The following article is reprinted from The M&A Tax Report, Vol. 12, No. 6, January 2004, Panel Publishers, New York, NY (800/638-8437).

WHAT HAPPENS IF YOU HAVE TO COLLECT ON YOUR TAX INDEMNITY AGREEMENT? ARE YOU TAXED ON THE TAX?
by Robert W. Wood and Dominic L. Daher

Tax indemnity payments are common features of many transactions, such as litigation settlement agreements, merger documents, purchase and sale agreements, leases, etcetera. Regardless of the context, in general, they say: “If you get taxed as a result of the transaction, I’ll cover it.”

Why would you include a tax indemnity provision in a corporate merger or acquisition agreement? Quite frankly, because if you have any nasty surprises later you want someone to point a finger at and help you pay the pieper.

Tax on the Tax?

So what happens if you get hit with a tax bill from the IRS and the other party to the transaction indemnifies you for it? How is the indemnity payment treated for tax purposes? Can the other guy just write you a check for the gross amount and make it all better? Or, will your now arch nemesis have to “gross-up” any payment to account for taxes that you may be subject to upon receipt of the indemnity payment?
 
Well, as they say, it depends whose story you believe. The IRS would likely argue that the receipt of a tax indemnity payment is taxable income. (Gee, there’s a surprise!)  See e.g., Priv. Ltr. Rul. 9833007 (Aug. 14, 1998); Priv. Ltr. Rul. 9743035(July 28, 1997); Priv. Ltr. Rul. 9743034 (July 28, 1997); Priv. Ltr. Rul. 9728052 (Apr. 16, 1997); Priv. Ltr. Rul. 9226033 (June 26, 1992). There is substantial uncertainty surrounding the proper taxation of indemnity payments. Unfortunately, there have been very few developments in this area of the law in recent years.

Taxpayers have generally cited Clark v. Commissioner for the proposition that tax indemnity payments are excludible from gross income. 40 B.T.A. 33 (1939), nonacq. sub nom., 1939-2 C.B. 45; acq. 1957-2 C.B. 4. Clark is an old, hoary, even ancient case. In fact, it goes back to 1939–more than a coon’s age in tax lore. The IRS has made no secret of the fact that notwithstanding Clark, it generally considers tax indemnity payments to be fully taxable.

Finding Streets Paved With Gold

The IRS has frequently attacked tax indemnity payments as being taxable by asserting that under I.R.C. § 61 gross income is income from whatever source derived, and that under Treas. Reg. § 1.61-14(a), the payment of another person’s income tax (directly or indirectly) results in gross income to that person (unless otherwise excluded by law). See e.g., Priv. Ltr. Rul. 9833007 (Aug. 14, 1998); Priv. Ltr. Rul. 9743035 (July 28, 1997); Priv. Ltr. Rul. 9743034 (July 28, 1997); Priv. Ltr. Rul. 9728052 (Apr. 16, 1997); Priv. Ltr. Rul. 9226033 (June 26, 1992). See also, Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929).

Nonetheless, one can argue that tax indemnity payments, such as those that would be paid out under most standard tax indemnity agreements which are part of most merger and acquisition agreements, are not gross income. Perhaps, these types of tax indemnity payments are distinguishable from the tax payments in Old Colony Trust Co. v. Commissioner as well as those contemplated by Treas. Reg. § 1.61-14(a)? In this case, you would clearly end up paying additional taxes as a result of your involvement in the transaction. Old Colony Trust and Treas. Reg. § 1.61-14(a) contemplate the payment of another’s taxes where the person making those payments is not doing so to make the recipient whole.

As noted by the court in Centex Corporation v. United States, 55 Fed. Cl. 381 (2003), a common thread in recent Private Letter Rulings dealing with tax indemnification is to distinguish Clark v. Commissioner, 55 Fed. Cl. 381, 389. In Centex, the court held that unlike the situation in Clark, the taxpayer was not ultimately paying any more in federal income tax than it otherwise would have, but for the negligence of another; hence, the tax indemnity payment it received was includible in gross income. 55 Fed. Cl. 381, 389 citing, Priv. Ltr. Rul. 9833007 (Aug. 14, 1998); Priv. Ltr. Rul. 9743035 (July 28, 1997); Priv. Ltr. Rul. 9743034 (July 28, 1997); Priv. Ltr. Rul. 9728052 (Apr. 16, 1997); Priv. Ltr. Rul. 9226033 (June 26, 1992). If you can prove that you paid more in federal income taxes than you would have if you had not gotten involved with the other party, we think that you might have a credible argument under Centex that any indemnification you receives is not taxable.

Goodnight From the Ballpark

Most tax indemnity provisions do seem to sit unnoticed most of the time. Thus, it is entirely possible (and we would hope) that none of you will never need to claim benefits under any tax indemnity agreements you may have entered into. If you do, if the other side pays, if you fails to report the payment as income, and if you finds herself in a precarious position with the IRS (admittedly a lot of ifs), we wish you the best in trying to convince the Service that the indemnity payments you receive are not gross income.

What Happens If You Have to Collect on Your Tax Indemnity Agreement? Are You Taxed on the Tax?, with Dominic L. Daher, Vol. 12, No. 6, The M&A Tax Report (January 2004), p. 7.

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