Insight Center: Publications

Tax Diligence and Tax-Related Provisions in Acquisition Agreements

Authors: Steven D. Bortnick and Timothy J. Leska


This article was originally published in the January-February 2012 issue of Deal Lawyers (Vol. 6, No. 1). © 2012 Executive Press, Inc. It is reprinted here with permission.

Tax due diligence impacts the structure of buying and selling a company. The acquisition agreement ensures that risks associated with tax liabilities discovered in diligence are appropriately allocated among the parties. By requiring the parties to be bound by certain courses of action, the acquisition agreement can also act as a mechanism to achieve identified tax goals underlying the acquisition structure. Accordingly, a lawyer navigating an acquisition must understand the tax diligence process, the tax provisions of the definitive agreement, and the manner in which structuring considerations, diligence, and negotiating and drafting the acquisition agreement all interrelate. The purpose of this article is to provide a basic understanding of these issues.

I. Overview of Tax Due Diligence

A. Parties to the Process

  • Sell-side. As the party with possession to target’s books and records and the party that typically is most familiar with target’s assets and liabilities, the participation of the seller in the diligence process is critical. Seller, however, would be wise to retain legal counsel to guide seller through the process and advise on the levels and form of information disclosure. Moreover, seller’s legal counsel, as well as seller’s financial and tax accountants, often previously advised sellers with respect to prior transactions, the operation of target’s business, and positions taken on tax returns, and can therefore serve as important data points in the diligence process. Seller’s legal counsel and accountants can also interface with the parties on the buy-side of the transaction with respect to certain information.
  • Buy-side. Buyer, as the party that ultimately bears the economic risk associated with the transaction, must be involved as information is uncovered to make business judgments as to the value or merits of the transaction. A buyer typically engages legal counsel and accountants to examine the information provided by seller, and summarize the information in a manner that permits buyer to make its business judgment. In additional, legal counsel and accountants are also engaged to assist buyer in integrating target into buyer’s business post-closing in a tax-efficient manner.

B. Two Components of Tax Diligence

  • Traditional tax review portion—will buyer inherit tax liabilities other than those shown on target’s books and records? This portion of diligence focuses on the tax returns and tax examinations of the target, and seeks to determine whether target has timely paid all of its tax liabilities and whether it has established appropriate reserves for anticipated adjustments in the future.
  • Maximizing tax efficiencies post-closing. This portion of diligence relates to creating a tax efficient structure for buyer post-closing, with a particular focus on the buyer’s ability to amortize a portion of its investment. This component can impact not only the structure of the deal itself, but can also lead to pre- or post-closing restructuring of the target group.

C. Inheriting Liabilities: Remembering the Structure of the Transaction and the Tax Status of Target

  • The structure of the transaction. Whether the transaction is an asset or stock deal must be considered during the diligence process, as it impacts the liabilities that buyer will inherit.
    • In a stock sale, the buyer is acquiring a company and, therefore, will bear any liabilities of target (absent a different risk allocation in the acquisition agreement). In addition, as buyer is acquiring a company, it will inherit the company’s tax history. Generally, this means buyer will be required to use, with respect to the target business, target’s historic tax accounting practices and be subject to target’s historic tax elections. Target thus likely will be subject to audit in post-closing years on issues that attributable to decisions made in pre-closing periods.
    • In an asset sale, the historic liabilities of seller generally can be retained by seller (absent liabilities that have given rise to a lien). Nevertheless, tax due diligence is important in asset sales because there are exceptions to this rule. For example, the bulk sale provisions of local law generally permit target’s creditors to sue buyer for a period of time after the acquisition unless notice and other procedures were followed. Similarly, many states impose transferee liability on a buyer for seller’s unpaid taxes (typically sales taxes) following a bulk sale of assets if certain procedures are not followed. Moreover, if an asset sale is really the sale of the assets of an operating division rather than a specific asset, the likelihood of inheriting liabilities or being subject to decisions relating to tax accounting that occurred prior to closing is increased, because a division generally represents a business operating as a going concern (as opposed to a specific item of tangible property).
    • In a stock sale with a "Section 338 election,"1 notwithstanding that target’s shareholders are treated as selling stock, target is deemed to sell all of its assets in a taxable transaction. This deemed sale can significantly increase target’s tax liability post-closing.
  • The tax status of target. The tax status of target can also impact the liabilities that buyer will inherit. An entity that is a flow-through entity likely will have no entity level income tax liabilities; a member of a consolidated group has potential liability with respect to taxes owed by the group for tax periods during which it was a member of the group.

