe tax on that income.

The good news is that if you are a US citizen residing in the US, then you only have to deal with the US Internal Revenue Service. The bad news is that if you're not, you'll have to reconcile across two country's revenue agencies (always amusing....)

Based on your question, it certainly appears that you have a legitimate long term gain. That said, I'd encourage you to go back through your files - contracts, letters, e-mails, notes from meetings, etc and see if you can find any documentation which supports the view that this is a long term capital gain. You want to be prepared ahead of time for any future audit.

Last, in this situation, given the amount at stake, I'd strongly encourage you to hire a tax professional to assist you in filing all the forms correctly and in ensuring you do things like file quarterly payments so you avoid future penalties.

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Thanks for the comments. I thing I failed to mention in my original write-up is that I have not performed any services for the acquirer between when the acquisition happened and when we received our earnout. I'm pretty sure it was a long-term gain anyway but when I thought about it in that light I think that seals the deal. I definitely will be working with a tax professional on this but I know it's always good to get multiple takes on stuff like this. Sharon's mentions of Sections 1202 and 1244 could indeed prove helpful here. – Brady Anderson Mar 23 '10 at 14:59

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