Earn-Out Tax: Why One Deal Produces Two Completely Different Answers
Earn-out tax exposure is the most misunderstood consequence of selling a British company while holding a US passport, because Britain and America refuse to agree on when the gain exists. You sign one share purchase agreement. HMRC then treats it as two separate disposals of two separate assets, while the IRS treats it as one sale paid in slices. Consequently the tax falls in different years, at different rates, in different currencies, against reliefs that never line up. Furthermore, the mismatch is not theoretical. It routinely leaves sophisticated sellers paying tax twice on the same economic profit.
At TaxYork we see this every deal season. A founder negotiates hard on headline price, secures a respectable multiple, and never asks the one question that decides the after-tax outcome. That question is simple. When does each revenue authority think the money became taxable?
The Earn-Out Tax Problem Stated in a Single Sentence
Britain taxes a promise. America taxes a payment. Therefore the earn-out tax charge in the United Kingdom lands roughly two years before the matching American charge, and a foreign tax credit cannot cross that gap unaided.
That sentence explains almost every unpleasant surprise we unwind. HMRC values your right to future money on completion day and charges capital gains tax on that value immediately. The Internal Revenue Service ignores the promise entirely and waits for cash. Accordingly you end up with British tax in year one and American tax in year three, each looking for a credit that the other year cannot supply.
Who Actually Carries This Earn-Out Tax Risk
American citizens and green card holders resident in Britain carry it in full. Additionally, dual nationals who have never lived in the United States carry it too, because citizenship-based taxation does not care where you were raised. Founders who moved to London on an intra-company transfer and then built something of their own sit squarely in the same position.
Non-resident British sellers who later move to America face a mirror image of the problem. Importantly, the analysis below assumes you are a US person who is tax resident in the United Kingdom throughout, which is by far the most common fact pattern we encounter.
How HMRC Charges Earn-Out Tax: The Marren v Ingles Two-Disposal Rule
The British earn-out tax analysis rests on a 1980 House of Lords decision that predates every modern deal structure yet still governs them all. In Marren v Ingles, a shareholder sold shares for cash plus a right to further money if the company floated. The courts held that the right itself was a separate chargeable asset, a chose in action, and that receiving money under it was a second disposal.
HMRC restates this at length in its Capital Gains Manual guidance on deferred consideration. The distinction that matters is between ascertainable and unascertainable consideration. Moreover, that distinction is drawn on completion day, not with hindsight.
Disposal One: Cash Plus the Value of a Promise
On completion you dispose of your shares. Your consideration comprises the cash actually paid plus the open market value of the right to receive the earn-out. HMRC expects a reasoned valuation, discounted for contingency, for the risk that targets are missed, and for the time value of money.
That valuation drives your entire earn-out tax position for the year of sale. Furthermore, it becomes the base cost of the new asset you now own. Get it wrong and every subsequent calculation inherits the error. Notably, HMRC challenges valuations that look conveniently low, and the manual on valuing deferred rights sets out what officers look for.
The practical sting is obvious. You pay capital gains tax on money you have not received. Therefore the first earn-out tax charge is a dry one, payable by 31 January following the tax year of completion and funded entirely from the upfront cash.
Disposal Two: When the Money Actually Arrives
When the earn-out pays out, you dispose of the right. Your proceeds are the cash received. Your base cost is the valuation agreed at completion. The difference is a fresh chargeable gain, or a capital loss if the business underperformed.
This second charge falls in the tax year of receipt. Additionally, it is measured against the main capital gains tax rates, which for 2026/27 stand at eighteen per cent within the basic rate band and twenty-four per cent above it. The current rates and allowances are published by HMRC, alongside an annual exempt amount of just £3,000.
Why Business Asset Disposal Relief Dies on the Second Disposal
Here is the detail that costs British sellers the most money, and the one that deal lawyers mention only in a footnote. Business Asset Disposal Relief applies to disposals of shares in a personal trading company. The Marren v Ingles right is not a share. It is a chose in action.
Consequently the second disposal attracts no relief whatsoever. Your completion-day gain may qualify for Business Asset Disposal Relief at eighteen per cent for 2026/27, up from fourteen per cent the previous year, on the first million pounds of lifetime gains. The deferred earn-out tax charge on receipt, by contrast, runs at the full twenty-four per cent. We explore the interaction in our guide to Business Asset Disposal Relief and US tax on a UK company sale.
How the IRS Charges Earn-Out Tax: Section 453 and Form 6252
American law reaches a different destination by a shorter route. There is no second asset. There is one sale of stock, paid over time, and the default mechanism is the instalment method under Internal Revenue Code section 453.