D. Key Information to Request and Review

  • Corporate structure chart. Starting with a corporate structure chart and all elections affecting the tax classification2 of the entities of the target group provides an understanding of where entities reside within the corporate chain and their role in current planning. Understanding the relative fair market values, the outside and inside bases, and the jurisdiction of operation of each company can not only highlight potential areas of exposure, but can help establish the groundwork for integrating the target and acquirer businesses post-acquisition in a tax-efficient manner.
  • Tax returns. Once familiar with the target’s structure, a review of all income tax returns, especially for years not closed for assessment under the applicable statute of limitations, as well as accountants’ workpapers and tax reserves should be undertaken.
    • The process of reviewing the target’s tax returns should focus on aggressive tax positions and analyzing their likelihood of withstanding challenge. Unreasonable compensation paid by closely held corporations is a common example, and is of note as it continues to remain on tax authorities’ radar and tends to be a simpler issue to identify. Other examples include undervaluation of ending inventory, participation in tax shelters (e.g., listed and reportable transactions), and aggressive allocation of purchase price to depreciable/amortizable assets in prior acquisitions.
    • Adequate reserves can limit buyer’s exposure to target’s pre-closing aggressive tax positions, as the reserves represent a set-aside of value that can be accessed to satisfy a tax liability that arises from a particular tax position on a prior tax return. Accordingly, a tax lawyer should evaluate the adequacy of these reserves, in light of both issues that result in a permanent tax cost but those that result in a timing difference. For example, a reserve may cover the underpayment portion of a tax liability, but may not be adequate in light of time-value considerations. To test the established reserves, further information relating to the transaction giving rise to the reserve should be obtained.
  • Information related to prior transactions. Information, such as prior rulings, opinions, and appraisal reports, relating to all prior significant acquisitions and dispositions of target should be reviewed. Potential exposures in these transactions can arise either from the structure of the transaction itself or with respect to more discrete issues, such as the allocation of purchase price in the transaction.
  • Audits—what have tax authorities been investigating? Inquiries should be made as to the status of all examinations and the results of reviews in prior audits. In addition to identifying potential liabilities, the results of past audit reports can be compared with the reserves established by target to provide a sense of the aggressiveness of target in tax matters.
  • State and local tax issues should not be overlooked. State and local taxes present often overlooked areas of potential exposure. These taxes include not only income taxes, but also sales and property taxes. In addition, given the ease of transacting business in multiple jurisdictions in today’s economic environment, many targets may be subject to taxes in multiple localities but may not be properly reporting their income to these taxing authorities. Thus, buyer should carefully review, for example, the target’s state income tax position and the manner in which it apportions its income between states where the target engages in business. Sales tax exemption certificates also should be requested if target is not charging sales tax on the grounds of a resale exemption.
  • Information related to specific aspects of target’s structure and tax reporting. A review of target’s tax returns can trigger supplemental diligence requests.
    • For example, if it is determined that target has non-U.S. subsidiaries, the buyer’s tax lawyer should ensure that target is properly filing all information with respect to its subsidiaries (e.g., a U.S. shareholder of a controlled foreign corporation must file IRS Form 5471 or face a $10,000 per failure penalty). Foreign tax credit calculations also should be obtained, as foreign tax credits often serve as both an area of exposure, but also one for post-closing planning.
    • An S corporation target is another example of when additional information will be needed that relates particularly to target’s structure. A review of all potential issues that could have caused the S election to have previously terminated is necessary. These issues include (i) confirmation that the corporation has only eligible S corporation shareholders, (ii) that the number of shareholders is within the S corporation limits, and (iii) that the S corporation has issued only one class of stock.
      • If target’s S status previously terminated, target is liable for corporate level taxes for all periods (not closed by the statute of limitations) subsequent to the termination. As target likely has been paying no tax as it viewed itself as a "flow-through" entity, the potential liability for these unpaid taxes could be substantial.
      • Moreover, as will be discussed below, the parties’ ability to make a Section 338(h)(10) election with respect to the transaction would be foreclosed as a result of a prior termination of S status.

