1001-00006 · Ardent Capital Partners · Earnout Treatment

earnout-tax-characterization-memorandum.docx DOCUMENT M&A / Corporate

6 / 35 ← → ✕

Contract analysis Extract to table

MEMORANDUM

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE / ATTORNEY WORK PRODUCT

From: Calderwood & Harkness LLP

Leonard Cross, Partner, Tax Robert Jansen, Senior Associate, Tax

To: Ardent Capital Partners III LP

Marcus Pellegrino, Partner, Healthcare Claire Ashworth, Co-Founder & Managing Partner

Date: March 1, 2024

Re: Tax Characterization of Earnout Payments — Acquisition of Pinnacle Health Services Group LLC

Engagement No.: 1001-00006

Matter No.: 1001-00006

Right-click to update Table of Contents

I. Executive Summary

Calderwood & Harkness LLP has been engaged by Ardent Capital Partners III LP ("Ardent Capital" or "Fund III") to advise on the tax structuring of its proposed acquisition of one hundred percent (100%) of the membership interests in Pinnacle Health Services Group LLC ("Pinnacle" or "PHSG"), a Delaware limited liability company currently classified as a partnership for federal income tax purposes, at an aggregate enterprise value of $412.0 million (equity value of approximately $339.4 million after deducting net debt of $72.6 million). This memorandum addresses one discrete, but critically important, issue within the broader tax structuring engagement: the proper federal income tax characterization of contingent earnout consideration payable to the selling members of Pinnacle under the proposed Merger Agreement.

The Merger Agreement, which is expected to be signed on or about March 15, 2024, contemplates contingent earnout consideration with a maximum aggregate payout of $35.0 million, payable across two distinct measurement periods tied to the post-closing financial performance of Pinnacle's business. Period 1 (June 1, 2024 through May 31, 2025) carries a target of $58.0 million of Adjusted EBITDA and a payout of $15.0 million, and Period 2 (June 1, 2025 through May 31, 2026) carries a target of $65.0 million of Adjusted EBITDA and a payout of $20.0 million.

This memorandum analyzes the federal income tax characterization of the earnout payments and reaches the following principal conclusion: the earnout should be treated as additional purchase price for the Pinnacle membership interests, resulting in capital gain to the selling members under Section 741 of the Internal Revenue Code, rather than as compensation for services rendered by certain continuing seller-employees, which would result in ordinary income to those individuals and a corresponding deduction to the buyer. This conclusion is subject to the implementation of certain structuring safeguards described in detail in Section V of this memorandum, which we strongly recommend be incorporated into the definitive Merger Agreement prior to execution.

In addition, this memorandum addresses two subsidiary issues that arise in connection with the earnout. First, we analyze the application of Section 483 imputed interest rules to deferred earnout payments, concluding that both Period 1 and Period 2 payments, if and when made, will include a component of unstated interest taxable as ordinary interest income to the sellers and deductible as interest expense by the buyer. The applicable short-term Applicable Federal Rate ("AFR") is 5.12% as of the anticipated signing date. Second, we analyze the tax treatment of earnout acceleration upon a change of control of Ardent Healthcare Holdings LLC, concluding that the acceleration feature does not alter the capital gain characterization of the earnout and, in fact, provides additional support for purchase price treatment because it is triggered by a transaction-level event rather than an employment-related event.

Our overall recommendation is that capital gain treatment of the earnout payments is supportable and defensible, subject to the safeguards described in Section V below. We further recommend that Calderwood & Harkness coordinate with buyer's M&A counsel, Harcourt Shaw & DeVries LLP, to implement these safeguards in the definitive Merger Agreement, and we anticipate delivering a separate comment letter to that effect on or before March 12, 2024.

II. Background and Transaction Overview

A. Parties. Buyer/Sponsor. The acquiring party is Ardent Capital Partners III LP, a Delaware limited partnership (EIN: 87-3491520), whose general partner is Ardent Capital GP III LLC, also a Delaware limited liability company. Fund III is a 2022-vintage private equity fund with total committed capital of approximately $3.2 billion, focused on healthcare services, technology-enabled services, and business services investments. Fund III maintains its principal office at 600 Lexington Avenue, 38th Floor, New York, New York 10022. The firm's managing partners are Dominic Ferrera and Claire Ashworth, and the deal team for the Pinnacle acquisition is led by Marcus Pellegrino, Partner, Healthcare.

Ardent Capital has extensive experience in the healthcare services sector, having completed twelve platform acquisitions in the space since the inception of its predecessor fund, Ardent Capital Partners II LP. This institutional context is relevant to the earnout characterization analysis insofar as it demonstrates that the use of earnout mechanisms in Ardent Capital's acquisitions is a standard purchase price tool deployed in arm's-length negotiations, rather than a compensation structure designed to incentivize post-closing management behavior.

Target. The acquisition target is Pinnacle Health Services Group LLC, a Delaware limited liability company classified as a partnership for federal income tax purposes (EIN: 82-1947632). Pinnacle's principal office is located at 2200 Renaissance Boulevard, Suite 400, King of Prussia, Pennsylvania 19406. Pinnacle was founded in 2016 by Dr. Raymond Carvallo and Dr. Nadia Ostrowski, and it operates thirty-four (34) urgent care clinics and eight (8) ambulatory surgery centers across five states: Pennsylvania, Virginia, Maryland, North Carolina, and Georgia. For the fiscal year ended December 31, 2023, Pinnacle reported revenue of approximately $287.4 million and Adjusted EBITDA of approximately $51.8 million. Pinnacle employs approximately 1,620 individuals, including 142 employed physicians.

Pinnacle's classification as a partnership for federal income tax purposes is central to several aspects of the tax structuring, including the application of Section 741 to the sale of membership interests, the availability of a Section 743(b) basis adjustment for the buyer, and the purchase price allocation under Section 1060 (as applied by analogy to partnership interest acquisitions). The partnership classification has been in effect since Pinnacle's formation and has not been the subject of any prior IRS examination or challenge.

Sellers. The pre-closing members of Pinnacle and their respective ownership percentages are as follows:

Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth (collectively, the "Continuing Sellers") will remain employed by Pinnacle in their current executive capacities following the closing. The fourteen (14) minority physician-investors (collectively, the "Minority Sellers") will not have any continuing employment, consulting, or other service relationship with Pinnacle or any Ardent Capital affiliate following the closing, although certain of these physicians may continue to practice at Pinnacle clinics as independent contractors under existing professional services agreements. The distinction between the Continuing Sellers and the Minority Sellers is a critical element of the earnout characterization analysis, as discussed in Section IV.B.1 below.

B. Acquisition Structure

The proposed acquisition will be structured as a reverse merger in which Ardent Healthcare Merger Sub LLC, a newly formed Delaware limited liability company and wholly owned subsidiary of Ardent Healthcare Intermediate Inc. ("Intermediate"), will merge with and into Pinnacle, with Pinnacle surviving the merger as a wholly owned subsidiary of Intermediate. Intermediate is a Delaware C-corporation organized as a "Blocker" entity to shield Fund III's tax-exempt and foreign limited partners from direct flow-through of unrelated business taxable income and effectively connected income. Intermediate is, in turn, wholly owned by Ardent Healthcare Holdings LLC ("Holdings LLC"), a Delaware limited liability company classified as a partnership for federal income tax purposes.

Holdings LLC is the principal equity vehicle for the acquisition and will be owned by the following parties immediately following the closing:

The reverse merger structure is designed to achieve several tax objectives, including (i) treating the transaction as a purchase of partnership interests (rather than an asset acquisition) for purposes of Section 741, (ii) permitting a Section 743(b) basis adjustment to reflect the buyer's cost basis in the acquired partnership interests, and (iii) allowing the rollover equity to be contributed in a tax-deferred transaction. The selection of this structure was the subject of a separate Calderwood & Harkness memorandum dated February 15, 2024 (Acquisition Structure Tax Analysis Memorandum), and is not revisited here except as necessary for context.

C. Rollover Participants (Context for Earnout Characterization Analysis)

Three of the Pinnacle sellers are rolling over a portion of their equity proceeds into Holdings LLC, as follows:

Dr. Raymond Carvallo. Dr. Carvallo holds a 38.2% membership interest in Pinnacle, which yields gross equity proceeds of approximately $129.65 million based on the $339.4 million aggregate equity value. Dr. Carvallo will roll over 25.0% of his gross proceeds ($32.41 million) into Class B Units of Holdings LLC and will receive cash consideration for the remaining 75.0% ($97.24 million). Dr. Carvallo will continue to serve as Chief Executive Officer of Pinnacle following the closing pursuant to a three-year employment agreement that is being independently negotiated.

Dr. Nadia Ostrowski. Dr. Ostrowski holds a 28.5% membership interest in Pinnacle, yielding gross equity proceeds of approximately $96.73 million. Dr. Ostrowski will roll over 25.0% of her gross proceeds ($24.18 million) and will receive cash consideration for the remaining 75.0% ($72.55 million). Dr. Ostrowski will continue to serve as Chief Medical Officer of Pinnacle following the closing under a separate three-year employment agreement.

Jonathan Farnsworth. Mr. Farnsworth holds a 5.8% membership interest in Pinnacle, yielding gross equity proceeds of approximately $19.69 million. Mr. Farnsworth will roll over 15.0% of his gross proceeds ($2.95 million) and will receive cash consideration for the remaining 85.0% ($16.74 million). Mr. Farnsworth will continue as Chief Financial Officer under a two-year employment agreement.

Minority Physician-Investors. The fourteen minority physician-investors collectively hold 27.5% of the Pinnacle membership interests, yielding aggregate gross equity proceeds of approximately $93.34 million. None of these sellers is contributing rollover equity to Holdings LLC.

The rollover participants are receiving Class B Units in Holdings LLC. Fifty percent (50%) of each rollover participant's Class B Units will vest at closing, with the remaining 50% vesting ratably over a thirty-six (36) month period from the closing date, subject to continued service. The Class B Units are structured as "profits interests" within the meaning of Revenue Procedure 93-27, as clarified by Revenue Procedure 2001-43, and will have an initial liquidation value of zero (with the rollover equity credited as a capital contribution and reflected in the participant's capital account, separate from the profits interest vesting schedule). The profits interest arrangements are the subject of a separate Calderwood & Harkness analysis and are addressed in this memorandum only insofar as they bear on the earnout characterization. Specifically, the earnout is structurally separate from the rollover and profits interest arrangements, and the earnout payments are not dependent on, linked to, or conditioned upon the rollover participants' Class B Unit vesting.

D. Earnout Terms

The Merger Agreement provides for contingent earnout consideration on the following terms:

Measurement Periods and Targets. The earnout is structured around two distinct measurement periods, each with a binary (all-or-nothing) payout threshold:

Maximum Aggregate Earnout. The maximum aggregate earnout payable is $35.0 million ($15.0 million for Period 1 plus $20.0 million for Period 2). The earnout payments for each period are independent; failure to achieve the Period 1 target does not affect the availability or amount of the Period 2 earnout.

Earnout Acceleration. One hundred percent (100%) of any remaining unpaid earnout consideration becomes payable immediately upon a "Change of Control" (as defined in the Merger Agreement) of Ardent Healthcare Holdings LLC occurring during the earnout period (i.e., prior to May 31, 2026). The acceleration provision is not conditioned on the employment status of any seller.

Allocation. Earnout payments are allocated pro rata among all pre-closing Pinnacle members based on their respective membership interest percentages, as set forth in the Pinnacle Operating Agreement as of immediately prior to the closing. For rollover participants, the earnout is payable only with respect to their cashed-out portions — that is, Dr. Carvallo's earnout allocation is based on 75% of his 38.2% interest (the portion being sold for cash), and similarly for Dr. Ostrowski and Mr. Farnsworth.

Payment Timing. The Merger Agreement provides that each earnout payment, if earned, will be made within sixty (60) days following the end of the applicable measurement period, subject to a dispute resolution mechanism (independent accounting firm determination) that could extend the payment date by up to an additional ninety (90) days.

