How Earn-Outs, Loan Notes and Deferred Payments Are Taxed When You Sell

When a buyer makes an offer for your company, the headline price is only part of the story. How the money reaches you decides when you pay tax, how much you pay and how much risk you carry. Few deals are paid entirely in cash on the day of completion, so it pays to understand each form of payment before you sign heads of terms.

Cash on completion

This is the simplest case. The gain is taxed in the tax year of the sale. Capital gains tax on shares is charged at up to 24%. If you qualify for Business Asset Disposal Relief, the first £1 million of lifetime gains is taxed at 18%.

A fixed price paid in instalments

Suppose the price is agreed at a fixed figure but you are paid over several years. Generally, the full amount is brought into your gain at the time of the sale, even though part of the cash arrives later. That means a tax bill can fall due before you have been paid in full.

If an instalment is never paid, relief may be available, but only after you have already paid the tax. Where the payments run for longer than 18 months, it may be possible to pay the tax by instalments as well.

Earn-outs

An earn-out is a slice of the price that depends on something happening after completion, typically the profits the business makes. Where it is paid in cash and the amount cannot be known at the outset, the usual treatment has two stages:

1. At completion, you are taxed on the cash you receive plus the value of your right to receive the earn-out. That value is taxed even though no earn-out money has arrived.
2. When the earn-out is paid, the amount is compared with the value taxed at completion. If you receive more, the excess is a further gain.

This produces two points to keep in mind. First, you can end up paying tax on money you never receive if the business underperforms. Relief for a shortfall may be available, but the rules are complicated. Second, Business Asset Disposal Relief can usually apply to the gain at completion, including the value of the earn-out right. It does not extend to later gains on the right itself.

If the earn-out is settled in shares or loan notes in the buying company instead of cash, different rules can apply and these may allow the gain to be deferred.

The employment income trap

Buyers, and private equity buyers in particular, often want the sellers to stay in the business. If HMRC concludes that an earn-out is really a reward for your continuing work, it can tax the payments as employment income. That means income tax rates and National Insurance, not capital gains tax.

Watch for these warning signs in the draft agreement:

• You lose the earn-out, or part of it, if you leave the business. Bad leaver clauses are the usual culprit.
• Payments depend on your personal performance, not the performance of the business as a whole.
• Your salary is set below what the role would normally command, so more of your reward sits in the earn-out.

Careful drafting makes a real difference. Where possible, keep the earn-out linked to the business's results and separate from your employment terms.

Loan notes

Loan notes are written promises from the buyer to pay you later, usually with interest. Their tax treatment turns on the type of note:

• Qualifying corporate bonds (QCBs). The gain on your shares is calculated at completion but held over until the notes are redeemed. You can lose Business Asset Disposal Relief unless you make an election to claim it when the sale takes place.
• Non-QCBs. These can be treated as a new holding that stands in place of your old shares, so no gain arises until they are redeemed. An election may again be needed so that the relief is claimed on the original sale.

Which type you receive is a drafting decision. Agree what you want before the terms are fixed, because it is hard to change later.

Shares in the buyer

Sometimes the buyer offers its own shares as part of the price. This is called a rollover. It can defer tax on that part of the price and give you a stake in future growth. The details deserve their own discussion, and our specialist team can walk you through how rollover works in a private equity deal.

Practical steps

• Decide the form of payment with the tax consequences in front of you, before heads of terms are signed.
• Avoid tying an earn-out to your continued employment wherever you can.
• Choose the type of loan note deliberately and record any elections you need.
• Plan your cash flow, because you may have to pay tax upfront on amounts you will only receive later.
• Compare offers by what you keep after tax and when, not by the headline figure.

Talk to our team before you agree terms

The form of consideration is one of the few things you can still shape once an offer is on the table. Our team prepares advice for sellers on exactly this, and every piece of advice is prepared by our specialist team and reviewed by a Chartered Tax Adviser. If you have an offer, or expect one, book a call with our team and we will map out the tax on each element before you commit.

This article is general information, not advice. Tax rules change and their effect depends on your circumstances. Please speak to us before acting.

For a closer look at selling or buying a business, see our specialist practice, Transaction Tax Partners.