Deferred Payment on the Sale of Owner-Managed Businesses

By Patrick Westaway

Deferred payment on the sale of an owner-managed business is commonplace. Getting it right, however, by addressing the issues across a range of legal practice areas, is not. The purpose of this note is to cross the usual boundaries of corporate, tax and employment law to address payment deferrals coherently and in one place.

There may be different reasons for deferred payment. It may be that the purchaser does not have the full amount of the purchase price on closing and wants the business itself to pay for the balance. A purchaser is unlikely to say so, however. Rather, the reason usually given is that the purchase price is based on anticipated revenues such that payment of the former must depend on the realization of the latter. It is here that the parties invite confusion between sale proceeds and profit sharing and the very different consequences they entail.

The Canada Revenue Agency will accept characterization as deferred sale proceeds rather than profit sharing if the only variable is the timing. If, for example, payments are for fixed amounts and payable at set instalments, they are clearly deferred sale proceeds. And, if payments are for fixed amounts but payable only when certain conditions, such as sales targets, are met, those amounts will again be characterized as sale proceeds. If, however, the payments are instead to be determined as a percentage of profits then the line has been crossed and the payments will be characterized as profit sharing. And, whereas deferred sale proceeds are subject to the 50% capital gains income inclusion rate, a share of profits is fully taxable as ordinary income. At stake, then, is a doubling of the tax cost (and loss of any remaining lifetime capital gains exemption room, which is a matter for another article).

The vendor’s preference is therefore for a fixed purchase price. This does not, however, help the purchaser who may well be concerned that sales targets might never be met. In such situations, the parties can apply what is known as a “reverse earnout”. Despite the jargon, this simply means that reductions are allowed. For example, rather than deferring payment until sales targets are met, one can also reduce those payments if the sales targets are altogether missed. The key is that the agreement can only provide for reduction, not increase.

Having established the nature of the future payments, there remains the question of timing. In Canada, sale proceeds are fully taxable in the year of the sale. To the extent that proceeds are not receivable until a later year, the vendor can claim what is known as a “reserve”, being a deduction for amounts not yet receivable. It is important to note, however, that a reserve can only be claimed for five years, including the year of the sale. And, at least 20% of the proceeds must be recognized in each year. In contrast, no such constraint arises in the case of profit sharing. Such profits are recognized for income tax purposes only in the year in which they are earned, or in the year of receipt depending on whether the vendor’s accounting is on an accrual or cash basis.

If the purchaser justifies the deferral of payment on the basis that the sale price is contingent upon future revenues, the vendor’s continued role within the company is presupposed. This argument for deferral would not stand up if the vendor were no longer to be involved after the sale since the vendor would have no control or influence over operations or, therefore, sales and profitability. Negotiations for the sale of the business are not, therefore, complete until the employment agreement is settled.

There are, then, three specific issues to be addressed in the employment agreement with respect to deferred payment: management participation, records access & audit and changes. These issues apply whenever the timing or amount of the vendor’s payments may vary and, therefore, regardless of whether the deferred payments are characterized as sale proceeds or profit sharing.

First, as noted already, the vendor must have a say in the management. The vendor should not be penalized for the purchaser’s management and the purchaser should not be able to front-load costs and defer revenues to manipulate the sale price. For simple business continuity alone, the purchaser should welcome this participation.

Second, the vendor must have access not only to the financial statements but to the company’s books and records generally. This is key to ensuring that the vendor is paid its due. For the same reason, the vendor must have the right to make formal audits.

Third, the company cannot claim the right to change the vendor’s role. The purchaser’s counsel may well say that employers must have this flexibility, that it is standard and avoids the need for a new employment agreement if the job changes but such arguments are nonsense. The deferral of payment is already a substantial concession to the purchaser. And, if the vendor’s role is to change then there should be a new agreement to address consequent collateral changes. Vendor’s counsel must keep their eye on the ball, which is getting the vendor paid.

The above illustrates the importance of a cohesive approach to legal services particularly, if not exclusively, when selling owner-managed businesses.