At issue: how will earn-out as part of sale be taxed?

Q: My partner and I are in the process of selling our business. Although we will receive the majority of our sales proceeds at close, part of our consideration is tied to an earn-out. My question is how will the money we receive as part of the earn-out be taxed?

Answer: The answer depends on how the sale is structured. The tax characteristics of the proceeds from the sale are dependent on the type of property being sold. If the property constitutes a capital asset (defined below) in the hands of the seller, then the proceeds will be treated as resulting from the sale of a capital asset and will be subject to tax at the capital gains rate. If the property is a non-capital asset in the hands of the seller, any gain on the sale will be taxed at ordinary income rates. The fact that some or all of the purchase price is contingent on some future happening does not change the tax character of the gain or loss on the sale. Thus, in the case of the sale of a capital asset with a contingent earn-out as part of the purchase price, the earn-out will be taxable as gain on the sale of a capital asset when it is earned and will be taxed at either long- or short-term capital gain rates, depending on the length of time the asset was owned by the seller.

Capital assets are defined by exclusion; capital assets mean all property (whether or not connected with a trade or business), except certain classes of property listed in the Internal Revenue Code and Regulations (see, for example, IRC sec. 1221). These excluded classes of property include inventories, notes, and accounts receivable acquired in the ordinary course of trade or business; depreciable business property; real property used in the taxpayer's trade or business; certain artistic or intellectual properties (but not a patent or invention); supplies of a type commonly consumed by the taxpayer in the ordinary course of business; and certain financial derivatives.

In an equity purchase (i.e., the sale of the stock of a corporation, the membership interests of a limited liability company, or the partnership interests in a partnership), the assets being sold will generally qualify as capital assets, subject to either long or short term capital gain or loss on the sale. In an asset purchase (i.e., where the assets of the business are being separately sold apart from the business itself), the purchase price will need to be allocated among the assets, some of which will be non-capital assets subject to ordinary income treatment, and some of which will likely be capital assets subject to capital gain treatment.

Business sales, even of small businesses, can result in complex tax results, sometimes unforeseen by the buyer and seller. Consequently, it is important to carefully consider the structure of the sale of a business before entering into the sales agreement.

Q: I currently own raw land in the East San Fernando Valley. I am in negotiations with a prospective buyer. I am skeptical about the buyer's ability to close, but am more skeptical about where I see the market going if I do not exit now. I have asked the buyer to put down 5% of the purchase price as a deposit (due at the end of his due diligence period), which he stands to lose as liquidated damages if he then fails to close. His broker insists that I cannot ask for more than 3% of the purchase price as liquidated damages. Is he correct?

A: No. Buyer's broker is mistaken. The 3% cap he refers to applies to residential home sales only. In a land deal, such as yours, provided the liquidated damage provision is properly drafted, there is nothing preventing you from asking for 5% as you propose. Given your concerns, I would stick to the 5% deposit and be sure to conduct your own diligence, including reviewing buyer's financial statement, speaking with buyer's bank reference, and spending time with his finance source.

Q: We are currently in a dispute with our outside legal counsel over advice we recently received. Although we hope to resolve our differences, I am afraid we may not be successful in doing so. Our CFO recently noted that our fee agreement with outside legal counsel includes an arbitration provision. If we pursue legal action, can we choose to file in Superior Court if we prefer?

A: The answer to your question is "yes." However, the real question is once you file, can the defendants successfully petition the Superior Court for an order compelling the parties to arbitrate their case? In English, can your lawyers force you to arbitrate? The answer to that question is likely "no."

Although California law generally enforces binding arbitration provisions between parties in private agreements, the court will apply a higher standard in your case. The attorney client relationship is a fiduciary relationship of the highest character. It is anecdotal that arbitrations do not involve juries, and, by extension, reduce exposure for one party or the other. So while there is nothing inherently improper about an arbitration agreement between a lawyer and a client which extends to malpractice claims, courts have held that the client must be "fully informed of the possible consequences of that agreement." Lawrence v. Walzer & Gabrielson (1989) 207 Cal. App. 3d 1501, 1507. Your contract, therefore, will be "closely scrutinized with the utmost strictness for any unfairness." Hawk v. State Bar (1988) 45 Cal.3d 589,598. In the end, if the judge decides that the arbitration provision in your fee agreement is conspicuous, clear, and is drafted in a way so as to clearly apply to this type of dispute, I would expect a judge to grant your lawyer's anticipated motion to compel arbitration.

This column contains general information and under no circumstances constitutes legal advice. This information is not provided in the context of an attorney-client relationship and nothing herein creates an attorney-client relationship. Readers should not act upon this general information without first seeking professional advice.

Ira Rosenblatt is a business and corporate lawyer and a co-founder and Director of Stone, Rosenblatt & Cha, a business law firm in Warner Center. Rosenblatt has earned Martindale-Hubbell's highest rating ("AV") for legal ability and ethics and is listed in Martindale-Hubbell's National Bar Register of Preeminent Lawyers. He can be reached at [e-mail].