If you are selling your limited company and part of the price depends on future performance, you are looking at an earn out arrangement. The tax treatment of those earn out payments is not always straightforward. Get it wrong and HMRC could reclassify part of your capital gain as income, costing you tens of thousands in extra tax.

This article explains how earn out payments are taxed, the difference between capital treatment and income treatment, and what you can do before signing to protect your position.

What Is an Earn Out Payment?

An earn out is a deferred consideration clause in a share sale agreement. Instead of paying the full price upfront, the buyer agrees to pay additional sums if the company hits certain targets after completion. Typical targets include revenue, profit before tax, or customer retention milestones.

Earn outs are common when the seller stays on as a director or consultant after the sale. The buyer wants to link part of the price to the company's continued performance. The seller gets a higher potential price but carries the risk that targets are missed.

From a tax perspective, the critical question is whether HMRC treats the earn out payment as a capital gain (subject to Business Asset Disposal Relief or CGT) or as income (subject to income tax and NIC). The difference is substantial.

Earn Out Payments Tax Treatment: The Core Rule

HMRC's default position is that earn out payments are treated as capital consideration for the shares. That means they fall within the capital gains tax regime, not income tax. This is the earn out payments tax treatment you want, because it opens the door to Business Asset Disposal Relief (BADR) at 14% in 2025/26, rising to 18% from April 2026, rather than income tax at up to 45% plus 2% NIC.

But there is a catch. HMRC will look at the substance of the arrangement, not just the legal form. If the earn out looks more like remuneration for ongoing services than deferred sale proceeds, HMRC will reclassify it as employment income.

The key distinction is this: is the earn out payment linked to the value of the shares at completion, or is it linked to your personal performance after the sale?

Capital Treatment: What You Need

For capital treatment to apply, the earn out must be genuinely part of the consideration for the shares. That means:

  • The payment formula must be based on the company's overall performance, not your individual input.
  • You must not be required to provide ongoing services to receive the payment. If you stay on, your salary or consultancy fee should be separate and market-rate.
  • The earn out must be structured as a right to additional consideration under the share sale agreement, not as a bonus or profit share.
  • You must not be an employee of the buyer after completion. If you are, the line between capital and income blurs significantly.

If these conditions are met, the earn out is treated as deferred consideration for CGT purposes. You report the gain in the year of disposal using the market value of the right to future payments. Alternatively, you can elect under TCGA 1992 s.280 to hold over the gain until the earn out payments are actually received.

Income Treatment: When HMRC Challenges

HMRC will challenge the capital treatment if the earn out looks like disguised remuneration. Common triggers include:

  • The earn out is calculated by reference to your personal billable hours or individual sales performance.
  • You are required to work full-time for the buyer to receive the full earn out.
  • The earn out is paid as a salary, bonus, or dividend rather than as a capital sum.
  • The earn out formula uses your personal targets rather than company-wide metrics.
  • You remain a director or employee with significant control over the targets.

If HMRC reclassifies the earn out as income, you will pay income tax at your marginal rate (up to 45%), plus employee NIC at 2%, and your company will pay employer NIC at 13.8%. On a £200,000 earn out, that could mean £90,000+ in tax versus £28,000 under BADR at 14%.

Structuring Earn Outs to Protect Capital Treatment

As ICAEW qualified accountants, we see earn out disputes arise most often when sellers fail to separate their role as shareholder from their role as employee or consultant. The solution is clean documentation and clean behaviour.

Here is what a well-structured earn out looks like:

  • The share sale agreement defines the earn out as additional consideration for the shares, not as a bonus or consultancy fee.
  • The earn out formula uses company-level EBITDA or revenue, not your personal metrics.
  • If you stay on post-completion, you have a separate service contract with a market-rate salary that does not depend on earn out targets.
  • The earn out payments are made to you as a former shareholder, not as an employee.
  • The earn out period is typically 1 to 3 years. Longer periods increase the risk of HMRC challenge.

Let us use a real example. A Manchester-based software consultancy sold for £500,000 upfront plus an earn out of up to £300,000 based on revenue growth over two years. The seller stayed on as a consultant under a separate contract at £800 per day. The earn out was paid as capital consideration. The seller claimed BADR on the full £800,000, paying 14% CGT. Total tax: £112,000.