Anticipated Closing Date. The transaction is expected to close on May 31, 2024, concurrent with the commencement of the Period 1 measurement period.

E. Advisors Referenced

The following advisors to the parties are referenced in this memorandum:

• Buyer's M&A Counsel: Harcourt Shaw & DeVries LLP (Thomas Kundra, Partner; Allison Cho, Partner), 787 Seventh Avenue, New York, New York 10019.

• Buyer's Tax Counsel: Calderwood & Harkness LLP (Leonard Cross, Partner; Robert Jansen, Senior Associate), One Liberty Plaza, 45th Floor, New York, New York 10006.

• Seller's Counsel: Whitford & Gaines LLP (Patricia Engelman, Partner; Kevin Driscoll, Partner), 1650 Market Street, Suite 3200, Philadelphia, Pennsylvania 19103.

• Financial Advisor to Buyer: Meridian Tuck Partners LLC (Daniel Kessler, Managing Director), 399 Park Avenue, New York, New York 10022.

• Financial Advisor to Sellers: Larchmont & Co. (Sarah Quinlan, Managing Director), 200 South Broad Street, Suite 1100, Philadelphia, Pennsylvania 19102.

• Quality of Earnings Provider: Northmark Advisory Group LLC, 1735 Market Street, Suite 2400, Philadelphia, Pennsylvania 19103.

III. Issue Presented

This memorandum addresses the following principal question:

Whether the earnout payments under the Merger Agreement should be treated for federal income tax purposes as (a) additional purchase price for the Pinnacle membership interests, resulting in capital gain to the selling members under Section 741 of the Internal Revenue Code of 1986, as amended (the "Code"), (b) compensation for post-closing services rendered by the Continuing Sellers (Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth), resulting in ordinary income to those individuals and a corresponding deduction to the buyer under Sections 61(a)(1) and 162(a)(1) of the Code, or (c) some hybrid treatment under which a portion of the earnout is characterized as purchase price and a portion is characterized as compensation.

In addition, this memorandum addresses two subsidiary issues:

Subsidiary Issue 1: Section 483 Imputed Interest. To the extent that earnout payments are properly characterized as additional purchase price, what is the application of Section 483 of the Code to deferred earnout payments made more than one year after the closing date, and what portion of each deferred payment must be treated as imputed (unstated) interest rather than capital gain?

Subsidiary Issue 2: Change of Control Acceleration. What is the federal income tax treatment of earnout acceleration upon the occurrence of a change of control of Ardent Healthcare Holdings LLC, including the impact on (i) the capital gain vs. compensation characterization, (ii) the Section 483 imputed interest calculation, and (iii) the potential application of Section 280G (excess parachute payments)?

IV. Analysis

A. Capital Gain vs. Compensation — General Framework

1. The Governing Standard. The federal income tax characterization of contingent payments made in connection with the acquisition of a business represents one of the more fact-intensive inquiries in the tax law. The determination carries significant consequences: if the earnout payments are treated as additional purchase price, the sellers recognize capital gain (currently taxable at a maximum rate of 20%, plus the 3.8% net investment income tax under Section 1411, for a combined maximum rate of 23.8%), and the buyer receives no deduction. If the payments are recharacterized as compensation, the sellers recognize ordinary income (currently taxable at a maximum rate of 37%, plus the 0.9% additional Medicare tax under Section 3101(b)(2), for a combined maximum rate of approximately 40.8% when including both the employee and self-employment tax components), and the buyer is entitled to a deduction under Section 162(a)(1) (subject to certain limitations, including Section 162(m) for publicly held corporations).

Under established case law and IRS guidance, contingent payments in connection with the sale of a business are generally treated as additional purchase price — that is, as capital gain to the sellers — unless the facts and circumstances indicate that the payments are more properly characterized as compensation for services. The burden of establishing that a payment labeled as purchase price is in fact compensation rests with the IRS. See Kieselbach v. Commissioner, 317 U.S. 399 (1943) (holding that the government bears the burden of demonstrating that the allocation of purchase price in the transaction documents does not reflect the economic substance of the arrangement).

Several foundational authorities govern the analysis:

The Danielson Principle. In Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), the Third Circuit held that a party to a transaction who has agreed to a particular tax characterization cannot later challenge that characterization unless the party can establish that the agreement was the product of fraud, duress, or undue influence. Because Pinnacle is headquartered in Pennsylvania and the sellers reside in the Third Circuit, the Danielson principle is directly applicable and provides significant support for the parties' agreed-upon characterization of the earnout as additional purchase price. Specifically, if the Merger Agreement expressly provides that the earnout constitutes additional purchase price (which we recommend in Section V below), the sellers and the buyer will be bound by that characterization absent a showing of fraud, duress, or undue influence. The IRS, however, is not bound by the Danielson principle and may challenge the parties' characterization.

Economic Substance Doctrine. Under the economic substance doctrine, codified at Section 7701(o) of the Code, a transaction is treated as having economic substance only if (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction. In the earnout context, this doctrine is invoked to determine whether the form of the earnout (as purchase price) reflects its economic substance. If the earnout economically functions as a retention bonus or performance incentive for the Continuing Sellers, the IRS may argue that the capital gain characterization lacks economic substance.

Revenue Ruling 69-435. In Rev. Rul. 69-435, 1969-2 C.B. 95, the IRS concluded that where a taxpayer sold stock and agreed to remain as an employee for a specified period, and a portion of the purchase price was contingent on continued employment, the contingent amount was more properly treated as compensation than as purchase price. This ruling highlights the importance of ensuring that the Pinnacle earnout is not conditioned on continued employment of any seller.

Private Letter Ruling 200452012. In PLR 200452012, the IRS ruled that earnout payments tied to the financial performance of the acquired business and payable to all selling shareholders (including those with no continuing involvement) constituted additional purchase price. This ruling is particularly instructive because it involved a factual pattern similar to the present transaction, and its analysis focused on many of the same factors discussed below.

The overarching analytical framework is a "substance over form" inquiry in which the IRS and the Tax Court examine whether the earnout is truly tied to the value of the acquired business or, alternatively, functions as disguised compensation to seller-employees who continue to provide services after the closing. The inquiry is inherently factual, and no single factor is dispositive. Courts and the IRS have identified a series of factors that, taken together, inform the characterization.

2. Factors Favoring Capital Gain Treatment. The multi-factor test derived from case law, including Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009), Lane Processing Trust v. United States, 25 F.3d 662 (8th Cir. 1994), and the Tax Court's analysis in Peterson v. Commissioner, T.C. Memo. 2013-271, examines the following factors, each of which generally favors capital gain treatment when present:

(a) Payment is Contingent on Business Performance Metrics. Where the earnout is tied to objective financial metrics of the acquired business as a whole (such as revenue, EBITDA, or net income), rather than to the individual performance of specific sellers, the payment more closely resembles additional purchase price for the business. Business-level metrics reflect the value of the enterprise and are influenced by factors beyond the control of any individual employee, including market conditions, competitive dynamics, the performance of hundreds or thousands of employees, and macroeconomic trends. In contrast, payments tied to individual performance metrics (such as personal billings, patient volumes attributed to a specific physician, or individual revenue targets) suggest compensation.

(b) Payment is Allocated Pro Rata Among All Selling Members. A pro rata allocation among all sellers, including those with no continuing role, strongly supports purchase price treatment because it indicates that the payment relates to the sale of the business rather than to any particular individual's services. If the earnout were compensation, one would expect it to be allocated exclusively or disproportionately to the individuals providing services.

(c) No Forfeiture for Termination of Employment. Where the earnout right survives the termination of a seller's employment — that is, where a seller who is terminated or resigns post-closing retains his or her full earnout right — the payment is more consistent with purchase price than compensation. Compensation is typically forfeited upon termination; a vested right to additional consideration for the sale of a business interest is not.

(d) Earnout Negotiated at Arm's Length as Purchase Price. Where the earnout is the product of arm's-length negotiations between a buyer and seller, each represented by independent financial advisors and legal counsel, and where the earnout is part of the purchase price negotiations to bridge a valuation gap, the characterization as purchase price is more defensible. Contemporaneous documentation of these negotiations is critical.

(e) Payment is Not Conditioned on Continued Employment. If the earnout payment is due regardless of whether any particular seller continues to be employed by the acquired business, this strongly favors purchase price characterization. In contrast, if any seller must remain employed for the earnout to be payable (either in whole or in part), the arrangement begins to resemble a retention bonus.

(f) Payment is Based on Aggregate Financial Performance, Not Attributable to Specific Individuals. Where the performance metric reflects the output of the entire business — including the contributions of non-selling employees, the value of existing customer relationships, the regulatory environment, and other factors unrelated to the Continuing Sellers' individual efforts — the payment is more properly viewed as reflecting the value of the acquired enterprise.

3. Factors That Could Support Compensation Recharacterization (Risk Analysis). While we believe that capital gain treatment is the correct and defensible characterization of the Pinnacle earnout, we note the following factors that the IRS could potentially point to in support of a compensation recharacterization:

(a) Continuing Employment of Major Sellers. Three of the earnout-eligible sellers — Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth — will continue as employees of Pinnacle following the closing. The IRS could argue that the earnout functions as a retention mechanism or performance incentive for these individuals, particularly given their importance to the business. Dr. Carvallo, as CEO, and Dr. Ostrowski, as CMO, are the co-founders of the business and arguably the individuals most responsible for achieving the EBITDA targets.

(b) Concentration of Ownership Among Continuing Sellers. The three Continuing Sellers collectively hold 72.5% of the Pinnacle membership interests (38.2% + 28.5% + 5.8%), meaning they are entitled to approximately 72.5% of the cashed-out portion of any earnout payment. The IRS could argue that the earnout effectively functions as a bonus to these three individuals, with the 27.5% allocation to the Minority Sellers being incidental or cosmetic.

(c) Potential Argument That EBITDA Is Driven by Continuing Sellers. The IRS could attempt to argue that, given the Continuing Sellers' senior executive roles, the achievement of the EBITDA targets is substantially dependent on their continued performance and leadership. This argument, however, is significantly weakened by the scale and geographic breadth of Pinnacle's operations (42 facilities across five states, 1,620 employees), which make it implausible that the EBITDA targets are attributable to any three individuals.

(d) Potential Section 409A Exposure. If the IRS were to recharacterize the earnout as deferred compensation, Section 409A of the Code would potentially apply, subjecting the Continuing Sellers to an additional 20% tax plus an interest charge on the amount of the deemed deferred compensation. This recharacterization risk, while we believe it is low given the safeguards we recommend, underscores the importance of including protective Section 409A language in the Merger Agreement.

We address the mitigation of each of these risk factors through our recommended structuring safeguards in Section V below.

B. Application to the Pinnacle Earnout

Having set forth the general analytical framework, we now apply it to the specific facts of the Pinnacle earnout. For the reasons discussed below, we conclude that the balance of factors strongly favors capital gain treatment.

1. Pro Rata Allocation. The single most significant factor supporting capital gain treatment is the pro rata allocation of earnout payments among all pre-closing Pinnacle members. The earnout is not limited to the Continuing Sellers; it is payable to every pre-closing member in proportion to their respective membership interest percentages, without regard to whether the member has any continuing relationship with Pinnacle or any Ardent Capital entity.

This means that approximately 27.5% of any earnout payment — up to $9.625 million of the maximum $35.0 million aggregate earnout — will flow to the fourteen Minority Sellers who have no continuing employment, consulting, or service relationship with Pinnacle or any affiliate of Ardent Capital after the closing. These individuals are pure sellers: they are cashing out the entirety of their membership interests and walking away from the business. Their entitlement to a pro rata share of the earnout is economically identical to a right to receive additional purchase price for their membership interests. There is no plausible compensation theory that would support treating a payment to a former owner with no continuing involvement as compensation for services.

Moreover, the rollover participants (Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth) receive the earnout only with respect to their cashed-out portions, not on their rollover equity. This is a critical structural feature: Dr. Carvallo, for example, is entitled to an earnout allocation based on 75% of his 38.2% interest (i.e., 28.65% of the aggregate earnout), not on the full 38.2%. The rollover equity is compensated through the Class B Units in Holdings LLC, which have their own separate vesting schedule and economic profile. The segregation of the earnout (tied to the cashed-out sale proceeds) from the rollover (tied to go-forward equity participation) reinforces the characterization of the earnout as a purchase price mechanism.

