The Earn-Out: A Common Feature of Agency Sales
You have built your agency over years. Maybe a decade. The offer comes in from a larger group or a competitor. The headline price looks good. But the buyer wants to tie part of the payment to future performance. That is an earn-out.
An earn-out is a deferred payment structure where you receive part of the sale price only if the agency hits certain targets after completion. Common targets include revenue growth, profit margins, client retention, or EBITDA milestones. For buyers, it protects them from overpaying if the agency underperforms post-sale. For sellers, it can bridge a valuation gap and access a higher total price.
The tax treatment of an earn-out under HMRC rules is not straightforward. Get the structure wrong and you could pay income tax at 45% instead of capital gains tax at 18% or 24%. That is a difference of tens or hundreds of thousands of pounds.
Working exclusively with agency founders, we see earn-outs in at least half of the agency sales we advise on. This article covers exactly how HMRC treats earn-outs, what the 2026/27 rules say, and how to structure your deal to keep more of the money you have earned.
How HMRC Classifies Earn-Out Payments: Capital vs Income
The single most important question for tax purposes is whether HMRC treats the earn-out payment as capital or income. The answer determines the tax rate, the reliefs available, and your net proceeds.
Capital treatment. If the earn-out is structured as deferred consideration for the sale of shares, the payment is capital in nature. You pay Capital Gains Tax (CGT) on the gain. For most agency founders, the rate is 18% if BADR applies, 24% if it does not. The earn-out payment is added to the proceeds in the year you receive it, and you report it on your Self Assessment tax return (SA100 form).
Income treatment. If the earn-out is structured as a payment for services, consultancy, or ongoing employment, HMRC treats it as income. You pay Income Tax at your marginal rate (up to 45%) plus Class 4 National Insurance at 2%. If the earn-out is paid to you as a director or employee, Employer NI at 15% also applies. This is the worst-case scenario for most sellers.
HMRC looks at the substance of the arrangement, not just the label. If the earn-out is clearly linked to your ongoing involvement in the business post-sale, they may argue it is income. If it is purely deferred consideration for the shares you sold, it is capital.
The earn-out tax treatment HMRC agency sale cases have established that the key factors are: whether you remain employed or engaged, whether the payment is conditional on your personal performance, and whether the amount is fixed or variable based on results. The more the earn-out looks like a reward for your ongoing work, the more likely HMRC will treat it as income.
Business Asset Disposal Relief (BADR) and Earn-Outs
BADR (formerly Entrepreneurs' Relief) is the single most valuable relief for agency founders selling their business. It gives a reduced CGT rate on qualifying gains up to a lifetime limit of £1 million: 14% for disposals from 6 April 2025 to 5 April 2026, and 18% from 6 April 2026.
To qualify for BADR on an earn-out, you must meet the conditions at the time of the original disposal. You need to have held at least 5% of the shares, been an officer or employee of the agency, and held both for at least two years before the sale.
Here is where it gets specific. Whether BADR reaches the earn-out depends on how it is structured. A fixed, ascertainable deferred payment is taxed as part of the original disposal, so BADR applies at the rate for the year you sold. A contingent earn-out whose value is unknown at completion (the classic revenue-target earn-out) is treated as a separate disposal of a right when the cash arrives, and BADR is usually not available on that second disposal. This is a critical point many founders miss.
Example. You sell your agency in June 2025. You qualify for BADR on the upfront consideration of £800,000, taxed at the 14% rate for 2025/26 disposals. The earn-out is £200,000, payable in June 2027 if the agency hits its revenue targets. Because that payment is contingent and unascertainable at completion, it is a separate disposal when the cash arrives, and BADR usually does not reach it. Plan on the main 24% rate for the earn-out unless your advisers structure the deal otherwise.
There is a trap. If the earn-out is structured as a separate contract for services rather than deferred consideration for shares, BADR does not apply. You lose the reduced rate entirely. We have seen buyers push for this structure because it gives them a tax deduction for the earn-out payment. Do not agree to it without understanding the cost to you.
Structuring the Earn-Out: Three Common Approaches
1. Deferred Consideration as a Fixed Amount
This is the simplest structure. You agree a fixed additional payment, say £150,000, payable in two years. The amount does not depend on performance. HMRC treats this as capital consideration for the shares. You pay CGT at 18% or 24% depending on BADR eligibility.
This structure gives you certainty. The downside is that the buyer takes all the risk if the agency underperforms. Many buyers will push for a variable earn-out instead.
2. Performance-Linked Variable Earn-Out
The earn-out is calculated based on post-sale performance, typically EBITDA or revenue. The amount is unknown at completion. HMRC still treats this as capital if it is clearly deferred consideration for the shares and you have no ongoing employment obligation.
The key document is the Share Purchase Agreement (SPA). The SPA must state that the earn-out is consideration for the shares, not payment for services. We recommend including a specific clause confirming this. HMRC can and does challenge earn-outs that look like disguised remuneration.
3. Earn-Out Paid as Consultancy or Employment Income
The buyer pays you a salary, consultancy fee, or dividend post-sale, linked to the agency's performance. This is income. You pay Income Tax and NI. The buyer gets a corporation tax deduction. This structure is common where the buyer wants you to stay on and run the agency for a period.
If you agree to this structure, you are effectively paying tax at 45% plus NI on what could have been a 10% capital gain. For a £200,000 earn-out, the difference is roughly £70,000 in extra tax. That is real money.
HMRC's Approach to Earn-Outs: Key Cases and Principles
HMRC has published guidance on earn-outs in their Capital Gains Manual (specifically CG12780-CG12790). The general principle is that deferred consideration is taxed in the year you receive it, not the year of sale. This is called the "part disposal" approach.
However, HMRC also has the power to reclassify earn-out payments as income if they believe the substance is employment-related. The case of HMRC v Gray & Anor (2015) is relevant. In that case, earn-out payments made to former shareholders who continued as directors were held to be capital gains, not income, because the payments were linked to the value of the shares sold, not the individuals' ongoing services.
The distinction turns on the facts. If the earn-out is calculated by reference to the agency's overall performance (not your personal performance), and you are not required to work a minimum number of hours, HMRC is more likely to accept capital treatment. If the earn-out is explicitly tied to your continued employment or personal billable targets, it looks like income.