VERTESS Answers: Why Are Earnouts and Seller Notes Advantageous Come Tax Time?

Volume 12, Issue 5, March 11, 2025

By David E. Coit, Jr., DBA, CVA, CVGA, CM&AA, CBEC, CAIM

It’s quite common for healthcare mergers and acquisitions (M&A) transactions to include either an earnout or a seller note, or in some cases both. Earnouts are an addition to the enterprise value where buyers seek protection against a potential future decline in company performance post-closing. For example, the buyer may offer the seller future payouts based on revenue growth or an increase in profitability. Seller notes also allow the buyer to offer a higher price and provide the buyer acquisition financing provided by the seller. For example, the buyer may provide the seller with a note that pays principal and interest for several years post-closing.

You might be wondering why a seller would accept either an earnout or a seller note. The answer is that both allow the buyer to offer a higher price to the seller. Earnouts and seller notes are used by buyers to offer sellers a higher price than an all-cash offer. Additionally, both earnouts and seller notes have tax advantages over the cash paid at closing.

Before we discuss the tax advantages associated with an earnout or seller note, let’s first take a look at capital gains taxes.

Capital Gains Tax Example

In a typical healthcare M&A transaction, the seller receives cash proceeds at closing, net of closing-related costs. In an equity sale, the cash received by the seller at closing is subject to federal capital gains tax and state income taxes. The capital gains tax rates for 2025 are as follows:

A married seller, filing jointly, would pay zero federal taxes on the first $96,700 in capital gains, followed by 15% for capital gains between $96,701 and $600,050, then 20% for capital gains in excess of $600,050.

Let’s see what that looks like for $5 million in capital gains:

As such, the seller would need to pay $955,493 in federal taxes in the tax year of the sale.

Tax Advantage of Seller Note

If, however, the seller accepted $4 million at closing and a $1 million seller note that called for 12 quarterly principal payments of $83,333.33 plus interest at a rate of 7.0%, the capital gains taxes would look like this:

Instead of paying $955,493 in federal taxes in the tax year of the sale, the seller would pay $755,493. The seller would then pay $35,495 for each of the following three years as the principal portion of the seller note is paid to the seller, for total capital gains taxes of $790,987 (a savings of $164,506). Additionally, the seller would earn $113,750 in interest income that would be taxed as ordinary income.

Tax Advantage of Earnout

The tax advantage of an earnout looks similar to the seller note example above, but it would not include interest income. The difference between seller note capital gains taxes on the principal payments and the earnout proceeds is that sellers don’t always know in advance the amount of the earnout proceeds. For example, a buyer might offer the seller an earnout based on a percentage of incremental revenues for three years post-closing. Neither the seller nor the buyer will know the amount of annual revenue for each of the post-closing three years until the year ends.

Both the seller note and earnout provide the seller with a tax deferral and lower overall capital gains taxes. However, that assumes federal tax rates remain the same in future years.

Sellers must also take into consideration that there is a risk that the seller may not be able or willing to pay principal and interest on the seller's note or that the future performance of the company does not meet the earnout hurdles.

Understanding the Tax Advantages of Seller Notes and Earnouts

I hope this column has provided you with greater insight into the potential tax advantages of seller notes and earnouts. Knowing the potential tax advantages allows sellers to make more informed decisions regarding accepting a seller note or earnout.

Please note that most states tax capital gains as regular income. A seller note and earnout still provide the seller with a tax deferral, which may offer tax advantages for state income tax purposes depending on the overall taxable income of the seller post-closing. Most sellers expect lower amounts of regular income after they sell their business.

Although this column illustrates the potential tax savings of seller notes and earnouts, readers should always seek the advice of a tax professional like a CPA before making a decision on such matters.

Curious about what you should expect regarding the after-tax proceeds for the sale of your healthcare company? Request a market valuation of your business from VERTESS — regardless of whether you're considering selling soon. Knowing the current market valuation can provide insight you can use to better determine the go-forward plan for your company.

A good roadmap begins by knowing where you are today. A market valuation of your healthcare business is a great start to planning for your future.

David E. Coit, Jr., DBA, CVA, CVGA, CM&AA, CBEC, CAIM

I am a seasoned commercial and corporate finance professional with over 30 years of experience. As part of the VERTESS team, I provide clients with valuation, financial analysis, and consulting support. I have completed over 400 business valuations. Most of the valuation work I do at VERTESS is for healthcare companies such as behavioral healthcare, home healthcare, hospice care, substance use disorder treatment providers, physical therapy, physician practices, durable medical equipment companies, outpatient surgical centers, dental offices, and home sleep testing providers.

I hold certifications as a Certified Valuation Analyst (CVA), issued by the National Association of Certified Valuators and Analysts, Certified Value Growth Advisor (CVGA), issued by Corporate Value Metrics, Certified Merger & Acquisition Advisor (CM&AA), issued by the Alliance of Merger & Acquisition Advisors, and Certified Business Exit Consultant (CBEC), issued by Pinnacle Equity Solutions, and Certified Acquisition Integration Manager (CAIM), issued by Intista. Moreover, the topic of my doctoral dissertation was business valuation.

I earned a Doctorate in Business Administration from Walden University with a specialization in Corporate Finance (4.0 GPA), an MBA from Keller Graduate School of Management, and a BS in Economics from Northern Illinois University. I am a member of the Golden Key International Honor Society and Delta Mu Delta Honor Society.

Before joining VERTESS, I spent approximately 20 years in commercial finance, having worked in senior-level management positions at two Fortune 500 companies. During my commercial finance career, I analyzed the financial condition of thousands of companies and successfully sold over $2 billion in corporate debt to institutional buyers.

I am a former adjunct professor with 15 years of experience teaching corporate finance, securities analysis, business economics, and business planning to MBA candidates at two nationally recognized universities.

Email David Coit or Call: (480) 285-9708.