The IRS sets out the mechanics in Publication 537 on instalment sales, and you report each year on Form 6252. Accordingly the American earn-out tax charge tracks cash received, which is precisely what British law refuses to do.
The Instalment Method Applies Automatically
You do not elect into the instalment method. It applies unless you elect out. Each payment carries out a proportion of your total gain, determined by a gross profit ratio calculated at the outset.
The ratio is gross profit divided by total contract price. Subsequently you multiply each payment by that ratio to find the taxable slice. Meanwhile the balance of each payment is a tax-free return of basis, and any stated or imputed interest is stripped out first as ordinary income taxed at your marginal rate rather than the capital gains rates.
Stated Maximum Selling Price, Fixed Period, or Fifteen Years
Contingent earn-outs complicate the ratio because the total price is unknown, so the earn-out tax calculation cannot simply follow the contract. Treasury Regulation 15a.453-1(c) supplies three fallbacks, applied in a strict order.
Where the agreement caps the consideration, that stated maximum selling price becomes the contract price. Where no cap exists but payments run over a fixed period, you spread basis rateably across that period instead. Where neither a cap nor a fixed period exists, you recover basis rateably over fifteen years, which is usually the worst available outcome.
Therefore the drafting of your earn-out clause fixes your American earn-out tax profile before a single payment is made. Capping the earn-out helps the IRS analysis and simultaneously caps your British stamp duty exposure. Notably, a cap also depresses the HMRC valuation of the right, which is a rare instance of both authorities pulling the same way.
The Section 453A Interest Charge Above Five Million Dollars
Section 453A imposes a non-deductible interest charge where the sale price exceeds $150,000 and your outstanding instalment obligations exceed $5 million at year end. The charge then applies in every subsequent year the obligation remains outstanding, even if the balance later falls below the threshold.
For a substantial UK exit this matters enormously. Furthermore, the charge is calculated on the deferred tax liability rather than on the note itself, and it is not creditable against British tax. Consequently a seller with a large uncapped earn-out pays an annual penalty for deferral they never asked for, which is a pure addition to the overall earn-out tax cost.
The Timing Mismatch That Strands Your Foreign Tax Credit
Now the two systems collide. Your British earn-out tax charge peaks in the year of completion. Your American charge peaks two or three years later. The foreign tax credit is an annual computation, so it cannot simply reach across that gap.
A Dry UK Charge Against No Corresponding US Income
In the year of sale you pay capital gains tax to HMRC on cash plus the valued right. The IRS, on the instalment method, taxes only the gain proportion of the cash actually received. You therefore generate excess foreign tax credits in year one and a bare American liability in year three.
Excess credits do carry. The rules permit a one-year carryback and a ten-year carryforward, and the IRS explains the framework in its foreign tax credit guidance. Nevertheless, carryforwards relieve tax only within the same limitation basket, and they help only if you still hold foreign-source income of that character years later. Our guide to foreign tax credit carryforwards when leaving the UK explains how quickly that assumption fails.
Sourcing, Baskets and Article 24(6)
Capital gains are sourced by residence under section 865. A US citizen living in London therefore produces a gain that America regards as American-source, which leaves nothing for the British tax to offset. Article 24(6) of the US-UK double taxation treaty re-sources such gains to the United Kingdom specifically to preserve the credit, which is what rescues the earn-out tax credit position entirely.
That re-sourcing is never automatic on your return. You claim it, on a separate Form 1116 using the treaty-resourced category, and you disclose the treaty position. Additionally the gain sits in the passive basket, which cannot absorb general-basket credits generated by your salary. Misallocating the basket is the most common earn-out tax error we correct, as our note on foreign tax credit basket errors sets out.
The Section 453(d) Election That Fixes the Timing
The cleanest solution is also the least used. Section 453(d) lets you elect out of the instalment method altogether, accelerating the entire American gain into the year of sale. Where the fair market value of the contingent right can be reasonably ascertained, you include that value as consideration immediately.
This aligns the American charge with the British one almost exactly, because HMRC has already valued the same right for its own purposes. Consequently your foreign tax credit works in the year it arises rather than depending on a decade-long carryforward. The election falls due with the return for the year of sale, including extensions, and it is revocable only with IRS consent. Therefore you decide once, early, and permanently.
The Currency Layer Nobody Prices In
Every American figure is a dollar figure. Your base cost converts at the historic rate, your completion proceeds at the completion rate, and each earn-out payment at the rate on its own payment date. Sterling weakness between signing and payout can therefore manufacture an American gain with no British counterpart, or erase one that does exist.
Furthermore, where the proceeds sit in a sterling account before repatriation, section 988 can generate separate ordinary income on the currency movement alone. We cover the mechanics in our article on foreign currency gains on GBP accounts. This currency layer sits on top of the earn-out tax analysis rather than inside it.