The pro rata allocation is consistent with the IRS's analysis in PLR 200452012, where the IRS favorably characterized an earnout as additional purchase price in part because it was payable to all selling shareholders, including those with no continuing involvement. We view this factor as the strongest single piece of support for capital gain treatment.

2. EBITDA-Based Performance Metric. The earnout targets of $58.0 million (Period 1) and $65.0 million (Period 2) are based on Adjusted EBITDA, a business-level financial metric that reflects the aggregate operating performance of all 42 of Pinnacle's facilities across five states. Adjusted EBITDA is a function of dozens of revenue streams, cost centers, and operational variables that are far beyond the control or influence of any individual seller. The metric captures the contributions of Pinnacle's 1,620 employees, 142 employed physicians, the value of its payor contracts, the regulatory environment in each of its five states, patient volume trends driven by demographic and macroeconomic factors, and the efficiency of its back-office operations.

The earnout targets represent achievable but meaningful growth over Pinnacle's 2023 Adjusted EBITDA of $51.8 million. Specifically, the Period 1 target of $58.0 million represents approximately 12.0% growth over 2023, and the Period 2 target of $65.0 million represents approximately 25.5% growth over 2023. These growth rates are consistent with the growth assumptions underlying the buyer's financial model (which projects EBITDA growth driven by same-store patient volume increases, payor mix improvements, the opening of three new clinics already in the pipeline, and modest cost synergies), and they are within the range of growth rates that Pinnacle has historically achieved. The targets were developed by reference to business performance projections, not to any individual's service contribution, and they were negotiated between the buyer's financial advisor (Meridian Tuck Partners LLC) and the sellers' financial advisor (Larchmont & Co.) as part of the purchase price discussion.

The implied EV/EBITDA multiple of the base transaction is approximately 7.95x ($412.0 million enterprise value divided by $51.8 million 2023 Adjusted EBITDA). The earnout effectively allows the sellers to participate in the upside if Pinnacle's post-closing performance validates a higher valuation. This is precisely the function of a purchase price earnout: to bridge a valuation gap between a buyer's and a seller's view of the business's worth.

No individual performance metrics, personal productivity targets, patient volume quotas, or personal service conditions are attached to the earnout. The absence of any individual-level performance criteria is a strong indicator that the earnout relates to the value of the business as an enterprise, not to the services of any particular individual.

3. Absence of Employment-Condition Language. As currently drafted (based on our review of the February 22, 2024 term sheet and the preliminary discussion draft of the Merger Agreement circulated by Harcourt Shaw & DeVries LLP on February 28, 2024), the earnout provisions do not contain any forfeiture-for-termination clause. That is, no seller's earnout right is forfeited or reduced if that seller ceases to be an employee of Pinnacle during the earnout period, whether by voluntary resignation, involuntary termination, retirement, disability, or death.

This is a critical feature. If the Merger Agreement were to provide that a seller's earnout is forfeited upon termination of employment, that clause would be the single strongest indicator that the earnout is compensation rather than purchase price. The forfeiture-for-termination clause is, in the IRS's view, the hallmark of a compensatory arrangement, because it conditions the payment on the provision of services. See Rev. Rul. 69-435 (contingent payment forfeited upon early termination treated as compensation); see also Robinson v. Commissioner, T.C. Memo. 2018-88 (earnout with employment condition recharacterized as compensation).

We strongly recommend that the Merger Agreement not only omit any forfeiture-for-termination language, but also include an affirmative provision stating that each seller's right to receive earnout payments survives any termination of employment, whether voluntary or involuntary, and is not conditioned on the seller's continued service to Pinnacle or any affiliate. This affirmative language, recommended in Section V.A.2 below, creates a clear contractual record that the earnout is a non-forfeitable right incident to the sale of the business, not a compensatory promise.

4. Separation from Non-Compete and Consulting Arrangements. The Merger Agreement and the related transaction documents include separate non-compete agreements with certain of the founders and executives. Specifically, the purchase price allocation prepared by Northmark Advisory Group LLC allocates $17.4 million of the total enterprise value to non-compete agreements, which are classified as Class V intangible assets under Section 1060 and amortized over a five-year useful life for tax purposes. The non-compete agreements are being independently negotiated as standalone contractual obligations, with separate consideration and separate documentation.

It is essential that the earnout payment not be cross-referenced to, conditioned upon, or linked to compliance with any non-compete, consulting, or employment agreement. If the earnout were conditioned on a seller's compliance with a non-compete covenant (e.g., "Seller's earnout shall be forfeited if Seller breaches the Non-Compete Agreement"), the IRS could argue that the earnout is effectively a non-compete payment (ordinary income under Section 197(f)(9) and the regulations thereunder) or, more broadly, that the earnout is a form of service-related compensation.

Similarly, any consulting agreements with the Continuing Sellers must be independently valued and separately documented, with consulting fees that reflect fair market value for the services to be rendered. The consulting fees must not be artificially depressed in a manner that suggests the earnout is functioning as deferred consulting compensation, and the earnout payment must not be contingent on the seller's performance of consulting services.

Based on our review of the preliminary term sheet and our discussions with Harcourt Shaw & DeVries LLP, the earnout provisions are currently structured independently of the non-compete and employment agreements, and we recommend that this independence be maintained and documented throughout the negotiation process.

5. Arm's-Length Negotiation. The earnout was negotiated at arm's length between Ardent Capital (represented by Meridian Tuck Partners LLC as financial advisor) and the Pinnacle founders (represented by Larchmont & Co. as financial advisor) as a component of the purchase price negotiation. The negotiation history, which we understand to be well-documented in correspondence and term sheet exchanges between the parties' financial advisors, reflects a classic valuation gap dynamic:

The sellers, advised by Larchmont & Co., initially proposed a total enterprise value of $460.0 million, reflecting a forward EV/EBITDA multiple of approximately 8.9x based on their projected 2024 EBITDA of $51.8 million (flat to 2023). The buyer, advised by Meridian Tuck Partners LLC, initially proposed an enterprise value of $395.0 million, reflecting an EV/EBITDA multiple of approximately 7.6x. The parties bridged the valuation gap through a combination of (i) an increase in the fixed enterprise value from $395.0 million to $412.0 million and (ii) the introduction of the earnout mechanism, which allows the sellers to receive up to an additional $35.0 million if the business achieves specified EBITDA targets post-closing.

The earnout structure — a binary payout at two threshold levels — was initially proposed by the sellers, who favored a dollar-for-dollar earn-up above baseline EBITDA (i.e., uncapped incremental consideration for each dollar of EBITDA above 2023 levels). The buyer negotiated the structure down to fixed payout amounts at discrete threshold levels, with no partial payouts below the threshold. This negotiation dynamic is characteristic of a purchase price mechanism, not a compensation arrangement: the parties were negotiating over value, not over employment terms.

We recommend that Ardent Capital retain all contemporaneous documentation of these negotiations, including term sheet drafts, correspondence between financial advisors, and internal deal team communications reflecting the commercial rationale for the earnout, to create a robust evidentiary record in the event of an IRS examination.

C. Section 483 Imputed Interest Analysis

1. Applicability. Section 483 of the Code provides that, in the case of any payment under a contract for the sale or exchange of property where some or all of the payments are due more than one year after the date of the sale or exchange, the payments shall be treated as including a component of imputed (unstated) interest if the contract does not provide for adequate stated interest. The imputed interest component is treated as ordinary interest income to the seller and deductible interest expense to the buyer, and it reduces the amount of the payment that is treated as capital gain.

The Pinnacle earnout qualifies as a payment under a contract for the sale of property (i.e., the membership interests in Pinnacle). The closing date is anticipated to be May 31, 2024. The timing of earnout payments, if earned, is as follows:

• Period 1 Earnout ($15.0 million): Measurement period ends May 31, 2025. Payment due within sixty (60) days after the end of the measurement period (i.e., by approximately July 30, 2025). This payment would be made approximately 14 months after the closing date — more than one year after the date of the sale. Accordingly, Section 483 applies to the Period 1 earnout.

• Period 2 Earnout ($20.0 million): Measurement period ends May 31, 2026. Payment due within sixty (60) days after the end of the measurement period (i.e., by approximately July 30, 2026). This payment would be made approximately 26 months after the closing date — well more than one year after the date of the sale. Accordingly, Section 483 applies to the Period 2 earnout.

The Merger Agreement, as currently drafted, does not provide for stated interest on the earnout payments. In the absence of adequate stated interest at or above the applicable AFR, Section 483 requires that a portion of each deferred payment be treated as imputed interest.

2. Applicable Federal Rate (AFR). Under Section 483(b) and Treasury Regulation Section 1.483-1(a)(2), the applicable discount rate for determining imputed interest is the Applicable Federal Rate ("AFR") in effect on the date of the contract. For purposes of Section 483, the "date of the contract" is the date of the Merger Agreement (the signing date), which is anticipated to be March 15, 2024.

As of March 2024, the applicable AFRs published by the IRS (Revenue Ruling 2024-05) are:

Both the Period 1 earnout (deferred approximately 12–13 months from closing) and the Period 2 earnout (deferred approximately 24–25 months from closing) fall within the short-term AFR window (i.e., payment is due within three years of the closing date). Accordingly, the short-term AFR of 5.12% (annual compounding) applies to both periods. We note that the AFR is determined as of the signing date of the Merger Agreement (the contract date), not the closing date. If the signing occurs on March 15, 2024 as anticipated, the March 2024 AFR of 5.12% will govern regardless of any subsequent changes in the AFR.

3. Computation Methodology. Under Section 483, the imputed interest component is calculated by applying the applicable AFR to the deferred payment amount over the period from the closing date (the date of the sale) to the payment date. The computation assumes annual compounding unless the parties elect a different compounding period.

Period 1 Earnout ($15.0 million):

Assuming the Period 1 earnout payment is made on approximately June 15, 2025 (380 days after the closing date of May 31, 2024), the imputed interest calculation is as follows:

Imputed Interest = $15,000,000 × 5.12% × (380 / 365)

Imputed Interest ≈ $15,000,000 × 0.0512 × 1.0411

Imputed Interest ≈ $799,562

The imputed interest component of the Period 1 earnout is approximately $799,562. The balance — approximately $14,200,438 — would be treated as additional purchase price (capital gain to the sellers).

Period 2 Earnout ($20.0 million):

Assuming the Period 2 earnout payment is made on approximately June 15, 2026 (746 days after the closing date of May 31, 2024), the imputed interest calculation is as follows:

Imputed Interest = $20,000,000 × 5.12% × (746 / 365)

Imputed Interest ≈ $20,000,000 × 0.0512 × 2.0438

Imputed Interest ≈ $2,093,370

The imputed interest component of the Period 2 earnout is approximately $2,093,370. The balance — approximately $17,906,630 — would be treated as additional purchase price (capital gain to the sellers).

The following table summarizes the illustrative imputed interest computations:

These computations are illustrative and will depend on the exact payment dates. If payment is delayed due to the dispute resolution mechanism, the imputed interest component will increase correspondingly.

We note that the Merger Agreement could potentially provide for adequate stated interest at or above the short-term AFR, which would eliminate the Section 483 imputed interest issue. However, we understand from discussions with the deal team and Harcourt Shaw & DeVries LLP that the sellers are resistant to the inclusion of a stated interest provision, as it would reduce the portion of the payment characterized as purchase price (capital gain) and increase the ordinary income component. Given the relatively modest imputed interest amounts involved (approximately $2.9 million in the aggregate across both periods), the parties may determine that the inclusion of stated interest is not commercially necessary.

