Earn-Out Clauses in Company Sales: Tax-Free Capital Gains or Tax Trap?

However, there are exceptions. In particular, earn-out clauses in share purchase agreements may lead to a reclassification of tax-free capital gains into taxable income, depending on the specific conditions of the deal.

For financial advisors, understanding this distinction is essential when supporting entrepreneurs during business succession planning or M&A transactions.

What Is an Earn-Out?

An earn-out is a variable portion of the purchase price, paid after the transaction based on the future performance of the business. The buyer typically pays a fixed upfront amount and agrees to pay the remaining portion over time – often one to three years – if certain performance targets (e.g. revenue, EBITDA, completion of pending contracts) are met.

Earn-outs are frequently used when the valuation of a business involves uncertainty or when the seller continues working in the business after the sale.

A Practical Example

Mr. Meier sells his company for CHF 1.5 million under the following conditions:

• CHF 1 million as a fixed purchase price at closing

• CHF 500,000 as an earn-out, conditional on reaching a specific revenue goal the following year

• Mr. Meier continues working as an advisor for 12 months, with a reduced salary

In this case, the earn-out payment risks being classified as taxable income – particularly if it is linked to Mr. Meier’s continued services or a non-compete agreement.

Capital Gain or Income?

The legal and tax qualification of an earn-out is not explicitly regulated in Swiss tax law. However, Art. 16(3) of the Swiss Federal Tax Act (DBG) provides that capital gains on private assets are tax-free – as long as they are not compensation for personal services or obligations.

Red flags indicating taxable income:

• Tied to personal performance: If the earn-out depends on the seller’s continued work or a non-compete clause

• Compensation substitute: If salary is reduced post-sale and the earn-out fills the gap

• Unequal treatment: Active sellers receive higher earn-outs than passive ones

• Contract wording: The earn-out is explicitly linked to an employment or service agreement

Structuring Earn-Outs Correctly

To ensure that the earn-out is treated as a tax-free capital gain, the deal structure and documentation must be clean and deliberate. Key considerations include:

1. Fair market value: The total purchase price (including the earn-out) should reflect the objective market value, ideally supported by an independent valuation.

2. Clear separation of services: The earn-out should not be linked to future services, obligations, or behavior of the seller.

3. Transparent compensation: If the seller remains involved, their salary should remain at market level to avoid requalification risks.

4. Separate non-compete agreements: Any non-compete should be governed by independent contractual clauses with dedicated penalties or compensations.

Conclusion

The tax treatment of earn-outs is a complex and often overlooked issue. When structured poorly, an earn-out can unexpectedly become fully taxable income – leading to significant financial consequences for the seller.

For financial advisors, it's crucial to raise awareness among clients and involve experienced tax professionals early in the process. Earn-outs are a powerful negotiation tool – but only when structured properly. Getting it right can preserve a significant portion of the seller’s proceeds.