When HMRC Recharacterises Your Earn-Out as Employment Income
The entire earn-out tax analysis collapses if HMRC decides the payment is really pay. Employment income attracts up to forty-five per cent income tax plus National Insurance, against a capital rate of twenty-four per cent. The gap is enormous and the test is purely factual.
The Six Indicators in ERSM110940
HMRC publishes its position in the Employment Related Securities Manual. Officers ask whether the agreement genuinely treats the payment as consideration for securities, whether the value received reflects the value of what was given up, and whether it compensates for under-remuneration during the earn-out period.
They ask three further questions that decide most cases in practice. Is payment conditional on continued employment beyond what is reasonable to protect value? Does the formula incorporate personal performance targets rather than business performance targets? Do non-employee shareholders receive identical terms to those who stay?
Drafting That Protects the Earn-Out Tax Position
Business metrics beat personal metrics every time. Revenue, EBITDA or gross margin targets support capital treatment, whereas targets tied to an individual seller's own billings invite immediate challenge. Additionally, good leaver provisions that preserve payment on death or ill health strengthen the capital argument considerably.
Reallocation clauses create the sharpest risk. Where a departing seller's forfeited entitlement is redistributed to those who remain, HMRC has a strong argument that the redistributed slice is remuneration. Consequently the earn-out tax treatment of the remaining sellers can differ from their co-founders on otherwise identical paperwork.
What Recharacterisation Does on the American Side
American law runs a parallel analysis without reaching a parallel outcome. The IRS asks whether the payment is purchase price or compensation under general principles and section 83, and section 409A can apply to service-conditioned deferred payments.
Here lies the trap. A British income recharacterisation moves the charge to PAYE, while the American analysis may still treat the payment as capital. Therefore you face British income tax and American capital gains tax on the same money, in different baskets, with a credit that may not fit. Moreover, the National Insurance element earns no American credit at all, because social security contributions are not creditable income taxes.
Loan Notes, Section 138A and the Rollover the IRS Ignores
Sellers frequently take their deferred consideration in loan notes rather than cash, which changes the earn-out tax profile completely. Section 138A of the Taxation of Chargeable Gains Act 1992 then permits the right to be treated as a security, rolling the gain forward until the notes are redeemed. The statutory text is published on legislation.gov.uk.
Why the British Deferral Is Genuine
Section 138A converts an immediate charge into a deferred one. You avoid the dry tax charge on completion, and the gain crystallises when the notes are redeemed or disposed of. For a purely British seller this is often the decisive structuring point in the whole transaction.
Why an American Seller Gains Almost Nothing
American law recognises no equivalent rollover for a share-for-note exchange of this kind. Consequently the IRS still taxes under section 453 as payments are received, and it does not care that HMRC has deferred anything. The result inverts the usual mismatch, because now America taxes first and Britain taxes later.
That inversion is worse, not better. Your American earn-out tax charge arises in a year with no British tax to credit, and the later British charge arrives with no American liability left to shelter. Therefore the section 138A election, which suits almost every British seller, is frequently wrong for an American one.
When the Earn-Out Disappoints: Losses, Section 279A and Clawbacks
Earn-outs miss their targets far more often than founders expect, and the earn-out tax consequences do not simply reverse. The tax consequences of a shortfall are asymmetric and unforgiving unless you act within tight deadlines.
The Section 279A Carry-Back Election
If the earn-out pays less than the valuation placed on the right at completion, you realise a capital loss on the second disposal. Ordinarily British capital losses carry forward only, which would leave you having paid tax on a valuation that reality disproved.
Section 279A of the Taxation of Chargeable Gains Act 1992, inserted by Finance Act 2003, solves precisely that. You may elect to carry the loss back against the gain on the original share disposal. HMRC explains the conditions in its manual on the election for treatment of loss, with procedural detail at CG15121, and the statutory wording sits at section 279A.
The deadline is unforgiving. You must notify HMRC in writing on or before the first anniversary of the 31 January following the tax year of the loss. Furthermore the election is irrevocable, and separate notices are required for separate losses. Missing it converts a recoverable overpayment of earn-out tax into a permanent one.
Reverse Earn-Outs and Repayment Obligations
A reverse earn-out pays the full price upfront subject to clawback if targets are missed. British law treats this as ascertainable consideration, so the whole amount is taxed at completion, with section 48 permitting adjustment when part later proves irrecoverable.
American treatment of a clawback is considerably harsher. Repaying previously taxed proceeds generates a capital loss in the repayment year, useable only against capital gains, unless you qualify for relief under section 1341. Consequently the earn-out tax cost of a failed reverse structure can exceed the cost of a conventional one by a substantial margin.
