What Is Tax Indemnification and How Does It Work?

Tax indemnification is a contractual agreement where one party commits to covering the tax liabilities and associated losses of another. This arrangement transfers responsibility for specific tax obligations that may surface after a business deal is concluded. It provides financial protection by ensuring one party is not left bearing the cost of another’s historical or resulting tax issues.

Common Scenarios for Tax Indemnification

Tax indemnification clauses are common in mergers and acquisitions (M&A) due to the risks tied to a target company’s tax history. In a stock sale, the buyer acquires the entire legal entity, including all its assets and historical liabilities, whether known or hidden. Because the buyer inherits the seller’s pre-existing tax obligations and potential audit risks, a tax indemnity from the seller is a standard requirement.

In an asset sale, the buyer purchases specific assets from the selling company rather than the company itself. This structure does not automatically transfer the seller’s historical tax liabilities to the buyer. However, an indemnity might still be used to cover taxes associated with the transfer of the assets, such as sales or transfer taxes, or if the buyer agrees to assume certain liabilities.

Beyond M&A, these agreements appear in other business arrangements. In joint ventures or partnerships, one partner may indemnify others against tax liabilities from their contributed assets or prior business activities. Financing or lending agreements may also include provisions where a borrower indemnifies the lender against tax consequences related to the transaction.

Key Provisions in a Tax Indemnification Clause

The scope of the agreement specifies which taxes are covered, such as federal, state, and local income, sales, payroll, and property taxes. The provision also delineates the time periods it applies to, covering all tax periods before the transaction’s closing date. This ensures the seller remains responsible for tax matters that arose under their ownership.

The agreement establishes a “survival period,” a negotiated timeframe during which the indemnified party can make a claim. The survival period is linked to the relevant statute of limitations for the tax in question. For many federal taxes, the IRS has three years to assess additional tax, but this can extend to six years for substantial underreporting of income or be indefinite for fraud. This ensures the buyer’s protection lasts as long as the legal threat from a tax authority.

Provisions for limitations on liability balance risk between the parties. A “basket,” or deductible, requires tax losses to exceed a monetary threshold before the payment obligation is triggered, preventing claims for minor amounts. Conversely, a “cap” sets the maximum amount the indemnifying party must pay, which is linked to a percentage or the entirety of the purchase price.

The agreement addresses the control of tax contests. Since the indemnifying party is financially responsible, they demand the right to manage any audits, disputes, or litigation with a tax authority. This provision outlines their authority to select counsel, make strategic decisions, and settle the matter. The indemnified party retains rights to be informed and may have consent rights over a final settlement.

A “gross-up” provision may be included to ensure the indemnified party is made whole after considering potential taxes on the payment itself. The tax treatment of an indemnification payment is not always straightforward, and it is not guaranteed to be non-taxable.

Because the taxability is not guaranteed, parties include a gross-up clause to address this risk. This provision requires the indemnifying party to pay an additional amount to cover the taxes the recipient would owe on the indemnity payment. This ensures that after taxes are paid, the recipient is left with the full amount of their original loss.

The Tax Indemnification Claim Process

The claim process begins with a formal notice when a potential tax liability emerges. The indemnified party, upon learning of a tax audit or assessment from a tax authority, must promptly inform the indemnifying party in writing. This notice details the nature of the issue, the estimated liability, and references the relevant contractual provisions.

Following the notice, the agreement mandates cooperation between the two parties. The indemnified party must provide the indemnifying party with all relevant documents, records, and access to personnel needed to evaluate the claim. This includes tax returns, financial statements, and correspondence from the tax agency.

The management of the tax contest proceeds according to the agreement’s terms. If the indemnifying party has control, they lead the response, engage with auditors, direct legal strategy, and make defense decisions. The indemnified party, while not in control, has rights to participate, review filings, and consult on the strategy to protect their business interests.

Once the tax contest is resolved through a settlement or court judgment, the claim is paid. The indemnifying party pays the determined amount, including the tax due, interest, and any penalties. The payment may be made directly to the tax authority or as a reimbursement to the indemnified party if they have already paid the liability. The process concludes when the indemnified party is financially restored to the position they would have been in had the tax liability not occurred.