4. Seller Reporting Obligations. Each seller must separately report the imputed interest component as ordinary interest income on its federal income tax return for the taxable year in which the earnout payment is received. The balance of the payment is reported as additional capital gain. The allocation of imputed interest among sellers is pro rata based on their respective membership interest percentages. For example, if the Period 1 earnout of $15.0 million is paid in full, Dr. Carvallo (38.2% interest, cashed-out at 75%) would report the following:

Dr. Carvallo's Share of Period 1 Earnout: $15,000,000 × 28.65% (75% of 38.2%) = $4,297,500

Dr. Carvallo's Share of Imputed Interest: $799,562 × 28.65% = $229,075

Dr. Carvallo's Capital Gain: $4,297,500 − $229,075 = $4,068,425

Similar allocations would apply to each other seller. Each seller is responsible for reporting its pro rata share of imputed interest and capital gain on its own return, and we recommend that the Merger Agreement include a provision requiring the buyer to provide each seller with a written statement showing the total earnout payment, the imputed interest component, and the capital gain component promptly following each earnout payment.

D. Section 409A Considerations

Section 409A of the Code imposes strict requirements on "nonqualified deferred compensation plans," broadly defined. If a payment arrangement constitutes deferred compensation under Section 409A and fails to comply with the statute's timing and form requirements, the service provider is subject to an additional 20% tax on the amount of deferred compensation, plus an interest charge calculated from the date the amounts should have been included in income. These penalties are severe and apply at the individual level, without any corresponding benefit to the service recipient.

Under the recommended capital gain characterization, the earnout is additional purchase price for the sale of a capital asset and is not deferred compensation within the meaning of Section 409A. Section 409A, by its terms, applies only to compensation for services. See Code § 409A(d)(1) (defining a "nonqualified deferred compensation plan" as any plan that provides for the deferral of compensation). A payment that constitutes purchase price for the sale of a business interest is not "compensation for services" and does not give rise to a Section 409A issue.

However, as a protective measure in the event that the IRS were to recharacterize the earnout as compensation, we recommend that the Merger Agreement include the following protective provisions:

(a) A statement that the earnout is not intended to constitute "deferred compensation" within the meaning of Section 409A of the Code.

(b) A provision stating that, if any earnout payment were determined to constitute deferred compensation under Section 409A, such payment shall be made within the "short-term deferral" period described in Treasury Regulation Section 1.409A-1(b)(4) — that is, within 2½ months following the end of the taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture. Under this safe harbor, the payment would not be treated as deferred compensation subject to Section 409A.

(c) A provision stating that, to the extent the short-term deferral exception is not available, the earnout payments shall be structured to comply with the fixed schedule payment rules of Section 409A(a)(2)(A)(iv), with each payment treated as a separate payment for purposes of Section 409A.

These provisions operate as a belt-and-suspenders mechanism: the primary position is that Section 409A does not apply (because the earnout is purchase price, not compensation), and the fallback position is that, even if Section 409A were found to apply, the payment timing would satisfy Section 409A's requirements.

E. Earnout Acceleration upon Change of Control

1. Terms. Article VII, Section 7.04 of the preliminary Merger Agreement draft provides that, upon the occurrence of a "Change of Control" of Ardent Healthcare Holdings LLC at any time during the earnout period (i.e., prior to the later of (a) the last day of the Period 2 measurement period, May 31, 2026, or (b) the date on which all earnout payments have been finally determined and paid), one hundred percent (100%) of any remaining unpaid earnout consideration becomes immediately due and payable, regardless of whether the applicable EBITDA targets have been achieved. The full unpaid amount ($35.0 million maximum, less any amounts previously paid with respect to Period 1) would be payable within ten (10) business days following the consummation of the Change of Control.

The definition of "Change of Control" in the current draft cross-references a definition in Article I of the Merger Agreement that encompasses (i) the sale, transfer, or other disposition of all or substantially all of the assets of Holdings LLC, (ii) the merger or consolidation of Holdings LLC with or into another entity in which the equityholders of Holdings LLC immediately prior to the merger do not retain a majority of the voting power of the surviving entity, and (iii) any transaction or series of related transactions resulting in any person or group (other than Ardent Capital Partners III LP or its affiliates) acquiring beneficial ownership of a majority of the equity interests of Holdings LLC. We recommend that Calderwood & Harkness and Harcourt Shaw & DeVries LLP review this definition to ensure it is appropriately tailored for purposes of the earnout acceleration provision.

2. Tax Treatment of Acceleration. The acceleration of the earnout upon a Change of Control does not alter the character of the earnout as additional purchase price. Acceleration is a timing mechanism, not a characterization mechanism. It simply provides for early payment of the full contingent amount based on the occurrence of a specified transactional event. The character of the payment (capital gain vs. compensation) is determined by the nature of the underlying obligation, not by the timing of payment.

Upon acceleration, the full unpaid earnout amount (up to $35.0 million less any amounts previously paid) becomes immediately payable. Section 483 imputed interest applies to the accelerated payment based on the period from the closing date to the acceleration payment date. For example, if a Change of Control were to occur on December 31, 2024 (214 days after the May 31, 2024 closing), and the full $35.0 million were payable on January 15, 2025 (229 days after closing), the imputed interest calculation would be:

Imputed Interest = $35,000,000 × 5.12% × (229 / 365) ≈ $1,124,274

If the accelerated payment is made within one year of the closing date, Section 483 would not apply at all, because Section 483 applies only to payments due more than one year after the date of the sale.

Importantly, the acceleration feature itself provides additional support for purchase price characterization. The trigger for acceleration is a transaction-level event — a Change of Control of the holding company — not an employment-related event such as termination, resignation, or disability. The fact that the full earnout becomes payable upon a Change of Control, regardless of whether the EBITDA targets have been achieved and regardless of whether the Continuing Sellers remain employed, underscores that the earnout relates to the value of the business (which is being monetized through the Change of Control transaction) rather than to the services of any individual. If the earnout were compensation, one would expect its acceleration to be triggered by employment-related events (such as termination without cause or constructive dismissal), not by changes in the ownership of the holding company.

3. Section 280G Interaction. Section 280G of the Code provides that no deduction is allowed for any "excess parachute payment" made to a "disqualified individual" in connection with a "change in ownership or control" of a corporation. An excess parachute payment is defined as any payment in the nature of compensation that is contingent on a change in control and that exceeds a base amount equal to three times the individual's average annual compensation over the five preceding years (or a shorter period if the individual has been employed for fewer than five years). In addition, the disqualified individual is subject to a 20% excise tax on the excess parachute payment under Section 4999 of the Code.

If the accelerated earnout payment were recharacterized as compensation, it could potentially constitute a "parachute payment" within the meaning of Section 280G, because the acceleration is contingent on a Change of Control. If so, the payment could exceed the applicable base amount thresholds, resulting in loss of the buyer's deduction (to the extent the buyer were otherwise entitled to a deduction under the compensation characterization) and imposition of the 20% excise tax on the individual recipients.

Under the recommended capital gain characterization, Section 280G is inapplicable because the earnout payments are purchase price for the sale of a capital asset, not "compensation" within the meaning of Section 280G. Payments for the sale of a business interest are not "in the nature of compensation" and do not fall within Section 280G's ambit. See Treasury Regulation Section 1.280G-1, Q&A-11 (providing that payments made under a contract for the sale of property that are characterized as purchase price are not parachute payments).

Nevertheless, to reduce the risk of an IRS challenge, Calderwood & Harkness recommends that the Merger Agreement include protective language affirming that the accelerated earnout constitutes additional purchase price for the Pinnacle membership interests and not compensation for services, and that the parties agree not to take any inconsistent position on their tax returns. This protective language operates in tandem with the Danielson principle discussed above and creates a strong evidentiary record of the parties' intent and agreed characterization.

V. Structuring Safeguards and Drafting Recommendations

Based on the foregoing analysis, Calderwood & Harkness recommends the implementation of the following structuring safeguards and drafting provisions to support the capital gain characterization of the earnout. These safeguards are designed to address each of the risk factors identified in Section IV.A.3 above and to create a robust evidentiary record in the event of an IRS examination.

A. Mandatory Provisions in the Merger Agreement

The following provisions should be included in the definitive Merger Agreement:

1. Pro Rata Allocation. The Merger Agreement must expressly provide that earnout payments are allocated pro rata among all pre-closing Pinnacle members based on their respective membership interest percentages as set forth in the Pinnacle Operating Agreement as of immediately prior to the closing. The allocation must include all fourteen (14) minority physician-investors, none of whom has a continuing employment or service relationship with Pinnacle or any Ardent Capital affiliate. For rollover participants, the earnout must be allocated based on the cashed-out portion of their membership interests (i.e., excluding the rollover equity). The allocation methodology should be set forth in a schedule to the Merger Agreement and should not be subject to modification by the buyer post-closing.

2. No Forfeiture-for-Termination. The Merger Agreement must include an affirmative provision stating that each seller's right to receive earnout payments survives any termination of such seller's employment with Pinnacle or any affiliate, whether such termination is voluntary, involuntary, with or without cause, by reason of retirement, disability, or death. No seller's earnout shall be forfeited, reduced, or otherwise modified by reason of the cessation of such seller's services. We recommend the following specific language:

"Notwithstanding anything herein to the contrary, each Seller's right to receive Earnout Payments pursuant to this Article VII shall not be conditioned upon, and shall survive, any termination or cessation of such Seller's employment, consulting, or other service relationship with the Company, the Buyer, or any of their respective Affiliates, whether such termination is voluntary, involuntary, with or without Cause (as defined in such Seller's employment agreement, if any), or by reason of death, disability, retirement, or any other circumstance. For the avoidance of doubt, no Seller's Earnout Payment shall be subject to forfeiture, reduction, or set-off by reason of the termination or cessation of such Seller's services."

3. No Employment-Condition Language. The Merger Agreement must not condition any seller's eligibility for, or the amount of, earnout payments on such seller's continued employment or performance of services. No provision of the Merger Agreement should link the earnout to any individual seller's employment status, attendance, performance evaluation, or compliance with employment policies. The earnout provisions should be entirely independent of the employment agreements.

4. Separate Compensation Arrangements. Any consulting agreements, employment agreements, or non-compete agreements with Dr. Carvallo, Dr. Ostrowski, or Mr. Farnsworth must be (i) independently negotiated between the applicable seller and the buyer, (ii) separately documented from the Merger Agreement (though they may be cross-referenced as ancillary agreements), (iii) independently valued at fair market value, and (iv) not cross-referenced to or conditioned upon the earnout. In particular, the earnout should not be reduced or offset by amounts payable under any consulting, employment, or non-compete agreement, and conversely, no consulting, employment, or non-compete payment should be reduced or offset by amounts payable under the earnout.

5. Consistent Tax Reporting. The Merger Agreement must include a provision requiring all parties — the buyer, the sellers, and their respective affiliates — to treat the earnout payments as additional purchase price for the Pinnacle membership interests on their respective federal, state, and local income tax returns, and to not take any inconsistent position on any tax return, tax claim, tax proceeding, or other filing unless required by a final determination (within the meaning of Section 1313 of the Code) of a court of competent jurisdiction or the IRS. This provision binds the parties to the capital gain characterization and invokes the protection of the Danielson principle in the Third Circuit.

6. Section 409A Protective Language. The Merger Agreement must include a provision stating that:

(a) The earnout is not intended to constitute "nonqualified deferred compensation" within the meaning of Section 409A of the Code.

(b) To the extent that any earnout payment is determined to constitute nonqualified deferred compensation subject to Section 409A, such payment shall be made within the "short-term deferral" period prescribed by Treasury Regulation Section 1.409A-1(b)(4) (i.e., within 2½ months following the end of the seller's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture), and the parties shall cooperate in good faith to restructure the payment timing to comply with Section 409A.

(d) In no event shall the buyer be required to "gross up" or indemnify any seller for any taxes, penalties, or interest imposed under Section 409A.