Had the earn out been structured as a bonus linked to the seller's continued employment, the £300,000 would have been income. At 45% tax plus 2% NIC, that is £141,000 in tax on the earn out alone, plus employer NIC of £41,400. The difference is stark.

Tax Reliefs Available on Earn Out Payments

If the earn out qualifies as capital consideration, you can claim Business Asset Disposal Relief on the gain, provided you meet the usual conditions. That means you must have held at least 5% of the shares and voting rights for the 2 years before disposal, and been an employee or director of the company.

BADR rates for 2025/26 are 14% on gains up to the £1 million lifetime limit. From April 2026, the rate rises to 18%. Gains above £1 million are taxed at 24% for higher rate taxpayers (non-residential assets).

If you do not qualify for BADR, the standard CGT rates apply: 18% for basic rate taxpayers and 24% for higher rate taxpayers on gains above the annual exempt amount (£3,000 in 2025/26).

Deferring Tax on Earn Out Payments

You have two options for when you pay tax on earn out payments:

Option 1: Market value at completion. You value the right to receive future earn out payments at the date of sale and pay CGT on that value immediately. When you actually receive the cash, any difference between the estimated value and the actual payment is a further gain or loss in the year of receipt.

Option 2: Section 280 election. You elect under TCGA 1992 s.280 to defer the gain on the earn out until you actually receive the payments. This is simpler and avoids the need to value the contingent right. Most sellers prefer this route because you only pay tax when you have the cash in hand.

The s.280 election must be made in writing to HMRC within 2 years of the end of the tax year in which the disposal occurred. Miss the deadline and you are stuck with the market value approach.

What Happens If the Earn Out Target Is Missed?

If you never receive the earn out payment because the targets were not met, you have an allowable capital loss for CGT purposes. You can set that loss against other capital gains in the same year or carry it forward.

The loss is calculated as the market value you originally attributed to the right to receive the earn out. If you used a s.280 election, the loss arises in the year the right to payment expires, and the amount is whatever you would have received had the target been met.

This is a common area of confusion. Sellers often assume that a missed target means no tax consequence. In reality, if you used the market value approach and overvalued the earn out, you may have overpaid CGT upfront and need to claim a loss to recover it.

Earn Outs and Associated Companies

If you own shares in multiple companies, be careful how earn outs interact with the associated companies rules. For corporation tax purposes, associated companies affect the profit thresholds for marginal relief. But for CGT and BADR, the issue is whether the earn out relates to qualifying shares held for 2 years.

If you sell shares in one company and the earn out is linked to the performance of a different group company, HMRC may argue the earn out is not consideration for the shares at all. Keep the earn out tied to the specific company whose shares you are selling.

Practical Steps Before You Sign

Before you agree to an earn out structure, take these steps:

  • Get the share sale agreement reviewed by a solicitor who understands tax. The drafting of the earn out clause is critical. Vague language invites HMRC challenge.
  • Separate your ongoing role from the earn out. If you stay on, have a separate contract with market-rate remuneration that does not reference the earn out.
  • Use company-level targets. EBITDA, revenue, or gross profit. Avoid personal metrics like billable hours or individual sales.
  • Consider a s.280 election. It simplifies your tax position and defers payment until you have the cash.
  • Model the tax difference. Compare CGT at 14% or 24% versus income tax at up to 45% plus NIC. The numbers will focus your mind on getting the structure right.

If you are considering an earn out structure, speak to us early. Our services include exit planning and CGT advice for business owners across the UK, from our offices in Manchester and Birmingham. We can review your draft agreement and model the tax outcomes before you commit.

Earn Out Payments Tax Treatment: Summary

The earn out payments tax treatment depends on one core question: is the payment consideration for your shares or remuneration for your services? Structure it right and you pay CGT at 14% to 24%. Get it wrong and you pay income tax at up to 45% plus NIC.

HMRC will look at the substance, not just the legal form. Clean documentation, separate service contracts, and company-level targets are your best protection. If you use a s.280 election, you defer tax until the cash arrives and avoid valuation disputes.

For more on exit planning, read our guide on capital gains tax when selling your business. If you are at the negotiation stage, contact us to discuss your earn out structure before you sign.