Earnouts and Vendor Take-Back Loans When Selling a Business in Ontario

Many buyers do not pay the full price on closing day. You may be offered part in cash now and the rest later, either as a fixed loan you lend back to the buyer or as extra payments that depend on how the business performs.

Both can make a deal possible, but both leave you exposed after you have handed over the keys. This article explains how they work in plain terms, the main risks, and how the tax rules on deferred payments generally apply in Ontario.

What an earnout and a vendor take-back loan are

A vendor take-back (VTB) loan means you, the seller, lend the buyer part of the price. The buyer signs a promissory note, usually with an interest rate, a repayment schedule and security over the business assets or shares.

An earnout is different. Part of the price depends on future results, such as revenue or profit over the next one to three years. The final amount is not known on closing day, which is why the contract wording matters so much.

The risks of being paid over time

Once you are paid in instalments, you become a lender to the buyer. If the business struggles, your payments may be at risk, and you may rank behind a bank that financed the purchase. Whether you can step in depends entirely on what you negotiated.

• Security: whether your note is secured, and whether it ranks ahead of or behind other lenders.
• Control after closing: with an earnout, the buyer runs the business and can make decisions that lower the results used to calculate your payments.
• Definitions: terms such as profit, revenue and adjustments must be spelled out so both sides calculate them the same way.
• Default terms: what happens if a payment is missed, including whether the whole balance becomes due.
• Guarantees: whether the buyer's owners personally back the obligation.

These are drafting and negotiation points. They are worth settling in the agreement before closing, because fixing them afterward is much harder.

How the tax reserve applies to deferred payments

When part of the sale price is payable after the end of the year, you can generally claim a capital gains reserve instead of reporting the whole gain at once. The reserve is the lesser of a reasonable amount for the unpaid proceeds and 1/5 of the gain multiplied by (4 minus the number of preceding years ending after the sale).

In practice, at least 1/5 of the gain is taxed each year, and the whole gain is taxed within five years. The CRA describes this as a reserve period of up to four years, so the gain is included in income over five years in total. The reserve is claimed on Form T2017, Summary of Reserves on Dispositions of Capital Property.

Only one-half of a capital gain is taxable. The five-year spread is the general rule, but a 10-year reserve applies to some sales of qualified small business corporation shares to a child who is resident in Canada, and to certain intergenerational and qualifying business transfers. How the repayment schedule of a loan fits with the reserve, and how an uncertain earnout amount fits, depends on the facts and the wording, so confirm it with a tax professional.

When the reserve is not available or works differently

• No reserve is allowed if you were not resident in Canada, or were tax-exempt, at the end of the year or at any time in the following year.
• No reserve is allowed if the buyer is a corporation you control directly or indirectly, or a partnership in which you are a majority-interest partner immediately after the sale.
• If qualified small business corporation shares are sold to your child who is resident in Canada, the reserve can spread the gain over 10 years instead.
• Gains that are deferred, for example under a reserve, do not qualify for the capital gains deduction.

That last point matters if you plan to use the lifetime capital gains exemption. Whether and how to combine a reserve with the exemption is a planning question to settle before you sign.

What to do next

• Ask the buyer for a written term sheet showing cash at closing, the loan or earnout amount, and the dates.
• Ask what security, guarantees and default terms will back the deferred amount.
• Have an accountant estimate your tax each year with and without a reserve, including the possibility of alternative minimum tax on Form T691.
• Check whether any exception above applies to you or to the buyer.
• Have a lawyer review the agreement, note and security documents before you sign.

Frequently asked questions