B. Process Documentation

In addition to the contractual safeguards described above, we recommend that Ardent Capital create and maintain a comprehensive file of contemporaneous documentation supporting the arm's-length negotiation of the earnout as a purchase price mechanism. This documentation should include:

(a) All term sheet drafts exchanged between the buyer and the selle

MEMORANDUM
PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE / ATTORNEY WORK PRODUCT
From: Calderwood & Harkness LLP
Leonard Cross, Partner, Tax Robert Jansen, Senior Associate, Tax
To: Ardent Capital Partners III LP
Marcus Pellegrino, Partner, Healthcare Claire Ashworth, Co-Founder & Managing Partner
Date: March 1, 2024
Re: Tax Characterization of Earnout Payments — Acquisition of Pinnacle Health Services Group LLC
Engagement No.: 1001-00006
Matter No.: 1001-00006
Right-click to update Table of Contents
I. Executive Summary
Calderwood & Harkness LLP has been engaged by Ardent Capital Partners III LP ("Ardent Capital" or "Fund III") to advise on the tax structuring of its proposed acquisition of one hundred percent (100%) of the membership interests in Pinnacle Health Services Group LLC ("Pinnacle" or "PHSG"), a Delaware limited liability company currently classified as a partnership for federal income tax purposes, at an aggregate enterprise value of $412.0 million (equity value of approximately $339.4 million after deducting net debt of $72.6 million). This memorandum addresses one discrete, but critically important, issue within the broader tax structuring engagement: the proper federal income tax characterization of contingent earnout consideration payable to the selling members of Pinnacle under the proposed Merger Agreement.
The Merger Agreement, which is expected to be signed on or about March 15, 2024, contemplates contingent earnout consideration with a maximum aggregate payout of $35.0 million, payable across two distinct measurement periods tied to the post-closing financial performance of Pinnacle's business. Period 1 (June 1, 2024 through May 31, 2025) carries a target of $58.0 million of Adjusted EBITDA and a payout of $15.0 million, and Period 2 (June 1, 2025 through May 31, 2026) carries a target of $65.0 million of Adjusted EBITDA and a payout of $20.0 million.
This memorandum analyzes the federal income tax characterization of the earnout payments and reaches the following principal conclusion: the earnout should be treated as additional purchase price for the Pinnacle membership interests, resulting in capital gain to the selling members under Section 741 of the Internal Revenue Code, rather than as compensation for services rendered by certain continuing seller-employees, which would result in ordinary income to those individuals and a corresponding deduction to the buyer. This conclusion is subject to the implementation of certain structuring safeguards described in detail in Section V of this memorandum, which we strongly recommend be incorporated into the definitive Merger Agreement prior to execution.
In addition, this memorandum addresses two subsidiary issues that arise in connection with the earnout. First, we analyze the application of Section 483 imputed interest rules to deferred earnout payments, concluding that both Period 1 and Period 2 payments, if and when made, will include a component of unstated interest taxable as ordinary interest income to the sellers and deductible as interest expense by the buyer. The applicable short-term Applicable Federal Rate ("AFR") is 5.12% as of the anticipated signing date. Second, we analyze the tax treatment of earnout acceleration upon a change of control of Ardent Healthcare Holdings LLC, concluding that the acceleration feature does not alter the capital gain characterization of the earnout and, in fact, provides additional support for purchase price treatment because it is triggered by a transaction-level event rather than an employment-related event.
Our overall recommendation is that capital gain treatment of the earnout payments is supportable and defensible, subject to the safeguards described in Section V below. We further recommend that Calderwood & Harkness coordinate with buyer's M&A counsel, Harcourt Shaw & DeVries LLP, to implement these safeguards in the definitive Merger Agreement, and we anticipate delivering a separate comment letter to that effect on or before March 12, 2024.
II. Background and Transaction Overview
A. Parties.  Buyer/Sponsor. The acquiring party is Ardent Capital Partners III LP, a Delaware limited partnership (EIN: 87-3491520), whose general partner is Ardent Capital GP III LLC, also a Delaware limited liability company. Fund III is a 2022-vintage private equity fund with total committed capital of approximately $3.2 billion, focused on healthcare services, technology-enabled services, and business services investments. Fund III maintains its principal office at 600 Lexington Avenue, 38th Floor, New York, New York 10022. The firm's managing partners are Dominic Ferrera and Claire Ashworth, and the deal team for the Pinnacle acquisition is led by Marcus Pellegrino, Partner, Healthcare.
Ardent Capital has extensive experience in the healthcare services sector, having completed twelve platform acquisitions in the space since the inception of its predecessor fund, Ardent Capital Partners II LP. This institutional context is relevant to the earnout characterization analysis insofar as it demonstrates that the use of earnout mechanisms in Ardent Capital's acquisitions is a standard purchase price tool deployed in arm's-length negotiations, rather than a compensation structure designed to incentivize post-closing management behavior.
Target. The acquisition target is Pinnacle Health Services Group LLC, a Delaware limited liability company classified as a partnership for federal income tax purposes (EIN: 82-1947632). Pinnacle's principal office is located at 2200 Renaissance Boulevard, Suite 400, King of Prussia, Pennsylvania 19406. Pinnacle was founded in 2016 by Dr. Raymond Carvallo and Dr. Nadia Ostrowski, and it operates thirty-four (34) urgent care clinics and eight (8) ambulatory surgery centers across five states: Pennsylvania, Virginia, Maryland, North Carolina, and Georgia. For the fiscal year ended December 31, 2023, Pinnacle reported revenue of approximately $287.4 million and Adjusted EBITDA of approximately $51.8 million. Pinnacle employs approximately 1,620 individuals, including 142 employed physicians.
Pinnacle's classification as a partnership for federal income tax purposes is central to several aspects of the tax structuring, including the application of Section 741 to the sale of membership interests, the availability of a Section 743(b) basis adjustment for the buyer, and the purchase price allocation under Section 1060 (as applied by analogy to partnership interest acquisitions). The partnership classification has been in effect since Pinnacle's formation and has not been the subject of any prior IRS examination or challenge.
Sellers. The pre-closing members of Pinnacle and their respective ownership percentages are as follows:
Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth (collectively, the "Continuing Sellers") will remain employed by Pinnacle in their current executive capacities following the closing. The fourteen (14) minority physician-investors (collectively, the "Minority Sellers") will not have any continuing employment, consulting, or other service relationship with Pinnacle or any Ardent Capital affiliate following the closing, although certain of these physicians may continue to practice at Pinnacle clinics as independent contractors under existing professional services agreements. The distinction between the Continuing Sellers and the Minority Sellers is a critical element of the earnout characterization analysis, as discussed in Section IV.B.1 below.
B. Acquisition Structure
The proposed acquisition will be structured as a reverse merger in which Ardent Healthcare Merger Sub LLC, a newly formed Delaware limited liability company and wholly owned subsidiary of Ardent Healthcare Intermediate Inc. ("Intermediate"), will merge with and into Pinnacle, with Pinnacle surviving the merger as a wholly owned subsidiary of Intermediate. Intermediate is a Delaware C-corporation organized as a "Blocker" entity to shield Fund III's tax-exempt and foreign limited partners from direct flow-through of unrelated business taxable income and effectively connected income. Intermediate is, in turn, wholly owned by Ardent Healthcare Holdings LLC ("Holdings LLC"), a Delaware limited liability company classified as a partnership for federal income tax purposes.
Holdings LLC is the principal equity vehicle for the acquisition and will be owned by the following parties immediately following the closing:
The reverse merger structure is designed to achieve several tax objectives, including (i) treating the transaction as a purchase of partnership interests (rather than an asset acquisition) for purposes of Section 741, (ii) permitting a Section 743(b) basis adjustment to reflect the buyer's cost basis in the acquired partnership interests, and (iii) allowing the rollover equity to be contributed in a tax-deferred transaction. The selection of this structure was the subject of a separate Calderwood & Harkness memorandum dated February 15, 2024 (Acquisition Structure Tax Analysis Memorandum), and is not revisited here except as necessary for context.
C. Rollover Participants (Context for Earnout Characterization Analysis)
Three of the Pinnacle sellers are rolling over a portion of their equity proceeds into Holdings LLC, as follows:
Dr. Raymond Carvallo. Dr. Carvallo holds a 38.2% membership interest in Pinnacle, which yields gross equity proceeds of approximately $129.65 million based on the $339.4 million aggregate equity value. Dr. Carvallo will roll over 25.0% of his gross proceeds ($32.41 million) into Class B Units of Holdings LLC and will receive cash consideration for the remaining 75.0% ($97.24 million). Dr. Carvallo will continue to serve as Chief Executive Officer of Pinnacle following the closing pursuant to a three-year employment agreement that is being independently negotiated.
Dr. Nadia Ostrowski. Dr. Ostrowski holds a 28.5% membership interest in Pinnacle, yielding gross equity proceeds of approximately $96.73 million. Dr. Ostrowski will roll over 25.0% of her gross proceeds ($24.18 million) and will receive cash consideration for the remaining 75.0% ($72.55 million). Dr. Ostrowski will continue to serve as Chief Medical Officer of Pinnacle following the closing under a separate three-year employment agreement.
Jonathan Farnsworth. Mr. Farnsworth holds a 5.8% membership interest in Pinnacle, yielding gross equity proceeds of approximately $19.69 million. Mr. Farnsworth will roll over 15.0% of his gross proceeds ($2.95 million) and will receive cash consideration for the remaining 85.0% ($16.74 million). Mr. Farnsworth will continue as Chief Financial Officer under a two-year employment agreement.
Minority Physician-Investors. The fourteen minority physician-investors collectively hold 27.5% of the Pinnacle membership interests, yielding aggregate gross equity proceeds of approximately $93.34 million. None of these sellers is contributing rollover equity to Holdings LLC.
The rollover participants are receiving Class B Units in Holdings LLC. Fifty percent (50%) of each rollover participant's Class B Units will vest at closing, with the remaining 50% vesting ratably over a thirty-six (36) month period from the closing date, subject to continued service. The Class B Units are structured as "profits interests" within the meaning of Revenue Procedure 93-27, as clarified by Revenue Procedure 2001-43, and will have an initial liquidation value of zero (with the rollover equity credited as a capital contribution and reflected in the participant's capital account, separate from the profits interest vesting schedule). The profits interest arrangements are the subject of a separate Calderwood & Harkness analysis and are addressed in this memorandum only insofar as they bear on the earnout characterization. Specifically, the earnout is structurally separate from the rollover and profits interest arrangements, and the earnout payments are not dependent on, linked to, or conditioned upon the rollover participants' Class B Unit vesting.
D. Earnout Terms
The Merger Agreement provides for contingent earnout consideration on the following terms:
Measurement Periods and Targets. The earnout is structured around two distinct measurement periods, each with a binary (all-or-nothing) payout threshold:
Maximum Aggregate Earnout. The maximum aggregate earnout payable is $35.0 million ($15.0 million for Period 1 plus $20.0 million for Period 2). The earnout payments for each period are independent; failure to achieve the Period 1 target does not affect the availability or amount of the Period 2 earnout.
Earnout Acceleration. One hundred percent (100%) of any remaining unpaid earnout consideration becomes payable immediately upon a "Change of Control" (as defined in the Merger Agreement) of Ardent Healthcare Holdings LLC occurring during the earnout period (i.e., prior to May 31, 2026). The acceleration provision is not conditioned on the employment status of any seller.
Allocation. Earnout payments are allocated pro rata among all pre-closing Pinnacle members based on their respective membership interest percentages, as set forth in the Pinnacle Operating Agreement as of immediately prior to the closing. For rollover participants, the earnout is payable only with respect to their cashed-out portions — that is, Dr. Carvallo's earnout allocation is based on 75% of his 38.2% interest (the portion being sold for cash), and similarly for Dr. Ostrowski and Mr. Farnsworth.
Payment Timing. The Merger Agreement provides that each earnout payment, if earned, will be made within sixty (60) days following the end of the applicable measurement period, subject to a dispute resolution mechanism (independent accounting firm determination) that could extend the payment date by up to an additional ninety (90) days.
Anticipated Closing Date. The transaction is expected to close on May 31, 2024, concurrent with the commencement of the Period 1 measurement period.
E. Advisors Referenced
The following advisors to the parties are referenced in this memorandum:
•  Buyer's M&A Counsel: Harcourt Shaw & DeVries LLP (Thomas Kundra, Partner; Allison Cho, Partner), 787 Seventh Avenue, New York, New York 10019.
•  Buyer's Tax Counsel: Calderwood & Harkness LLP (Leonard Cross, Partner; Robert Jansen, Senior Associate), One Liberty Plaza, 45th Floor, New York, New York 10006.
•  Seller's Counsel: Whitford & Gaines LLP (Patricia Engelman, Partner; Kevin Driscoll, Partner), 1650 Market Street, Suite 3200, Philadelphia, Pennsylvania 19103.
•  Financial Advisor to Buyer: Meridian Tuck Partners LLC (Daniel Kessler, Managing Director), 399 Park Avenue, New York, New York 10022.
