You have found a buyer for your agency. The deal is structured as an upfront payment plus an earn-out based on the agency hitting certain revenue or profit targets over the next two to three years. That earn-out could be worth hundreds of thousands of pounds. But how is it taxed?

The answer is not straightforward. The tax treatment of earn-out payments when selling agency tax UK planning depends entirely on how the earn-out is structured in the legal documents. Get it right and you pay capital gains tax at 14% (or 20%). Get it wrong and HMRC treats the earn-out as income, taxed at up to 45% plus National Insurance.

This article explains the two main structures for earn-outs, how each is taxed, and what you need to discuss with your accountant and solicitor before signing anything.

What Is an Earn-Out in an Agency Sale?

An earn-out is a deferred payment mechanism. The buyer pays you part of the purchase price upfront, and the rest is contingent on the agency meeting agreed performance targets after the sale. Common targets include:

  • Revenue hitting a specific level (e.g., £1.2m in year one)
  • Gross profit margins staying above a certain percentage
  • Client retention rates (e.g., retaining 90% of the top 10 clients)
  • EBITDA hitting a target figure

Earn-outs are common in agency sales because the buyer wants to protect themselves against the risk that the agency's performance drops after you leave. They also bridge valuation gaps when the buyer and seller cannot agree on a fixed price.

From a tax perspective, the critical question is whether the earn-out is treated as a capital receipt (subject to capital gains tax) or as income (subject to income tax and National Insurance).

The Two Structures: Share Sale vs. Asset Sale

The first structural decision is whether the buyer purchases your shares (a share sale) or purchases the agency's assets and goodwill (an asset sale). This choice affects how the earn-out is taxed.

Share Sale with Earn-Out

In a share sale, you sell your shares in the agency to the buyer. The buyer pays you for those shares. If part of the payment is deferred through an earn-out, you are receiving additional consideration for the same shares.

HMRC's default position is that earn-out payments in a share sale are treated as capital receipts. This means they are subject to capital gains tax, not income tax. The rate depends on your total gains for the tax year and whether you qualify for Business Asset Disposal Relief (BADR).

BADR (formerly Entrepreneurs' Relief) gives you a 14% capital gains tax rate on qualifying disposals, up to a lifetime limit of £1 million. For agency founders, this is the most valuable relief available on an exit. But there are conditions.

To qualify for BADR on the earn-out element, you must meet the qualifying conditions at the time of the original disposal. You need to have held at least 5% of the shares and voting rights, and been an officer or employee of the agency, for the two years immediately before the sale completes.

If you qualify for BADR on the upfront payment, you generally also qualify on the earn-out payments, provided the earn-out is structured as additional consideration for the shares you already sold. This is a key point. Your solicitor must draft the share purchase agreement so that the earn-out is clearly part of the consideration for the shares, not a separate payment for ongoing services.

Asset Sale with Earn-Out

In an asset sale, the buyer purchases the agency's assets: client contracts, goodwill, intellectual property, equipment, and possibly the company name. The company (not you personally) receives the sale proceeds. The company then distributes the money to you as a shareholder, typically through a capital distribution or a dividend.

If the earn-out is paid to the company and then distributed to you, the tax treatment depends on how the distribution is structured. Capital distributions (winding up or share buyback) can qualify for capital gains treatment and potentially BADR. Dividend distributions are taxed at dividend rates (8.75%, 33.75%, or 39.35%).

Asset sales are less common for agency sales because the buyer typically wants to acquire the company itself to preserve contracts and relationships. But they do happen, particularly when the buyer wants to avoid inheriting the company's liabilities.

The Income Tax Trap: When HMRC Treats Earn-Outs as Employment Income

Here is where many agency founders get caught out. If the earn-out is structured as a payment for ongoing services, or if you stay on as a director or employee of the agency after the sale, HMRC may argue that the earn-out is effectively remuneration for your continued role.

HMRC has a specific rule: if you receive a payment that is "earned" by providing services after the sale, it is income, not capital. This is called the "earned income" argument. HMRC uses it aggressively where the earn-out is tied to you staying with the agency and meeting personal performance targets.

For example, if the earn-out says you must remain as Managing Director for three years and the payment is based on your personal billable hours or your own client relationships, HMRC will likely treat the earn-out as employment income. You will pay income tax at up to 45%, plus employee and employer National Insurance (13.8% employer, 2% employee above thresholds).

Compare that to 14% capital gains tax under BADR. The difference is enormous.

On a £500,000 earn-out, the difference between 10% CGT and 45% income tax is £175,000. That is a £175,000 mistake.

How to Structure the Earn-Out to Protect Capital Gains Treatment

There are several steps you can take to maximise the chance that HMRC treats the earn-out as capital rather than income.

1. Make the Earn-Out Contingent on Company Performance, Not Your Personal Performance

The earn-out targets should be based on the agency's overall financial performance: revenue, gross profit, EBITDA, or client retention rates. Avoid targets that are tied to your personal billable hours, your own client relationships, or your individual output.

If the earn-out is based on the agency's performance, it looks like additional consideration for the shares you sold. If it is based on your personal performance, it looks like remuneration for ongoing services.

2. Do Not Stay On as an Employee or Director

If you can, leave the agency entirely on completion. If you must stay on to help with the transition, do so as a consultant or non-executive director, not as an employee. Have a separate consultancy agreement with a market-rate fee that is clearly distinct from the earn-out.

