What Is a Tax Indemnification Agreement?

A tax indemnification agreement is a contract where one party commits to covering the tax-related losses of another. It is a risk-management tool used in business transactions to shift the financial burden of specific tax liabilities. This protects one party from unforeseen tax costs that arise after a deal is complete but relate to events that occurred before the transaction. The agreement manages financial uncertainty by clearly defining who is responsible for potential tax obligations, such as those from past actions or future assessments.

Common Scenarios for Use

Tax indemnification agreements are frequently used in mergers and acquisitions (M&A), particularly in stock sales. In a stock sale, the buyer acquires the entire company, including its tax history and any unknown liabilities. An indemnification agreement obligates the seller to reimburse the buyer for any pre-closing tax liabilities that surface after the deal is finalized.

In an asset sale, the buyer purchases specific assets rather than the entire legal entity and does not inherit the seller’s full tax history. However, an agreement may still be used to address tax risks associated with the transferred assets. For example, it could cover potential unpaid sales taxes on equipment or property tax reassessments.

Corporate reorganizations and spin-offs are another common use case. When a company splits, an agreement clarifies which new entity is responsible for the original company’s tax liabilities. These agreements help ensure that tax-free spin-offs under Internal Revenue Code Section 355 remain compliant, with one party indemnifying the other if certain actions jeopardize that status.

Partnership agreements can include indemnification clauses to protect partners from tax issues created by others. In real estate transactions, these agreements allocate responsibility for liabilities like transfer taxes or unexpected property tax increases.

Key Provisions and Negotiating Points

Scope of Indemnified Taxes

An element of a tax indemnification agreement is the definition of the taxes it covers. The scope can be broad, covering all income, sales, payroll, and property taxes from before the transaction’s closing date. This offers comprehensive protection for the buyer from pre-existing tax issues.

Alternatively, the scope can be narrow to address specific risks. For example, if due diligence uncovers a potential payroll tax issue, the indemnification could be limited to that concern. The agreement explicitly lists the types of taxes and taxable periods covered.

Survival Period

The survival period dictates the timeframe for making an indemnification claim and is a negotiated point as it defines the risk exposure for the indemnifying party. The length of this period is linked to the relevant tax statutes of limitations, which is the time the IRS can legally audit past returns and assess additional taxes.

For many federal taxes, the statute of limitations is three years from the filing date but can extend to six years for a substantial understatement of income. The survival period is often negotiated to last for the duration of the applicable statute of limitations plus an additional 60 or 90 days. This ensures the indemnified party is protected for the entire time the tax authority can pursue a claim.

Limitations on Indemnification

Negotiations often place financial limits on the indemnification obligation to make the exposure more predictable for the seller. These limitations include baskets, deductibles, and caps. A “basket” provision sets a minimum loss threshold that must be reached before a claim can be made. For example, with a $50,000 basket, the buyer cannot seek reimbursement until total losses exceed that amount.

With a “tipping basket,” once the threshold is met, the indemnifying party is responsible for the full loss from the first dollar. A “deductible” means the indemnifying party is only responsible for losses exceeding the threshold amount. A cap sets an absolute ceiling on the total amount the indemnifying party must pay, often calculated as a percentage of the purchase price.

Tax Gross-Up Provisions

A tax gross-up provision addresses the tax consequences of the indemnification payment itself. An indemnification payment received by the buyer could be considered taxable income. If the buyer has to pay taxes on the reimbursement, they would not be made whole for the original tax loss.

A gross-up provision requires the indemnifying party to pay an additional amount to cover the taxes owed on the indemnification payment. This ensures the net amount the buyer receives after paying taxes on the reimbursement equals the full amount of the initial loss.

Procedural Mechanics of a Tax Claim

Notice of a Claim

The process for making a claim begins with a formal notification. When the indemnified party becomes aware of a potential tax liability covered by the agreement, such as an audit notice from the IRS, they must promptly inform the indemnifying party. Agreements specify a timeframe for this notice, often within 30 to 60 days of discovery.

The written notice describes the tax issue, including the specific tax, the period in question, and the potential liability. Failing to provide timely notice can jeopardize the right to be reimbursed.

Control of Tax Audits and Contests

A negotiating point is determining who has the right to control the handling of the tax claim. This includes managing communications with the tax authority, making strategic decisions, and settling the case. Since the indemnifying party is responsible for payment, they demand the right to control the tax contest to minimize their financial exposure.

The buyer will want to ensure the defense is handled competently and does not harm their relationship with tax authorities. The agreement outlines the rights and responsibilities of the controlling party and the consultation required with the non-controlling party.

Cooperation

The agreement will contain a cooperation clause obligating both parties to assist each other in defending against the tax claim. Cooperation can include providing access to books and records, making employees available for interviews, and sharing information. This clause prevents one party’s lack of cooperation from undermining the ability to contest the tax liability. For example, the buyer must make pre-closing documents available to the seller if the seller is managing the audit.

Payment and Settlement Process

The party controlling the contest manages settlement negotiations with the tax authority. The agreement often requires the controlling party to get consent from the other party before finalizing a settlement, especially if it exceeds a certain amount.

Once the tax liability is finalized through a settlement or court ruling, the indemnifying party must make the payment to the indemnified party. The agreement will specify the timing and method of this payment.