You sold your business for $1.2 million — $800,000 at closing and $400,000 if revenue hits $2 million next year. Everyone shakes hands. Then bookkeeping asks: is that $400,000 revenue, a receivable, a gamble, or a liability? The answer decides whether your books show profit, whether your tax return is right, and whether the next year's earnout payment creates a second accounting headache.
Earnouts are the contingent portion of a deal tied to future performance — revenue, EBITDA, customer retention, or a milestone. For small businesses, they bridge valuation gaps: the buyer won't pay full price for a forecast, the seller won't accept less for what they built. Proper accounting keeps that bridge from collapsing into a mess of restatements and tax surprises.
How Earnouts Work in Small Deals
A typical small-business earnout has three pieces:
- Base price: Paid at closing, funded by cash, a loan, or seller financing
- Contingent price: Paid later, only if a metric is hit — for example, 10% of revenue over $1.5M for two years, or $50,000 per 100 retained subscribers
- Measurement period and cap: Often 12–36 months, with a cap (e.g., earnout not to exceed $400,000) and a floor (zero if target missed)
For accounting, the key question is whose performance triggers payment. If payment depends on the seller's former business performance post-closing (the buyer's new asset), the accounting is different than if payment depends on the buyer's future actions.
Seller Side: When to Record the Contingent Amount
If you are the seller, you sold the business and may receive more if it performs. You have not earned the earnout at closing — it is contingent.
Do not record the full $400,000 earnout as a receivable at closing. That overstates assets and revenue. Instead:
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At closing: Record the base price as proceeds. Remove the business's net assets from your books, recognize gain or loss on sale, and record the earnout right as a contingent receivable disclosed in the notes, not on the balance sheet, unless the earnout is determinable and collection is reasonably assured.
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As the earnout is earned: When the metric is met and the amount becomes determinable — for example, when year-one revenue is finalized at $2.1M and the earnout formula yields $180,000 — record
Dr Earnout Receivable $180,000/Cr Gain on Sale — Earnout $180,000(or as additional consideration for the sale). That keeps the earnout out of operating revenue; it is part of the sale proceeds, not a new service you performed.
Tax timing for sellers: For cash-basis sellers, the earnout is generally taxed when received, not when estimated. For accrual sellers, the treatment follows whether the earnout is treated as additional sale price (capital gain) or as ordinary income. The distinction often hinges on whether the seller stays on as an employee — see the compensation trap below.
The compensation trap: If the seller must remain employed to receive the earnout, the IRS may recharacterize part of the earnout as compensation for services, not sale price. That shifts the amount from capital gain to ordinary income and triggers payroll taxes. To keep earnout as purchase price, the employment and the earnout should be separable: a market-rate salary for the job, plus an earnout that is payable even if employment ends for reasons other than cause, with separate agreements.
Buyer Side: Contingent Consideration Under the Acquisition
If you are the buyer, the earnout is a liability you may have to pay. Accounting depends on whether you apply ASC 805 (business combination) or you are buying assets.
For a business acquisition (stock or merger): Under ASC 805, the buyer records the fair value of contingent consideration as a liability at acquisition. If the fair value of the earnout at closing is estimated at $260,000 (probability-weighted), the entry is Dr Goodwill $260,000 / Cr Contingent Consideration Liability $260,000, alongside the base price allocation. The liability is then remeasured at fair value each period through earnings until settled. That means if the earnout becomes more likely, you take a loss; if less likely, a gain — volatility that surprises buyers who thought the earnout was "free if we miss."
For an asset purchase: If you buy assets and agree to pay more later based on performance, the contingent payment is often treated as additional purchase price when it becomes determinable, rather than as a day-one fair value liability. That added amount adjusts the basis of the acquired assets, including goodwill, rather than flowing through the P&L.
Book the payment correctly: When you pay the earnout, Dr Contingent Consideration Liability $180,000 / Cr Cash $180,000, and record any change in fair value since last measurement as Dr/Cr Change in Fair Value — Earnout. Do not book the payment as Consulting Expense or Revenue Share unless it really is a post-acquisition service.
What Happens When the Target Is Missed or Exceeded
Missed target: If the earnout pays zero because revenue was $1.4M, the seller reverses nothing (it was never booked) and the buyer reverses the liability: Dr Contingent Consideration Liability $260,000 / Cr Gain on Change in Fair Value $260,000. The seller's tax return shows no additional gain; the buyer's P&L shows a gain.
Exceeded cap: If the formula yields $450,000 but the cap is $400,000, you book $400,000. The cap is substantive, not advisory.
Disputes: Many earnout agreements require the buyer to provide a calculation statement within 60–90 days after the measurement period, with audit rights for the seller. Keep the underlying revenue and expense records that feed the metric — not just the P&L, but the sales log, returns, and any adjustments the agreement defines (e.g., "revenue excludes sales to affiliates").
Bookkeeping Tips That Prevent Restatements
Define the metric in accounting terms. "Revenue" can mean cash collected, invoices issued, or GAAP revenue under ASC 606. The purchase agreement should say which, and whether it is net of returns, discounts, and sales tax. Your bookkeeping should track that exact definition in a separate earnout schedule, not just in the general ledger.
Substance over label: If you pay a former owner's earnout and they also consult for you, keep the payments and the consulting fees in separate accounts. Commingling makes recharacterization more likely.
Track probability for buyers: Even small buyers should maintain a simple earnout valuation log: original fair value, assumptions (revenue forecast, discount rate), and quarterly reassessment. That log supports the remeasurement entries and satisfies an auditor.
Cash flow: Sellers often forget that earnout proceeds may be received in a later tax year than the sale. Plan for cash flow and tax estimates accordingly — a $180,000 earnout received in 2027 is 2027 income, even if the sale was in 2026.
Tax and Legal Fine Print
- Installment sale: Earnout payments generally do not qualify for installment sale reporting under Section 453 if the amount is contingent and not determinable at closing. You recognize gain as payments become fixed.
- Imputed interest: If the earnout is paid over more than a year and the agreement provides no interest, the IRS may impute interest under Section 483 or 1274, recharacterizing part of the earnout as interest income/deduction.
- State apportionment: An earnout tied to a business that operated in multiple states may be sourced differently than the base price. Check state rules.
Keep Your Finances Organized From Day One
An earnout is not just a deal term — it is a year or two of accounting that will be tested by an auditor, a lender, or the IRS. The sellers who collect the full earnout without a fight are the ones whose books can prove the metric with a single schedule.
Beancount.io gives you plain-text, version-controlled accounting where an earnout is a disclosed contingent asset, a remeasured liability, and a final cash entry — each with a history you can diff. Tie the purchase agreement's metric to a ledger account, and the earnout stops being a guess. Get started for free and make contingent payments auditable, not anecdotal.