•  Financial Advisor to Sellers: Larchmont & Co. (Sarah Quinlan, Managing Director), 200 South Broad Street, Suite 1100, Philadelphia, Pennsylvania 19102.
•  Quality of Earnings Provider: Northmark Advisory Group LLC, 1735 Market Street, Suite 2400, Philadelphia, Pennsylvania 19103.
III. Issue Presented
This memorandum addresses the following principal question:
Whether the earnout payments under the Merger Agreement should be treated for federal income tax purposes as (a) additional purchase price for the Pinnacle membership interests, resulting in capital gain to the selling members under Section 741 of the Internal Revenue Code of 1986, as amended (the "Code"), (b) compensation for post-closing services rendered by the Continuing Sellers (Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth), resulting in ordinary income to those individuals and a corresponding deduction to the buyer under Sections 61(a)(1) and 162(a)(1) of the Code, or (c) some hybrid treatment under which a portion of the earnout is characterized as purchase price and a portion is characterized as compensation.
In addition, this memorandum addresses two subsidiary issues:
Subsidiary Issue 1: Section 483 Imputed Interest. To the extent that earnout payments are properly characterized as additional purchase price, what is the application of Section 483 of the Code to deferred earnout payments made more than one year after the closing date, and what portion of each deferred payment must be treated as imputed (unstated) interest rather than capital gain?
Subsidiary Issue 2: Change of Control Acceleration. What is the federal income tax treatment of earnout acceleration upon the occurrence of a change of control of Ardent Healthcare Holdings LLC, including the impact on (i) the capital gain vs. compensation characterization, (ii) the Section 483 imputed interest calculation, and (iii) the potential application of Section 280G (excess parachute payments)?
IV. Analysis
A. Capital Gain vs. Compensation — General Framework
1. The Governing Standard.  The federal income tax characterization of contingent payments made in connection with the acquisition of a business represents one of the more fact-intensive inquiries in the tax law. The determination carries significant consequences: if the earnout payments are treated as additional purchase price, the sellers recognize capital gain (currently taxable at a maximum rate of 20%, plus the 3.8% net investment income tax under Section 1411, for a combined maximum rate of 23.8%), and the buyer receives no deduction. If the payments are recharacterized as compensation, the sellers recognize ordinary income (currently taxable at a maximum rate of 37%, plus the 0.9% additional Medicare tax under Section 3101(b)(2), for a combined maximum rate of approximately 40.8% when including both the employee and self-employment tax components), and the buyer is entitled to a deduction under Section 162(a)(1) (subject to certain limitations, including Section 162(m) for publicly held corporations).
Under established case law and IRS guidance, contingent payments in connection with the sale of a business are generally treated as additional purchase price — that is, as capital gain to the sellers — unless the facts and circumstances indicate that the payments are more properly characterized as compensation for services. The burden of establishing that a payment labeled as purchase price is in fact compensation rests with the IRS. See Kieselbach v. Commissioner, 317 U.S. 399 (1943) (holding that the government bears the burden of demonstrating that the allocation of purchase price in the transaction documents does not reflect the economic substance of the arrangement).
Several foundational authorities govern the analysis:
The Danielson Principle. In Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), the Third Circuit held that a party to a transaction who has agreed to a particular tax characterization cannot later challenge that characterization unless the party can establish that the agreement was the product of fraud, duress, or undue influence. Because Pinnacle is headquartered in Pennsylvania and the sellers reside in the Third Circuit, the Danielson principle is directly applicable and provides significant support for the parties' agreed-upon characterization of the earnout as additional purchase price. Specifically, if the Merger Agreement expressly provides that the earnout constitutes additional purchase price (which we recommend in Section V below), the sellers and the buyer will be bound by that characterization absent a showing of fraud, duress, or undue influence. The IRS, however, is not bound by the Danielson principle and may challenge the parties' characterization.
Economic Substance Doctrine. Under the economic substance doctrine, codified at Section 7701(o) of the Code, a transaction is treated as having economic substance only if (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction. In the earnout context, this doctrine is invoked to determine whether the form of the earnout (as purchase price) reflects its economic substance. If the earnout economically functions as a retention bonus or performance incentive for the Continuing Sellers, the IRS may argue that the capital gain characterization lacks economic substance.
Revenue Ruling 69-435. In Rev. Rul. 69-435, 1969-2 C.B. 95, the IRS concluded that where a taxpayer sold stock and agreed to remain as an employee for a specified period, and a portion of the purchase price was contingent on continued employment, the contingent amount was more properly treated as compensation than as purchase price. This ruling highlights the importance of ensuring that the Pinnacle earnout is not conditioned on continued employment of any seller.
Private Letter Ruling 200452012. In PLR 200452012, the IRS ruled that earnout payments tied to the financial performance of the acquired business and payable to all selling shareholders (including those with no continuing involvement) constituted additional purchase price. This ruling is particularly instructive because it involved a factual pattern similar to the present transaction, and its analysis focused on many of the same factors discussed below.
The overarching analytical framework is a "substance over form" inquiry in which the IRS and the Tax Court examine whether the earnout is truly tied to the value of the acquired business or, alternatively, functions as disguised compensation to seller-employees who continue to provide services after the closing. The inquiry is inherently factual, and no single factor is dispositive. Courts and the IRS have identified a series of factors that, taken together, inform the characterization.
2. Factors Favoring Capital Gain Treatment.  The multi-factor test derived from case law, including Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009), Lane Processing Trust v. United States, 25 F.3d 662 (8th Cir. 1994), and the Tax Court's analysis in Peterson v. Commissioner, T.C. Memo. 2013-271, examines the following factors, each of which generally favors capital gain treatment when present:
(a) Payment is Contingent on Business Performance Metrics. Where the earnout is tied to objective financial metrics of the acquired business as a whole (such as revenue, EBITDA, or net income), rather than to the individual performance of specific sellers, the payment more closely resembles additional purchase price for the business. Business-level metrics reflect the value of the enterprise and are influenced by factors beyond the control of any individual employee, including market conditions, competitive dynamics, the performance of hundreds or thousands of employees, and macroeconomic trends. In contrast, payments tied to individual performance metrics (such as personal billings, patient volumes attributed to a specific physician, or individual revenue targets) suggest compensation.
(b) Payment is Allocated Pro Rata Among All Selling Members. A pro rata allocation among all sellers, including those with no continuing role, strongly supports purchase price treatment because it indicates that the payment relates to the sale of the business rather than to any particular individual's services. If the earnout were compensation, one would expect it to be allocated exclusively or disproportionately to the individuals providing services.
(c) No Forfeiture for Termination of Employment. Where the earnout right survives the termination of a seller's employment — that is, where a seller who is terminated or resigns post-closing retains his or her full earnout right — the payment is more consistent with purchase price than compensation. Compensation is typically forfeited upon termination; a vested right to additional consideration for the sale of a business interest is not.
(d) Earnout Negotiated at Arm's Length as Purchase Price. Where the earnout is the product of arm's-length negotiations between a buyer and seller, each represented by independent financial advisors and legal counsel, and where the earnout is part of the purchase price negotiations to bridge a valuation gap, the characterization as purchase price is more defensible. Contemporaneous documentation of these negotiations is critical.
(e) Payment is Not Conditioned on Continued Employment. If the earnout payment is due regardless of whether any particular seller continues to be employed by the acquired business, this strongly favors purchase price characterization. In contrast, if any seller must remain employed for the earnout to be payable (either in whole or in part), the arrangement begins to resemble a retention bonus.
(f) Payment is Based on Aggregate Financial Performance, Not Attributable to Specific Individuals. Where the performance metric reflects the output of the entire business — including the contributions of non-selling employees, the value of existing customer relationships, the regulatory environment, and other factors unrelated to the Continuing Sellers' individual efforts — the payment is more properly viewed as reflecting the value of the acquired enterprise.
3. Factors That Could Support Compensation Recharacterization (Risk Analysis).  While we believe that capital gain treatment is the correct and defensible characterization of the Pinnacle earnout, we note the following factors that the IRS could potentially point to in support of a compensation recharacterization:
(a) Continuing Employment of Major Sellers. Three of the earnout-eligible sellers — Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth — will continue as employees of Pinnacle following the closing. The IRS could argue that the earnout functions as a retention mechanism or performance incentive for these individuals, particularly given their importance to the business. Dr. Carvallo, as CEO, and Dr. Ostrowski, as CMO, are the co-founders of the business and arguably the individuals most responsible for achieving the EBITDA targets.
(b) Concentration of Ownership Among Continuing Sellers. The three Continuing Sellers collectively hold 72.5% of the Pinnacle membership interests (38.2% + 28.5% + 5.8%), meaning they are entitled to approximately 72.5% of the cashed-out portion of any earnout payment. The IRS could argue that the earnout effectively functions as a bonus to these three individuals, with the 27.5% allocation to the Minority Sellers being incidental or cosmetic.
(c) Potential Argument That EBITDA Is Driven by Continuing Sellers. The IRS could attempt to argue that, given the Continuing Sellers' senior executive roles, the achievement of the EBITDA targets is substantially dependent on their continued performance and leadership. This argument, however, is significantly weakened by the scale and geographic breadth of Pinnacle's operations (42 facilities across five states, 1,620 employees), which make it implausible that the EBITDA targets are attributable to any three individuals.
(d) Potential Section 409A Exposure. If the IRS were to recharacterize the earnout as deferred compensation, Section 409A of the Code would potentially apply, subjecting the Continuing Sellers to an additional 20% tax plus an interest charge on the amount of the deemed deferred compensation. This recharacterization risk, while we believe it is low given the safeguards we recommend, underscores the importance of including protective Section 409A language in the Merger Agreement.
We address the mitigation of each of these risk factors through our recommended structuring safeguards in Section V below.
B. Application to the Pinnacle Earnout
Having set forth the general analytical framework, we now apply it to the specific facts of the Pinnacle earnout. For the reasons discussed below, we conclude that the balance of factors strongly favors capital gain treatment.
1. Pro Rata Allocation.  The single most significant factor supporting capital gain treatment is the pro rata allocation of earnout payments among all pre-closing Pinnacle members. The earnout is not limited to the Continuing Sellers; it is payable to every pre-closing member in proportion to their respective membership interest percentages, without regard to whether the member has any continuing relationship with Pinnacle or any Ardent Capital entity.
This means that approximately 27.5% of any earnout payment — up to $9.625 million of the maximum $35.0 million aggregate earnout — will flow to the fourteen Minority Sellers who have no continuing employment, consulting, or service relationship with Pinnacle or any affiliate of Ardent Capital after the closing. These individuals are pure sellers: they are cashing out the entirety of their membership interests and walking away from the business. Their entitlement to a pro rata share of the earnout is economically identical to a right to receive additional purchase price for their membership interests. There is no plausible compensation theory that would support treating a payment to a former owner with no continuing involvement as compensation for services.
Moreover, the rollover participants (Dr. Carvallo, Dr. Ostrowski, and Mr. Farnsworth) receive the earnout only with respect to their cashed-out portions, not on their rollover equity. This is a critical structural feature: Dr. Carvallo, for example, is entitled to an earnout allocation based on 75% of his 38.2% interest (i.e., 28.65% of the aggregate earnout), not on the full 38.2%. The rollover equity is compensated through the Class B Units in Holdings LLC, which have their own separate vesting schedule and economic profile. The segregation of the earnout (tied to the cashed-out sale proceeds) from the rollover (tied to go-forward equity participation) reinforces the characterization of the earnout as a purchase price mechanism.
The pro rata allocation is consistent with the IRS's analysis in PLR 200452012, where the IRS favorably characterized an earnout as additional purchase price in part because it was payable to all selling shareholders, including those with no continuing involvement. We view this factor as the strongest single piece of support for capital gain treatment.