E. Structure Considerations: Building a Structure to Promote Business/Tax Efficiencies Adds Value to the Deal

  • Integration of businesses post-closing in a tax efficient manner. The ability to integrate target’s and buyer’s business tax efficiently will depend, in part, upon what tax counsel determined in the tax review phase of diligence. For example, whether mergers between entities can qualify as tax-free may depend upon the tax classification of the entities. If consolidated returns are not filed, the location of debt financing in the structure becomes very important. Thus, buyer and its counsel must consider techniques that increase interest expense where it can be most efficiently used, which can only be known by buyer after tax diligence has been conducted.
  • Eliminating inherent inefficiencies. Buyer’s tax counsel should consider whether there are inherent inefficiencies in the structure which can be eliminated prior to or at closing. For example, a U.S. buyer that is acquiring a foreign target with a U.S. subsidiary may prefer to buy the U.S. subsidiary directly rather than have a U.S.-Foreign-U.S. structure. The flexible check-the-box regulations, which generally permit elective tax classification of entities, may provide a simple way to eliminate inefficiencies or more effective integration.
  • Transforming a stock deal into an asset deal for tax—the Section 338 elections. A Section 338 election or a Section 338(h)(10) election creates a deemed asset sale for tax purposes.
    • Specifically, target is deemed to sell all of its assets to a newly formed corporation in a taxable transaction. As a result of this deemed sale, target is stripped of its tax history, as the new corporation that is deemed to acquire assets is considered to come into existence immediately after the transaction. This means that all of target’s historic earnings and profits will be eliminated, making future distributions from target to buyer less likely to be classified as dividends. Moreover, as a result of this deemed sale of assets, target acquires a fair market value basis in its assets. This means that target will be able to depreciate/amortize assets based on this (typically higher) fair market value basis.
    • These elections are only available in certain defined transactions, and there are certain tax costs arising by reason of the elections. Generally, both elections are only available where a corporation acquires by purchase stock possessing 80 percent or more of both the value and voting rights of the corporation within a 12 month period. A Section 338(h)(10) election contains the further requirements that the target be (i) an 80-percent owned subsidiary in an affiliated group of corporations or (ii) an S corporation.
    • By analyzing the structure of target and its tax attributes, the tax diligence process quantifies the benefits/costs of the elections and is therefore fundamental in determining whether these elections will be incorporated into the deal terms.

II. The Purchase Agreement

The purchase agreement can come in a variety of forms to match the structure adopted by the parties. The agreement can be an agreement and plan of merger (for either a taxable or tax-free forward or reverse merger), a stock purchase agreement, or an asset purchase agreement. Merger agreements are typically used in lieu of stock or asset purchase agreements where the merger eliminates the need to obtain shareholder or third party consents, or, in the context of a stock deal, where the number of shareholders that would need to be parties to the acquisition agreement cause the merger form to be more efficient. Regardless of the form of agreement, typical agreements contain three types of provisions that are of particular interest to the tax lawyer: (1) tax representations, (2) tax covenants, and (3) tax indemnities.

