How to Reduce Taxes on Earn-Outs in Canada

Earn-outs can be an effective way to earn additional money from the sale of your business based on its future financial performance.  This article will explain how earn-outs are taxed on the sale of a business in Canada.   Anyone who is planning to buy or sell a business should consider reading this.

This article will explain how earn-outs are taxed on the sale of a business in Canada.   Anyone who is planning to buy or sell a business should consider reading this.

To more easily understand the concept of an earn-out let’s look at the example of Mike and Samantha.  Mike offers to buy the shares of Samantha’s bakery business for $250,000.  However, Samantha believes that her business is worth $60,000 more for a total of $310,000.

To bridge this price gap, Mike agrees to make a bonus payment of $20,000 each year for three years.   The yearly bonus is only payable if the bakery has net operating income of $80,000 in the 1^st year after the sale, $90,000 in the second year after the sale, and $100,000 in the third year after the sale.  How are these bonus payments, also known as an earn-out, taxed to the seller, Samantha?

According to the Income Tax Act, earn-outs paid to a seller are taxed as ordinary income in the year they are received.  Samantha, in our example, would not be pleased with this result, as she wants to classify the earn-outs as capital gains, which are only 50% taxable.  Capital gains result in lower taxes than ordinary income, which is fully taxable.

Fortunately for Samantha, the Canada Revenue Agency will allow her to classify the bonus payments as capital gains in the year the payments are received.  This is because two conditions were met according to the CRA’s rules:  (1) Samantha and Mike had difficulty valuing the business at the time of sale and (2) The shares of Samantha’s company are being sold, instead of the assets.

So here’s the tip:  Before agreeing to buy or sell a business, consult with your accountant first to review the tax treatment of earn-outs.  This will impact how much money after-tax you end up paying or receiving.  For more ways on how to reduce taxes, this article on how to reduce taxes in Canada explores a number of different methods.

ABOUT THE AUTHOR

ALLAN MADAN

CPA, CA

Allan Madan is a CPA, CA and the founder of Madan Chartered Accountant Professional Corporation. Allan provides valuable tax planning, accounting and income tax preparation services in the Greater Toronto Area.

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