A Worked Case Study: Selling a London Software Company
The earn-out tax arithmetic becomes far clearer with real figures attached. Consider Sarah, an American citizen who has lived in London for eleven years and files in both countries. She sells her software company in November 2026 for £4,000,000 in cash plus an earn-out capped at £3,000,000, payable over two years against EBITDA targets. Her base cost is £50,000. We use an illustrative rate of $1.30 to the pound throughout.
Her accountants value the earn-out right at £1,800,000, discounted for contingency. Her British consideration is therefore £5,800,000, producing a gain of £5,750,000. Business Asset Disposal Relief covers the first £1,000,000 at eighteen per cent, costing £180,000, while the remaining £4,750,000 attracts twenty-four per cent, costing £1,140,000. Her total British earn-out tax and share sale liability is £1,320,000, due on 31 January 2028.
On the American side under the instalment method, her gross profit ratio is 99.3 per cent against a stated maximum selling price of £7,000,000. The completion payment of $5,200,000 therefore carries out roughly $5,163,000 of gain, taxed at twenty per cent for $1,032,600, plus net investment income tax of $196,200. Her British tax of $1,716,000 comfortably covers the creditable portion, leaving around $683,000 of excess passive-basket credit to carry forward.
Two years later the earn-out pays £2,200,000. HMRC charges twenty-four per cent on the £400,000 excess over the right's base cost, costing £96,000, with no Business Asset Disposal Relief available at all. The IRS taxes roughly $2,840,000 of gain at twenty per cent, costing $567,900, plus a further $108,700 of net investment income tax. Current-year British tax supplies only $124,800 of credit, so Sarah depends entirely on the carryforward to absorb the remaining $443,100.
Had Sarah elected out under section 453(d), her American gain would have arisen in 2026 alongside the British charge, costing roughly $1,495,000 against $1,716,000 of available credit. Her 2028 American gain would then have been only £400,000 in substance, matched almost exactly by the British charge on the same figure. Consequently the election removes her dependence on a ten-year carryforward, on remaining British resident, and on the passive basket still holding foreign income in 2028. The uncreditable net investment income tax of roughly $305,000 survives either route, because that charge earns no treaty relief whatsoever.
How TaxYork Can Help
We prepare the American and British returns for the same transaction together, which is the only way the timing can be controlled rather than merely discovered. Our team models the earn-out tax outcome under both the instalment method and a section 453(d) election before the share purchase agreement is signed, so the structuring decision is made with the numbers in front of you.
Furthermore, we handle the valuation support HMRC expects for the right, the Form 6252 reporting in every subsequent year, and the treaty-resourced Form 1116 that preserves your credit. Where a deal has already completed without planning, we review whether a section 279A election remains available and whether amended returns can recover stranded credit. Our cross-border planning service and our US tax return preparation for expats run as a single engagement rather than two.
Additionally, sellers who discover unfiled returns or unreported accounts from earlier years can regularise through IRS Streamlined Filing before a transaction invites scrutiny. Technical guidance from the ICAEW tax faculty, the Chartered Institute of Taxation and the AICPA tax section underpins how we document every earn-out tax position we take, and the IRS sets out the baseline obligations for US citizens and resident aliens abroad. HMRC publishes its own share valuation approach in the Capital Gains Manual chapter on company shares.
Conclusion
Earn-out tax is a timing problem disguised as a rate problem. Britain charges you on a valued promise in the year of completion, then charges you again, without Business Asset Disposal Relief, when the cash finally arrives. America ignores the promise entirely and taxes the cash, which pushes its charge into years where your British credits have already been consumed.
The fix is almost always decided before signing rather than afterwards. Capping the earn-out, keeping targets to business metrics, resisting the section 138A rollover, and electing out under section 453(d) each move the two systems closer together. Ultimately the seller who models both jurisdictions before completion keeps materially more of the price than the seller who models neither. Every American selling a British company should therefore treat the earn-out tax analysis as a deal term, not as an administrative consequence of one.
Contact Us
TaxYork prepares US and UK tax returns for company founders, investors and executives on both sides of the Atlantic. If you are negotiating a sale, or you have already completed one and need the earn-out tax position resolved correctly, we can help.
Email hello@taxyork.com or call 020 3488 8606 to speak to a specialist. Alternatively you can book a consultation directly, and we will review your share purchase agreement well before the reporting deadlines bite.
Disclaimer
This article provides general information on earn-out tax for US and UK filers and does not constitute tax or legal advice. Tax legislation, rates and thresholds change, and the treatment of any transaction depends entirely on its specific facts and documentation. You should obtain professional advice tailored to your circumstances before acting. TaxYork accepts no liability for any action taken in reliance on this article.