Proper Treatment of Deferred Purchase Payouts

Most transactions are not 100% cash paid at closing. The reason being that the buyer would bear the risk of some or all of the customer base disappearing after the transaction was concluded. Accordingly, in seeking to balance the risk between buyer and seller, most transactions have 50-75% of the purchase price paid at closing and the balance deferred and paid out over some agreed upon a number of years that generally could range from 1-3 years (and hopefully with interest added to the unpaid balance).

Not getting paid 100% up front does not sound great for a seller but in fact, such deferral could be an opportunity to defer income taxes if the seller were to make an installment sale election and recognize capital gains in the years that additional sale proceeds are received. However, many buyers seek to deny seller such treatment by characterizing a portion of the purchase price paid as compensation expense which can be written off when paid and avoids having to capitalize the amount and amortize it over 15 years.

Deferred Purchase Payouts: Be wary!

Accordingly, sellers need to be wary of a buyer drafting the definitive sale contract in a way that describes a portion of the deferred purchase price component as compensation/bonus pay, all of which will be reported as ordinary income to the seller’s owner (i.e., IRS Form W-2 if an employee or IRS Form 1099-MISC if a consultant). This treatment dramatically affects the after-tax proceeds going to a seller because the maximum capital gains tax rate is 20% while the maximum tax on ordinary income (that reflected on Form W-2 or 1099-MISC) is 39.6%. To make matters worse, FICA taxes are also now due on that portion of deferred sales proceeds characterized as compensation.

A savvy seller should be aware of the 20%+ added tax cost if the sales contract is allowed to be drafted in such fashion. We recently saw a transaction where the buyer had the sales price properly stated in the letter of intent (LOI) (i.e., no mention of compensation/bonus treatment) but when the actual asset purchase agreement was provided there was an about-face where the compensation technique was launched. Needless to say, we rejected such attempt and pointed to the LOI as a complete defense to such an ill-fated attempt to take advantage of our seller