2. EBITDA-Based Performance Metric.  The earnout targets of $58.0 million (Period 1) and $65.0 million (Period 2) are based on Adjusted EBITDA, a business-level financial metric that reflects the aggregate operating performance of all 42 of Pinnacle's facilities across five states. Adjusted EBITDA is a function of dozens of revenue streams, cost centers, and operational variables that are far beyond the control or influence of any individual seller. The metric captures the contributions of Pinnacle's 1,620 employees, 142 employed physicians, the value of its payor contracts, the regulatory environment in each of its five states, patient volume trends driven by demographic and macroeconomic factors, and the efficiency of its back-office operations.
The earnout targets represent achievable but meaningful growth over Pinnacle's 2023 Adjusted EBITDA of $51.8 million. Specifically, the Period 1 target of $58.0 million represents approximately 12.0% growth over 2023, and the Period 2 target of $65.0 million represents approximately 25.5% growth over 2023. These growth rates are consistent with the growth assumptions underlying the buyer's financial model (which projects EBITDA growth driven by same-store patient volume increases, payor mix improvements, the opening of three new clinics already in the pipeline, and modest cost synergies), and they are within the range of growth rates that Pinnacle has historically achieved. The targets were developed by reference to business performance projections, not to any individual's service contribution, and they were negotiated between the buyer's financial advisor (Meridian Tuck Partners LLC) and the sellers' financial advisor (Larchmont & Co.) as part of the purchase price discussion.
The implied EV/EBITDA multiple of the base transaction is approximately 7.95x ($412.0 million enterprise value divided by $51.8 million 2023 Adjusted EBITDA). The earnout effectively allows the sellers to participate in the upside if Pinnacle's post-closing performance validates a higher valuation. This is precisely the function of a purchase price earnout: to bridge a valuation gap between a buyer's and a seller's view of the business's worth.
No individual performance metrics, personal productivity targets, patient volume quotas, or personal service conditions are attached to the earnout. The absence of any individual-level performance criteria is a strong indicator that the earnout relates to the value of the business as an enterprise, not to the services of any particular individual.
3. Absence of Employment-Condition Language.  As currently drafted (based on our review of the February 22, 2024 term sheet and the preliminary discussion draft of the Merger Agreement circulated by Harcourt Shaw & DeVries LLP on February 28, 2024), the earnout provisions do not contain any forfeiture-for-termination clause. That is, no seller's earnout right is forfeited or reduced if that seller ceases to be an employee of Pinnacle during the earnout period, whether by voluntary resignation, involuntary termination, retirement, disability, or death.
This is a critical feature. If the Merger Agreement were to provide that a seller's earnout is forfeited upon termination of employment, that clause would be the single strongest indicator that the earnout is compensation rather than purchase price. The forfeiture-for-termination clause is, in the IRS's view, the hallmark of a compensatory arrangement, because it conditions the payment on the provision of services. See Rev. Rul. 69-435 (contingent payment forfeited upon early termination treated as compensation); see also Robinson v. Commissioner, T.C. Memo. 2018-88 (earnout with employment condition recharacterized as compensation).
We strongly recommend that the Merger Agreement not only omit any forfeiture-for-termination language, but also include an affirmative provision stating that each seller's right to receive earnout payments survives any termination of employment, whether voluntary or involuntary, and is not conditioned on the seller's continued service to Pinnacle or any affiliate. This affirmative language, recommended in Section V.A.2 below, creates a clear contractual record that the earnout is a non-forfeitable right incident to the sale of the business, not a compensatory promise.
4. Separation from Non-Compete and Consulting Arrangements.  The Merger Agreement and the related transaction documents include separate non-compete agreements with certain of the founders and executives. Specifically, the purchase price allocation prepared by Northmark Advisory Group LLC allocates $17.4 million of the total enterprise value to non-compete agreements, which are classified as Class V intangible assets under Section 1060 and amortized over a five-year useful life for tax purposes. The non-compete agreements are being independently negotiated as standalone contractual obligations, with separate consideration and separate documentation.
It is essential that the earnout payment not be cross-referenced to, conditioned upon, or linked to compliance with any non-compete, consulting, or employment agreement. If the earnout were conditioned on a seller's compliance with a non-compete covenant (e.g., "Seller's earnout shall be forfeited if Seller breaches the Non-Compete Agreement"), the IRS could argue that the earnout is effectively a non-compete payment (ordinary income under Section 197(f)(9) and the regulations thereunder) or, more broadly, that the earnout is a form of service-related compensation.
Similarly, any consulting agreements with the Continuing Sellers must be independently valued and separately documented, with consulting fees that reflect fair market value for the services to be rendered. The consulting fees must not be artificially depressed in a manner that suggests the earnout is functioning as deferred consulting compensation, and the earnout payment must not be contingent on the seller's performance of consulting services.
Based on our review of the preliminary term sheet and our discussions with Harcourt Shaw & DeVries LLP, the earnout provisions are currently structured independently of the non-compete and employment agreements, and we recommend that this independence be maintained and documented throughout the negotiation process.
5. Arm's-Length Negotiation.  The earnout was negotiated at arm's length between Ardent Capital (represented by Meridian Tuck Partners LLC as financial advisor) and the Pinnacle founders (represented by Larchmont & Co. as financial advisor) as a component of the purchase price negotiation. The negotiation history, which we understand to be well-documented in correspondence and term sheet exchanges between the parties' financial advisors, reflects a classic valuation gap dynamic:
The sellers, advised by Larchmont & Co., initially proposed a total enterprise value of $460.0 million, reflecting a forward EV/EBITDA multiple of approximately 8.9x based on their projected 2024 EBITDA of $51.8 million (flat to 2023). The buyer, advised by Meridian Tuck Partners LLC, initially proposed an enterprise value of $395.0 million, reflecting an EV/EBITDA multiple of approximately 7.6x. The parties bridged the valuation gap through a combination of (i) an increase in the fixed enterprise value from $395.0 million to $412.0 million and (ii) the introduction of the earnout mechanism, which allows the sellers to receive up to an additional $35.0 million if the business achieves specified EBITDA targets post-closing.
The earnout structure — a binary payout at two threshold levels — was initially proposed by the sellers, who favored a dollar-for-dollar earn-up above baseline EBITDA (i.e., uncapped incremental consideration for each dollar of EBITDA above 2023 levels). The buyer negotiated the structure down to fixed payout amounts at discrete threshold levels, with no partial payouts below the threshold. This negotiation dynamic is characteristic of a purchase price mechanism, not a compensation arrangement: the parties were negotiating over value, not over employment terms.
We recommend that Ardent Capital retain all contemporaneous documentation of these negotiations, including term sheet drafts, correspondence between financial advisors, and internal deal team communications reflecting the commercial rationale for the earnout, to create a robust evidentiary record in the event of an IRS examination.
C. Section 483 Imputed Interest Analysis
1. Applicability.  Section 483 of the Code provides that, in the case of any payment under a contract for the sale or exchange of property where some or all of the payments are due more than one year after the date of the sale or exchange, the payments shall be treated as including a component of imputed (unstated) interest if the contract does not provide for adequate stated interest. The imputed interest component is treated as ordinary interest income to the seller and deductible interest expense to the buyer, and it reduces the amount of the payment that is treated as capital gain.
The Pinnacle earnout qualifies as a payment under a contract for the sale of property (i.e., the membership interests in Pinnacle). The closing date is anticipated to be May 31, 2024. The timing of earnout payments, if earned, is as follows:
•  Period 1 Earnout ($15.0 million): Measurement period ends May 31, 2025. Payment due within sixty (60) days after the end of the measurement period (i.e., by approximately July 30, 2025). This payment would be made approximately 14 months after the closing date — more than one year after the date of the sale. Accordingly, Section 483 applies to the Period 1 earnout.
•  Period 2 Earnout ($20.0 million): Measurement period ends May 31, 2026. Payment due within sixty (60) days after the end of the measurement period (i.e., by approximately July 30, 2026). This payment would be made approximately 26 months after the closing date — well more than one year after the date of the sale. Accordingly, Section 483 applies to the Period 2 earnout.
The Merger Agreement, as currently drafted, does not provide for stated interest on the earnout payments. In the absence of adequate stated interest at or above the applicable AFR, Section 483 requires that a portion of each deferred payment be treated as imputed interest.
2. Applicable Federal Rate (AFR).  Under Section 483(b) and Treasury Regulation Section 1.483-1(a)(2), the applicable discount rate for determining imputed interest is the Applicable Federal Rate ("AFR") in effect on the date of the contract. For purposes of Section 483, the "date of the contract" is the date of the Merger Agreement (the signing date), which is anticipated to be March 15, 2024.
As of March 2024, the applicable AFRs published by the IRS (Revenue Ruling 2024-05) are:
Both the Period 1 earnout (deferred approximately 12–13 months from closing) and the Period 2 earnout (deferred approximately 24–25 months from closing) fall within the short-term AFR window (i.e., payment is due within three years of the closing date). Accordingly, the short-term AFR of 5.12% (annual compounding) applies to both periods. We note that the AFR is determined as of the signing date of the Merger Agreement (the contract date), not the closing date. If the signing occurs on March 15, 2024 as anticipated, the March 2024 AFR of 5.12% will govern regardless of any subsequent changes in the AFR.
3. Computation Methodology.  Under Section 483, the imputed interest component is calculated by applying the applicable AFR to the deferred payment amount over the period from the closing date (the date of the sale) to the payment date. The computation assumes annual compounding unless the parties elect a different compounding period.
Period 1 Earnout ($15.0 million):
Assuming the Period 1 earnout payment is made on approximately June 15, 2025 (380 days after the closing date of May 31, 2024), the imputed interest calculation is as follows:
Imputed Interest = $15,000,000 × 5.12% × (380 / 365)
Imputed Interest ≈ $15,000,000 × 0.0512 × 1.0411
Imputed Interest ≈ $799,562
The imputed interest component of the Period 1 earnout is approximately $799,562. The balance — approximately $14,200,438 — would be treated as additional purchase price (capital gain to the sellers).
Period 2 Earnout ($20.0 million):
Assuming the Period 2 earnout payment is made on approximately June 15, 2026 (746 days after the closing date of May 31, 2024), the imputed interest calculation is as follows:
Imputed Interest = $20,000,000 × 5.12% × (746 / 365)
Imputed Interest ≈ $20,000,000 × 0.0512 × 2.0438
Imputed Interest ≈ $2,093,370
The imputed interest component of the Period 2 earnout is approximately $2,093,370. The balance — approximately $17,906,630 — would be treated as additional purchase price (capital gain to the sellers).
The following table summarizes the illustrative imputed interest computations:
These computations are illustrative and will depend on the exact payment dates. If payment is delayed due to the dispute resolution mechanism, the imputed interest component will increase correspondingly.
We note that the Merger Agreement could potentially provide for adequate stated interest at or above the short-term AFR, which would eliminate the Section 483 imputed interest issue. However, we understand from discussions with the deal team and Harcourt Shaw & DeVries LLP that the sellers are resistant to the inclusion of a stated interest provision, as it would reduce the portion of the payment characterized as purchase price (capital gain) and increase the ordinary income component. Given the relatively modest imputed interest amounts involved (approximately $2.9 million in the aggregate across both periods), the parties may determine that the inclusion of stated interest is not commercially necessary.
4. Seller Reporting Obligations.  Each seller must separately report the imputed interest component as ordinary interest income on its federal income tax return for the taxable year in which the earnout payment is received. The balance of the payment is reported as additional capital gain. The allocation of imputed interest among sellers is pro rata based on their respective membership interest percentages. For example, if the Period 1 earnout of $15.0 million is paid in full, Dr. Carvallo (38.2% interest, cashed-out at 75%) would report the following:
Dr. Carvallo's Share of Period 1 Earnout: $15,000,000 × 28.65% (75% of 38.2%) = $4,297,500
Dr. Carvallo's Share of Imputed Interest: $799,562 × 28.65% = $229,075
Dr. Carvallo's Capital Gain: $4,297,500 − $229,075 = $4,068,425
Similar allocations would apply to each other seller. Each seller is responsible for reporting its pro rata share of imputed interest and capital gain on its own return, and we recommend that the Merger Agreement include a provision requiring the buyer to provide each seller with a written statement showing the total earnout payment, the imputed interest component, and the capital gain component promptly following each earnout payment.
