Reap Tax Benefits from an Earn-Out Agreement

Ordinarily, any income from your business or property is fully taxable but when you sell your business you benefit from a capital gains tax, where only half of the proceeds from the sale is taxable income.

But let’s say you sell your business under an earn-out agreement where the buyer pays a partial amount up front and the remainder is derived from and based on meeting certain financial goals. The precise amount of your proceeds cannot be determined at the time of sale and, in fact, may not be known for several years.

That type of earn-out agreement depends on the use of — or production from — the company’s property, and ordinarily the money generated would be taxed as business income, not as a capital gain.

Canada Revenue Agency (CRA), however, recognizes that bind and allows you to use the cost recovery method of reporting the gains or losses if you meet the following five conditions:

• You and the buyer deal at arm’s length.
• The gain or loss is clearly of a capital nature.
• It is reasonable to assume that the earn-out feature relates to underlying goodwill and that the two parties cannot reasonably be expected to agree on that value at the time of the sale.
• The duration of the agreement does not exceed five years.
• You, as the seller, file a copy of the sale agreement with your income tax return for the year of the sale, send a letter requesting the application of the cost recovery method to the sale, and agree to follow the cost recovery procedures.

Keep in mind, however, that if the deal amounts to an installment plan it is not considered an earn-out agreement for purposes of using the cost recovery method.Under the cost recovery method, you reduce the adjusted cost base (ACB) of your company’s shares when you are able to determine the amounts that will be paid. Amounts exceeding the ACB are considered a capital gain and the ACB becomes nil. All amounts that can then be calculated with certainty are treated as capital gains.

So let’s say your company’s stock’s ACB is $120,000 and you sell them all in an earn-out agreement. The sale price for the shares is $100,000 up front plus additional payments based on an earn-out formula over the next four years. The first $30,000 payment is due the year following the year of the sale. Here’s how the cost recovery works:

Year of the sale: You report no capital gain or loss, but the $100,000 reduces the ACB of the shares to $20,000 ($120,000 minus $100,000).

Year after the sale: The $30,000 payment due exceeds the $20,000 ACB, so you recognize a capital gain of $10,000. Half of that is included in your income as a taxable capital gain. You adjust the ACB of the shares to nil.

Following three years: The remaining payments under the earn-out formula are treated as capital gains, half of which are taxed.

The CRA recognizes a capital loss only when the maximum payable to you is less than the ACB of the shares. In that instance, the loss can be reported at the time of the sale. If, over time, it becomes clear that the actual total paid will be less than the initial maximum amount, a further capital loss can be claimed.

If there is no maximum amount set out in the agreement, a capital loss can be reported once it can be established that the total of the amounts to be paid will not exceed the ACB of the shares.