Structuring an Earn-Out Before Signing a Practice Sale

The situation

Sarah ran an incorporated physiotherapy consulting practice out of Brantford, contracting her clinical assessment services to several clinics across the region rather than seeing patients directly out of one location. After twelve years, she had an offer: a larger multidisciplinary health-services company wanted to acquire her client contracts and folded them into its own operations. Her spouse, Margaret, a police sergeant, had encouraged her to at least hear the offer out, and once the buyer's draft agreement arrived, the numbers looked reasonable on their face — a purchase price of roughly $500,000 for the shares of her corporation.

The structure was less simple than the headline number suggested. The buyer, represented in negotiations by its acquisitions lead, Andriy, proposed splitting the price: roughly $350,000 paid on closing, with the remaining $150,000 payable over the following two years as an earn-out tied to how much of Sarah's client revenue the buyer actually retained after the transition. If clients stayed, she got paid. If they left for other consultants, the buyer's obligation shrank proportionally. Sarah brought the draft agreement to our team before signing, mainly to check the earn-out math. What she had not considered was how the Canada Revenue Agency would treat that contingent $150,000 for tax purposes — and that the answer depended entirely on how the clause was drafted, not on what she and the buyer intended.

The tax problem

When shares of a qualifying small business corporation are sold outright for a fixed price, the seller generally reports a capital gain, only half of which is taxable, and may be able to shelter a substantial portion of that gain using the lifetime capital gains exemption available to owners of qualified small business corporation shares. Sarah's advisors had told her the base $350,000 would likely qualify for exactly that treatment. The problem sat entirely in the $150,000 earn-out.

An earn-out is a promise to pay more money later, contingent on the business performing a certain way. The Canada Revenue Agency's default position is that when the total sale price is genuinely uncertain at closing — as it was here, since nobody knew which clients would stay — the earn-out payments are not treated as part of the capital gain on the shares at all. Instead, absent specific structuring, they can be characterized as a separate stream of income, taxed at full rates with no access to the capital gains exemption and no ability to spread the gain forward using the multi-year capital gains reserve that would normally apply to deferred proceeds.

The draft agreement Andriy's company had sent made no attempt to address this. It described the $150,000 simply as "additional consideration payable on retention targets," with no reference to the price being a genuine estimate of value subject to later adjustment, and no election language at all. On a straightforward reading, that $150,000 was on track to be taxed as ordinary income to Sarah personally or her corporation, rather than as a capital gain. On her marginal rate, that difference was worth tens of thousands of dollars — real money she had budgeted as retirement funding, not as a tax bill.

There is a recognized way around this, at least in part. The Canada Revenue Agency has a long-standing administrative approach, commonly called the cost recovery method, that allows an earn-out to be treated as part of the capital gain rather than as separate income — but only where the agreement is drafted to meet specific conditions, including that the earn-out cannot run longer than five years and the underlying shares must otherwise qualify for capital gains treatment. Alternatively, some earn-outs can be structured as a price adjustment clause, where the parties agree upfront that the true price is uncertain and will be finalized once results are known, with the original agreement amended rather than a new payment stream created. Neither approach is automatic. Both require the sale agreement itself to say the right things, agreed to by both sides, before signing — not fixed afterward.

What we did

1. Reviewed the draft agreement against the cost recovery conditions. We compared the earn-out clause line by line against what the Canada Revenue Agency's administrative policy requires to treat contingent proceeds as part of a capital gain rather than ordinary income, and confirmed the draft met none of them — it lacked the reasonable-uncertainty language, the five-year cap, and any acknowledgment that the parties genuinely could not fix a price at closing.
2. Modelled the tax exposure under both structures. We set out, in plain terms, what Sarah would owe under the buyer's draft language versus under a properly worded cost recovery clause, so she could see the dollar difference before deciding how hard to push in negotiations rather than discovering it after filing a return.
3. Drafted revised earn-out language and sent it to Andriy's team. The redraft reframed the $150,000 as a price adjustment tied to genuinely uncertain retention outcomes, capped the earn-out period at two years, and added the specific representations the Canada Revenue Agency looks for when assessing whether contingent proceeds qualify for capital treatment.
4. Negotiated directly with the buyer's counsel once they pushed back. The buyer's own accountants had reasons to prefer the original wording — treating the payments as compensation expense was more favourable on their side — so this was not a drafting exercise the buyer would simply accept. We negotiated a middle position rather than holding out for the full result.
5. Confirmed the corporation, not Sarah personally, would qualify for the small business share exemption on the base amount. Before finalizing anything, we verified Sarah's corporation met the active business requirements needed for the exemption to apply at all, since none of the earn-out planning would matter if the underlying $350,000 did not qualify in the first place.

The outcome

The negotiation did not end with everything Sarah wanted. Andriy's company agreed to shorten the earn-out to eighteen months and to add language describing the $150,000 as a genuine price adjustment for retained revenue, which was enough to bring roughly $100,000 of the earn-out within the cost recovery approach and eligible for capital gains treatment alongside the base price. The buyer would not agree to characterize the full $150,000 that way, insisting on treating a $50,000 portion as a retention bonus tied to Sarah personally staying available for client transition calls during the changeover — a structure that meant that portion would be taxed as ordinary income no matter how it was worded, since payments for services rendered do not qualify as capital gains regardless of drafting.

The practical result: instead of the full $150,000 earn-out risking ordinary income treatment, Sarah ended up with $100,000 of it taxed as a capital gain — sheltered in large part by her lifetime capital gains exemption alongside the base $350,000 — and $50,000 taxed as income, which she had known and accepted going in rather than discovering on her tax return eighteen months later. The tax saved by the redraft, relative to the buyer's original wording, came to roughly $18,000 to $20,000, depending on her final income for the years the earn-out was paid. It was not the full result she had hoped for when she first asked us to look at the agreement, and we told her so directly before she signed rather than after — the $50,000 retention bonus cost her real money in tax that better drafting alone could not avoid, because it genuinely was payment for her time, not for her shares. What the process did avoid was the far larger and entirely avoidable cost of signing a $150,000 earn-out with no capital gains language in it at all, which would have put the whole amount at risk of ordinary income treatment.

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