HMRC looks at the substance, not just the form. If you are effectively running the agency post-sale, they will argue the earn-out is income regardless of what the contract says.

3. Use a "CGT-Friendly" Earn-Out Structure

There are two common structures that HMRC generally accepts as capital:

Fixed deferred consideration with a performance condition. You agree a total price upfront (say £2m). £1m is paid on completion. The remaining £1m is deferred and paid in instalments, but the obligation to pay is conditional on the agency hitting certain targets. This is still capital consideration for the shares.

Earn-out shares or loan notes. The buyer issues you with shares or loan notes in the buying company that are redeemable based on performance. These are capital assets. When you sell or redeem them, you pay capital gains tax on the gain. This structure is more complex but gives you more control over timing and tax rates.

4. Get a Professional Valuation and Document the Allocation

Your solicitor and accountant should document how the total consideration (upfront plus earn-out) is allocated to different assets: goodwill, client contracts, intellectual property, and so on. This allocation affects your capital gains calculation and any potential BADR claim.

HMRC can challenge the allocation if it looks artificial. Use a professional valuer who understands agency businesses. A valuation from a generic accountant that values goodwill at 90% of the total will raise red flags.

What Happens If the Earn-Out Is Paid in Shares or Loan Notes?

If the earn-out is paid in shares of the buying company, you have a different tax situation. You do not pay tax when you receive the shares. You pay capital gains tax when you eventually sell the shares. This defers the tax bill but does not eliminate it.

The valuation of the shares at the time you receive them is critical. If the shares are unquoted and hard to value, you may need a formal valuation for your tax return. HMRC's Share Valuation Division can challenge your valuation, so get professional advice.

Loan notes are similar. You receive loan notes that pay interest and are redeemed after a set period. The interest is taxable as income. The gain on redemption is capital. The structure of the loan notes (qualifying corporate bonds vs. non-qualifying) affects whether you can defer the gain or must pay it immediately.

This is specialist territory. Do not try to structure loan notes yourself. You need a corporate finance solicitor and an ICAEW qualified accountant who have done this before.

Badr and Earn-Outs: The Two-Year Rule

One of the most common mistakes we see is agency founders assuming they qualify for BADR on the entire earn-out, only to discover that the earn-out period extends beyond the qualifying window.

BADR requires that you meet the qualifying conditions (5% shareholding, officer or employee) for two years before the disposal. The "disposal" for BADR purposes is the date you sell your shares, not the date you receive the earn-out payments.

If you sell your shares on 1 June 2025, and the earn-out payments are made over the next three years, you still qualify for BADR on the earn-out payments because the disposal happened on 1 June 2025. The earn-out is just deferred consideration for that same disposal.

However, if the earn-out is structured as a separate payment for services (the income trap above), the two-year rule does not apply because it is not a capital disposal at all. The payment is income, and BADR does not apply to income.

The lesson is clear: get the structure right at the point of sale. You cannot fix it later.

Practical Steps Before You Sign Anything

If you are considering selling your agency and the deal includes an earn-out, here is what to do before you sign the heads of terms:

  1. Speak to your accountant first. Before you even start negotiations, have a conversation with your accountant about the tax implications of different earn-out structures. At Agency Founder Finance, we are ICAEW qualified accountants who work exclusively with agency founders. We see earn-out structures regularly and can advise on the tax-efficient approach for your specific situation.
  2. Instruct a solicitor who understands agency sales. Not all corporate solicitors understand the nuances of earn-outs in service businesses. Ask your solicitor how many agency sales they have handled. If the answer is fewer than five, find someone else.
  3. Model the tax outcomes. Work through the numbers with your accountant. What is the tax bill under different earn-out structures? What is the net amount you keep after tax? This should influence how you negotiate the deal.
  4. Document everything. The share purchase agreement, the consultancy agreement (if you stay on), and any side letters must all be consistent. If one document suggests the earn-out is for services and another says it is for shares, HMRC will use the ambiguity against you.
  5. Plan for the earn-out period. If you are staying on for the earn-out period, agree your ongoing role, your remuneration, and your exit terms in writing. This protects you if the relationship with the buyer deteriorates.

What If the Earn-Out Fails?

If the agency does not hit the earn-out targets, you receive less (or nothing) from the earn-out. This is a commercial risk you accept when you agree to the structure.

From a tax perspective, if you have already paid tax on the expected earn-out value (unlikely but possible if you elected to treat the earn-out as a fixed deferred consideration), you can claim a loss relief. More commonly, you simply receive less consideration and pay less tax.

If the earn-out is structured as shares or loan notes, and the value drops, you may have a capital loss that you can set against other capital gains. This is a complex area. Speak to your accountant if the earn-out fails to materialise as expected.

Final Thoughts

Earn-outs are a common feature of agency sales. They allow you to sell your agency for a higher total price while giving the buyer protection against underperformance. But the tax treatment of earn-out payments is not automatic. It depends on how you structure the deal.

The difference between paying 10% capital gains tax and 45% income tax on a £500,000 earn-out is £175,000. That is not a detail to leave to chance.

If you are planning an exit and expect an earn-out to form part of the deal, speak to us early. Our ICAEW qualified team at Agency Founder Finance can help you model the tax outcomes, structure the earn-out correctly, and ensure you keep as much of your hard-earned sale proceeds as possible.

Contact us to discuss your agency exit plans. Or read more about exit planning for agency founders on our blog.