D. Section 409A Considerations
Section 409A of the Code imposes strict requirements on "nonqualified deferred compensation plans," broadly defined. If a payment arrangement constitutes deferred compensation under Section 409A and fails to comply with the statute's timing and form requirements, the service provider is subject to an additional 20% tax on the amount of deferred compensation, plus an interest charge calculated from the date the amounts should have been included in income. These penalties are severe and apply at the individual level, without any corresponding benefit to the service recipient.
Under the recommended capital gain characterization, the earnout is additional purchase price for the sale of a capital asset and is not deferred compensation within the meaning of Section 409A. Section 409A, by its terms, applies only to compensation for services. See Code § 409A(d)(1) (defining a "nonqualified deferred compensation plan" as any plan that provides for the deferral of compensation). A payment that constitutes purchase price for the sale of a business interest is not "compensation for services" and does not give rise to a Section 409A issue.
However, as a protective measure in the event that the IRS were to recharacterize the earnout as compensation, we recommend that the Merger Agreement include the following protective provisions:
(a) A statement that the earnout is not intended to constitute "deferred compensation" within the meaning of Section 409A of the Code.
(b) A provision stating that, if any earnout payment were determined to constitute deferred compensation under Section 409A, such payment shall be made within the "short-term deferral" period described in Treasury Regulation Section 1.409A-1(b)(4) — that is, within 2½ months following the end of the taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture. Under this safe harbor, the payment would not be treated as deferred compensation subject to Section 409A.
(c) A provision stating that, to the extent the short-term deferral exception is not available, the earnout payments shall be structured to comply with the fixed schedule payment rules of Section 409A(a)(2)(A)(iv), with each payment treated as a separate payment for purposes of Section 409A.
These provisions operate as a belt-and-suspenders mechanism: the primary position is that Section 409A does not apply (because the earnout is purchase price, not compensation), and the fallback position is that, even if Section 409A were found to apply, the payment timing would satisfy Section 409A's requirements.
E. Earnout Acceleration upon Change of Control
1. Terms.  Article VII, Section 7.04 of the preliminary Merger Agreement draft provides that, upon the occurrence of a "Change of Control" of Ardent Healthcare Holdings LLC at any time during the earnout period (i.e., prior to the later of (a) the last day of the Period 2 measurement period, May 31, 2026, or (b) the date on which all earnout payments have been finally determined and paid), one hundred percent (100%) of any remaining unpaid earnout consideration becomes immediately due and payable, regardless of whether the applicable EBITDA targets have been achieved. The full unpaid amount ($35.0 million maximum, less any amounts previously paid with respect to Period 1) would be payable within ten (10) business days following the consummation of the Change of Control.
The definition of "Change of Control" in the current draft cross-references a definition in Article I of the Merger Agreement that encompasses (i) the sale, transfer, or other disposition of all or substantially all of the assets of Holdings LLC, (ii) the merger or consolidation of Holdings LLC with or into another entity in which the equityholders of Holdings LLC immediately prior to the merger do not retain a majority of the voting power of the surviving entity, and (iii) any transaction or series of related transactions resulting in any person or group (other than Ardent Capital Partners III LP or its affiliates) acquiring beneficial ownership of a majority of the equity interests of Holdings LLC. We recommend that Calderwood & Harkness and Harcourt Shaw & DeVries LLP review this definition to ensure it is appropriately tailored for purposes of the earnout acceleration provision.
2. Tax Treatment of Acceleration.  The acceleration of the earnout upon a Change of Control does not alter the character of the earnout as additional purchase price. Acceleration is a timing mechanism, not a characterization mechanism. It simply provides for early payment of the full contingent amount based on the occurrence of a specified transactional event. The character of the payment (capital gain vs. compensation) is determined by the nature of the underlying obligation, not by the timing of payment.
Upon acceleration, the full unpaid earnout amount (up to $35.0 million less any amounts previously paid) becomes immediately payable. Section 483 imputed interest applies to the accelerated payment based on the period from the closing date to the acceleration payment date. For example, if a Change of Control were to occur on December 31, 2024 (214 days after the May 31, 2024 closing), and the full $35.0 million were payable on January 15, 2025 (229 days after closing), the imputed interest calculation would be:
Imputed Interest = $35,000,000 × 5.12% × (229 / 365) ≈ $1,124,274
If the accelerated payment is made within one year of the closing date, Section 483 would not apply at all, because Section 483 applies only to payments due more than one year after the date of the sale.
Importantly, the acceleration feature itself provides additional support for purchase price characterization. The trigger for acceleration is a transaction-level event — a Change of Control of the holding company — not an employment-related event such as termination, resignation, or disability. The fact that the full earnout becomes payable upon a Change of Control, regardless of whether the EBITDA targets have been achieved and regardless of whether the Continuing Sellers remain employed, underscores that the earnout relates to the value of the business (which is being monetized through the Change of Control transaction) rather than to the services of any individual. If the earnout were compensation, one would expect its acceleration to be triggered by employment-related events (such as termination without cause or constructive dismissal), not by changes in the ownership of the holding company.
3. Section 280G Interaction.  Section 280G of the Code provides that no deduction is allowed for any "excess parachute payment" made to a "disqualified individual" in connection with a "change in ownership or control" of a corporation. An excess parachute payment is defined as any payment in the nature of compensation that is contingent on a change in control and that exceeds a base amount equal to three times the individual's average annual compensation over the five preceding years (or a shorter period if the individual has been employed for fewer than five years). In addition, the disqualified individual is subject to a 20% excise tax on the excess parachute payment under Section 4999 of the Code.
If the accelerated earnout payment were recharacterized as compensation, it could potentially constitute a "parachute payment" within the meaning of Section 280G, because the acceleration is contingent on a Change of Control. If so, the payment could exceed the applicable base amount thresholds, resulting in loss of the buyer's deduction (to the extent the buyer were otherwise entitled to a deduction under the compensation characterization) and imposition of the 20% excise tax on the individual recipients.
Under the recommended capital gain characterization, Section 280G is inapplicable because the earnout payments are purchase price for the sale of a capital asset, not "compensation" within the meaning of Section 280G. Payments for the sale of a business interest are not "in the nature of compensation" and do not fall within Section 280G's ambit. See Treasury Regulation Section 1.280G-1, Q&A-11 (providing that payments made under a contract for the sale of property that are characterized as purchase price are not parachute payments).
Nevertheless, to reduce the risk of an IRS challenge, Calderwood & Harkness recommends that the Merger Agreement include protective language affirming that the accelerated earnout constitutes additional purchase price for the Pinnacle membership interests and not compensation for services, and that the parties agree not to take any inconsistent position on their tax returns. This protective language operates in tandem with the Danielson principle discussed above and creates a strong evidentiary record of the parties' intent and agreed characterization.
V. Structuring Safeguards and Drafting Recommendations
Based on the foregoing analysis, Calderwood & Harkness recommends the implementation of the following structuring safeguards and drafting provisions to support the capital gain characterization of the earnout. These safeguards are designed to address each of the risk factors identified in Section IV.A.3 above and to create a robust evidentiary record in the event of an IRS examination.
A. Mandatory Provisions in the Merger Agreement
The following provisions should be included in the definitive Merger Agreement:
1. Pro Rata Allocation. The Merger Agreement must expressly provide that earnout payments are allocated pro rata among all pre-closing Pinnacle members based on their respective membership interest percentages as set forth in the Pinnacle Operating Agreement as of immediately prior to the closing. The allocation must include all fourteen (14) minority physician-investors, none of whom has a continuing employment or service relationship with Pinnacle or any Ardent Capital affiliate. For rollover participants, the earnout must be allocated based on the cashed-out portion of their membership interests (i.e., excluding the rollover equity). The allocation methodology should be set forth in a schedule to the Merger Agreement and should not be subject to modification by the buyer post-closing.
2. No Forfeiture-for-Termination. The Merger Agreement must include an affirmative provision stating that each seller's right to receive earnout payments survives any termination of such seller's employment with Pinnacle or any affiliate, whether such termination is voluntary, involuntary, with or without cause, by reason of retirement, disability, or death. No seller's earnout shall be forfeited, reduced, or otherwise modified by reason of the cessation of such seller's services. We recommend the following specific language:
"Notwithstanding anything herein to the contrary, each Seller's right to receive Earnout Payments pursuant to this Article VII shall not be conditioned upon, and shall survive, any termination or cessation of such Seller's employment, consulting, or other service relationship with the Company, the Buyer, or any of their respective Affiliates, whether such termination is voluntary, involuntary, with or without Cause (as defined in such Seller's employment agreement, if any), or by reason of death, disability, retirement, or any other circumstance. For the avoidance of doubt, no Seller's Earnout Payment shall be subject to forfeiture, reduction, or set-off by reason of the termination or cessation of such Seller's services."
3. No Employment-Condition Language. The Merger Agreement must not condition any seller's eligibility for, or the amount of, earnout payments on such seller's continued employment or performance of services. No provision of the Merger Agreement should link the earnout to any individual seller's employment status, attendance, performance evaluation, or compliance with employment policies. The earnout provisions should be entirely independent of the employment agreements.
4. Separate Compensation Arrangements. Any consulting agreements, employment agreements, or non-compete agreements with Dr. Carvallo, Dr. Ostrowski, or Mr. Farnsworth must be (i) independently negotiated between the applicable seller and the buyer, (ii) separately documented from the Merger Agreement (though they may be cross-referenced as ancillary agreements), (iii) independently valued at fair market value, and (iv) not cross-referenced to or conditioned upon the earnout. In particular, the earnout should not be reduced or offset by amounts payable under any consulting, employment, or non-compete agreement, and conversely, no consulting, employment, or non-compete payment should be reduced or offset by amounts payable under the earnout.
5. Consistent Tax Reporting. The Merger Agreement must include a provision requiring all parties — the buyer, the sellers, and their respective affiliates — to treat the earnout payments as additional purchase price for the Pinnacle membership interests on their respective federal, state, and local income tax returns, and to not take any inconsistent position on any tax return, tax claim, tax proceeding, or other filing unless required by a final determination (within the meaning of Section 1313 of the Code) of a court of competent jurisdiction or the IRS. This provision binds the parties to the capital gain characterization and invokes the protection of the Danielson principle in the Third Circuit.
6. Section 409A Protective Language. The Merger Agreement must include a provision stating that:
(a) The earnout is not intended to constitute "nonqualified deferred compensation" within the meaning of Section 409A of the Code.
(b) To the extent that any earnout payment is determined to constitute nonqualified deferred compensation subject to Section 409A, such payment shall be made within the "short-term deferral" period prescribed by Treasury Regulation Section 1.409A-1(b)(4) (i.e., within 2½ months following the end of the seller's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture), and the parties shall cooperate in good faith to restructure the payment timing to comply with Section 409A.
(c) Each earnout payment shall be treated as a separate payment for purposes of Section 409A.
(d) In no event shall the buyer be required to "gross up" or indemnify any seller for any taxes, penalties, or interest imposed under Section 409A.
B. Process Documentation
In addition to the contractual safeguards described above, we recommend that Ardent Capital create and maintain a comprehensive file of contemporaneous documentation supporting the arm's-length negotiation of the earnout as a purchase price mechanism. This documentation should include:
(a) All term sheet drafts exchanged between the buyer and the selle

MEMORANDUM

PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGE / ATTORNEY WORK PRODUCT

Record

Parties

Dates

Amounts