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 14% or 20%. That is a difference of tens or hundreds of thousands of pounds.

As ICAEW qualified accountants 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 2025/26 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 14% 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 13.8% 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 reduces the CGT rate to 10% on qualifying gains, up to a lifetime limit of £1 million.

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. If you receive an earn-out payment in a later tax year, HMRC allows you to claim BADR on that payment provided the original disposal qualified. You do not need to re-qualify at the point you receive the earn-out cash. 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. The earn-out is £200,000, payable in June 2027 if the agency hits its revenue targets. When you receive that £200,000 in 2027, you can claim BADR on it, provided the original disposal qualified. The gain is taxed at 14%, not 20%.

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 10% 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 14% 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.

Practical Steps to Protect the Capital Treatment

If you are negotiating an earn-out, here is what to do before you sign anything.

  • Get the SPA drafted by a specialist corporate solicitor. The wording matters. The earn-out must be expressed as deferred consideration for the shares, not a separate payment for services.
  • Limit your ongoing obligations. If you stay on as a director or consultant, make sure the earn-out is not conditional on your personal performance. Structure it around the agency's EBITDA or revenue, not your individual billable hours.
  • Consider a fixed earn-out. A fixed amount payable at a future date is less likely to be challenged than a variable amount based on performance. It also gives you certainty.
  • Negotiate the buyer's tax position separately. Buyers often want the earn-out structured as income so they can deduct it. You need to explain that this costs you tens of thousands in extra tax. A compromise is sometimes possible where the buyer gets a partial deduction and you get capital treatment.
  • Document your intentions. Have a clear paper trail showing that the earn-out is part of the sale consideration, not a reward for post-sale services. Board minutes, correspondence, and the SPA should all reflect this.

Tax Rates for Earn-Out Payments in 2025/26

Here are the rates that apply depending on classification.

Capital treatment (with BADR): 14% on gains up to £1 million lifetime limit. Above that, 20%.

Capital treatment (without BADR): 24% for higher rate taxpayers, 18% for basic rate taxpayers (if within the basic rate band).

Income treatment (self-employed): Income Tax at 20%, 40%, or 45% depending on total income. Class 4 NI at 2% on profits above £12,570.

Income treatment (employed): Income Tax at marginal rate. Employee NI at 2% on earnings above £12,570. Employer NI at 13.8% (borne by the buyer, but it reduces the amount they are willing to pay).

The difference between 10% and 45% is enormous. On a £300,000 earn-out, you keep £270,000 at 14% CGT, or £165,000 at 45% Income Tax. That is £105,000 less in your pocket.

What Happens If HMRC Challenges the Earn-Out?

HMRC has up to 12 months from the filing date of your Self Assessment to open an enquiry into your tax return. If you receive an earn-out payment and treat it as a capital gain, HMRC may challenge the classification.

If they do, the burden is on you to show that the payment is capital, not income. This is where the SPA wording and the factual circumstances matter. A well-drafted SPA that clearly states the earn-out is deferred consideration for shares is your strongest defence.

If HMRC reclassifies the payment as income, you will owe the difference in tax plus interest and potentially penalties. The penalty can be up to 30% of the additional tax if HMRC considers you were careless, or higher if they consider it deliberate.

This is not a reason to avoid earn-outs. It is a reason to structure them correctly from the start and to take professional advice before signing the SPA.

Earn-Outs and the Agency Context

Earn-outs are particularly common in agency sales because the value of an agency is heavily dependent on client relationships and key staff. Buyers want protection against the risk that clients leave or key people depart after the sale.

For a digital agency, the earn-out might be based on client retention rates. For a PR agency, it might be based on new business wins. For a creative agency, it might be based on project margins. Whatever the metric, the tax treatment depends on the legal structure, not the business metric.

If you are a marketing agency founder considering an exit, the earn-out is a tool you should understand. Used correctly, it can help you achieve a higher total price. Used badly, it can cost you a significant portion of your proceeds in unnecessary tax.

Our ICAEW qualified team at Agency Founder Finance works with agency founders on exit planning, including earn-out structuring. If you are considering a sale, contact us for a confidential discussion about your situation.

Frequently Asked Questions

Can I claim BADR on an earn-out payment received in a later tax year?

Yes, provided the original share disposal qualified for BADR. You do not need to re-qualify at the point you receive the earn-out. The gain on the earn-out is treated as part of the original disposal and qualifies for the 10% rate, up to the £1 million lifetime limit.

What happens if the earn-out is paid as a dividend post-sale?

If the buyer pays you a dividend instead of deferred consideration, you pay dividend tax at 8.75%, 33.75%, or 39.35% depending on your total income. This is often worse than capital treatment but better than income treatment. However, dividends are only payable if the company has distributable profits, and the buyer may not agree to this structure.

Does HMRC have a specific form for reporting earn-out payments?

No separate form exists. You report the earn-out payment on your Self Assessment tax return (SA100). For capital treatment, you complete the Capital Gains pages (SA108). For income treatment, you report it as employment or self-employment income on the relevant pages. Your accountant will handle this as part of your annual return.

Can I negotiate the earn-out structure after the sale is completed?

No. The earn-out structure is fixed at the point you sign the SPA. You cannot change the tax treatment after completion. This is why it is critical to take advice before you sign. Once the deal is done, the tax treatment is locked in.