Selling a business
Earn-outs, loan notes and deferred consideration: how sellers are taxed
Cash, earn-outs, loan notes and deferred consideration are taxed differently when you sell your company. What sellers need to know before agreeing terms.
Most sale prices aren't paid entirely in cash at completion. Buyers often defer part of the price, link it to future performance, or pay it in loan notes or shares. Each of these is taxed differently, and the difference can affect both how much tax you pay and when you pay it.
Cash at completion
The simplest case. The gain is taxed in the tax year of the sale, at capital gains tax rates of up to 24%, or 18% on up to £1 million of lifetime gains if Business Asset Disposal Relief applies.
Deferred consideration: a fixed amount paid later
If the price is fixed but paid in instalments, the whole amount is generally taxed at the time of the sale, even though you'll receive some of it later. If an instalment is never paid, relief may be available, but you'll have paid the tax upfront.
Where payments are spread over more than 18 months, HMRC may allow the tax to be paid in instalments too.
Earn-outs: an amount that depends on the future
An earn-out is part of the price that depends on what happens after completion, usually the business's future profits.
Where the earn-out is paid in cash and the amount isn't known at completion, the usual position is:
- At completion, you're taxed on the cash received plus the value of your right to receive the earn-out, even though you haven't been paid it yet.
- When the earn-out is paid, the payment is compared with the value taxed at completion, and any extra is a further gain.
Two practical points follow:
- You may pay tax on money you never receive. If the earn-out underperforms, relief may be available for the shortfall, but the rules are complex.
- Business Asset Disposal Relief can usually apply to the gain at completion, including the value of the earn-out right, but not to later gains on the right itself.
Where the earn-out is satisfied by shares or loan notes in the buyer, different rules can apply, which may allow the gain to be deferred.
The employment income trap
Buyers, especially private equity, often want sellers to stay on. If an earn-out is really a reward for your continued work, HMRC may tax it as employment income, at income tax rates and with National Insurance, rather than as capital gains.
Warning signs include:
- you lose the earn-out if you leave, or receive less if you're a "bad leaver"
- payments are linked to your personal performance rather than the business's
- you receive a lower salary than the role would normally pay
Careful drafting of the sale agreement makes a real difference here.
Loan notes
Loan notes are IOUs issued by the buyer. How they're taxed depends on what kind they are:
- Qualifying corporate bonds (QCBs): the gain on the shares is calculated at completion but held over until the loan notes are redeemed. Business Asset Disposal Relief can be lost unless you elect to claim it at the time of the sale.
- Non-QCBs: these can be treated as a new holding that replaces your shares, so no gain arises until they're redeemed. An election may be needed to claim Business Asset Disposal Relief on the original sale.
The type of loan note is a drafting choice, so agree what you need before the terms are fixed.
Shares in the buyer
Taking shares in the buyer, a "rollover", can defer tax on that part of the price, and give you a stake in future growth. We cover rollovers in detail in our article on selling to private equity.
What to do
- Agree the form of consideration with the tax consequences in mind, before heads of terms are signed.
- Avoid linking earn-outs to your continued employment where you can.
- Choose the type of loan note deliberately.
- Plan for the cash flow of paying tax upfront on amounts you'll receive later.
This article is general information, not advice. Tax rules change and their effect depends on your circumstances. Please speak to us before acting.
