Federal Tax Court: Does an earn-out linked to continued employment constitute a capital gain or employment income?

Summary

The central question was whether such earn-out payments constitute employment income under section 19 of the Income Tax Act or a capital gain under section 17. In practical terms, this determined whether the payments were taxed at up to approximately 48% or at approximately 28% under the partial income method (Teileinkünfteverfahren).

The plaintiffs were both shareholder-managing directors who sold their respective 50% shareholdings for EUR2.25 million each. Part of the purchase price—EUR625,000 per seller—was contingent on continued employment as managing director over a five-year period (the "earn-out"). Had either seller left earlier, he would have been required to repay his earn-out amount on a pro rata basis.

The plaintiff classified the entire amount as income under section 17 of the Income Tax Act. The tax authorities and the Regional Tax Court of Cologne (decision dated December 4, 2024, 12 K 1271/23), by contrast, treated the EUR625,000 component as employment income.

The BFH referred the case back to the Regional Tax Court, holding that the classification of the earn-out amount required further examination. It was unable to decide the matter itself because the relevant facts had not yet been fully established.

On the principal question of classification, the BFH clarified the following: whether a payment constitutes employment income or falls under a different income category by virtue of a separate legal relationship—here, the shareholder status—depends not on what was formally agreed, but on the economic substance and the objective circumstances of the transaction. The key question is whether the ancillary obligation has independent economic significance. If it does not, the payment is simply part of the purchase price.

The quality and stability of management is typically a factor that influences the value of the company and, as such, forms part of the purchase price calculation. In this case, two independent legal bases existed. However, the share disposal arose from the plaintiff’s shareholder status, not from his appointment as managing director.

For the second round of proceedings, the BFH gave the Regional Tax Court the following guidelines: 

• First, did the purchase price correspond to the fair market value of the shareholding? If the earn-out component falls within that fair market value, this points towards classification under section 17 of the Income Tax Act. If it exceeds the fair market value, employment income may be the appropriate classification. 
• Second, would the purchaser have paid the same amount to an unrelated third party without an equity stake who had agreed to serve as managing director? Conversely, would the plaintiff have received the payment had he not also been a disposing shareholder?

According to the BFH, the obligation to repay (part of) the earn-out upon early termination of the employment relation does not necessarily point to employment income. Rather, it can be seen as a mechanism to protect the acquired enterprise value and effectively amounts to a contractual damages claim. The BFH also noted that, if the earn-out were classified as employment income, the plaintiff’s salary would have risen from EUR140,000 to EUR265,000—an increase of roughly 50% over the previous salary of EUR180,000, for which no plausible justification was apparent.

Practical implications

The judgment highlights important criteria for structuring earn-out arrangements: where the total purchase price falls within the fair market value of the shareholding and the management retention component is documented as a factor in the purchase price calculation, there is a strong case for classification under section 17 of the Income Tax Act—with the well-known advantages of the partial income method.

In practice, documentation is key. Both sellers and purchasers should record, already during the transaction process, which factors were used to calculate the purchase price and why retaining management protects the enterprise value.

It remains to be seen how strictly the Regional Tax Court will apply the BFH’s standards in the second round of proceedings. The BFH does not necessarily require a formal expert valuation but does expect the parties to present comprehensible arguments on the underlying calculation.

In our view, the arm's length standard should be met where, alongside the shareholder-managing directors, there are other sellers (e.g. investors) and the disposal prices paid to the shareholder-managing directors—including the earn-out—are not disproportionately higher than those paid to the other sellers.

Whether the employment-linked earn-out is implemented—as in this case—through a pro-rata repayment arrangement or through additional payments over the term should, in our view, be immaterial. According to the BFH, what matters is not what was formally declared or agreed, but rather the economic substance and actual effect of the arrangement. Both structuring variants lead to the same result.

In our view, the decision should not be read as a carte blanche for arbitrary purchase price allocations. It is most helpful where the total purchase price is plausibly derived, management retention has been documented as a value driver, and ongoing remuneration remains at arm's length—including when compared with previous remuneration levels.