A. Tax Representations and Warranties

1. Tax representations can serve three purposes for Buyer

  • Tax representations further the due diligence process. Tax representations draw out facts about target that may not be apparent from the buyer’s review of the documents sellers provided. Tax representations can provide a direct answer from seller.
  • Breaches of tax representations may permit the termination. The acquisition agreement may provide that it is a condition to buyer’s obligation to close that seller’s representations be correct as of closing, such that buyer can choose not to close the transaction if a breach of a representation is discovered prior to closing. Typically, seller negotiates for the breach to be material in order for the breach to give rise to a termination of the agreement.
  • Tax representations can be bridge to indemnity claim. Tax representations may serve as the trigger that provides buyer with an indemnification right, thereby serving to allocate risk to the seller. However, seller may negotiate for a disclosure of a breach (or potential breach) to limit the ability of buyer to claim indemnification for liabilities arising from the disclosed item.
    • These purposes should be considered together when drafting the agreement. For example, although a tax representation may serve a diligence function, it must be negotiated in light of the indemnification provisions. If the buyer has obtained a full tax indemnity, the comprehensiveness of a tax representation may be less important than if buyer is indemnified only to the extent of a breach of a representation.

2. The role of Seller’s counsel is to negotiate representations and to limit the breadth of tax representations

  • Communicate with accountants/tax directors. Because most outside counsel often are unfamiliar with target’s internal tax picture, it is important for seller’s counsel to speak with target’s tax return preparers and internal tax directors about each of the requested tax representations. Such discussions are important for two reasons: (i) if an underlying issue exists which the representation addresses, the approach seller wishes to take in raising the issue with buyer should not be undermined by seller’s counsel uninformed response to buyer’s request; and (ii) a particular representation, even if not off-market or generally unreasonable, may expand the scope of an indemnification package beyond what was agreed to in the business deal.
  • What role will disclosure play? A threshold decision for seller is whether to seek to limit the representations based upon disclosures (i.e., no breach if item disclosed). In addition to the fact that buyer may not permit a disclosure to bar an indemnity claim, a seller must consider weigh disclosure against an increase in audit risks and ultimate exposure for the underlying issue.
  • Will representations be limited by qualifiers? The debate then moves to knowledge and materiality qualifiers in the tax representations. Buyers generally prefer sellers to represent without qualification (to serve the diligence function of uncovering all potential issues), whereas sellers seek to limit the representations provided (a certain amount of uncertainty is inherent in any transaction).

3. Definitions of Taxes and Tax Returns

  • The definition of Taxes and Tax Returns are important. These definitions limit the scope of the substantive representations relating to taxes.
    • Generally, interest, penalties and additions are included in the definition of taxes to protect buyer against all facets of a tax liability.
    • Whether, and the manner in which, taxes of others are included is an item for negotiation. For example, contractual gross-ups for taxes, like those contained in financing agreements, can be implicated in the definition of taxes if seller’s counsel is not careful.

4. Three fundamental tax representations

  • All tax returns required to be filed have been filed, and are true, correct and complete. The issues that surround this representations are: (1) whether the representation should cover all tax returns or only "material" tax returns; (2) whether the correctness prong of the representation should be free of materiality limitations or whether the representation should be limited so that the returns were true, correct, and complete in all "material" respects; and (3) to ensure that the representation only covers what is being sold and purchased.3
  • Target has paid all taxes required to have been paid and reserves for tax liability are adequate. Buyers typically seek to clarify that taxes were timely paid, and that the representation relates to all required taxes, whether or not the tax was actually shown on the tax return. Sellers typically seek to limit this representation to material taxes, although it is not uncommon for sellers to seek to represent only that taxes shown on the return have been paid.
  • There are no liens for taxes on the assets of target. Because there may be an overriding tax lien covering all property, liens for taxes not yet due and payable typically are carved out of this representation. If the representation relies on the general definition of lien or permitted liens in the acquisition agreement, buyer and seller likely will need to negotiate whether liens for taxes being contested in good faith should be excepted, and if so, whether such contests must be through the appropriate proceeds and whether target has established a reserve for the taxes underlying the contest.

5. Representations that serve diligence function

  • Target has received no indication from a jurisdiction in which it does not file tax returns that it may be subject to tax in that jurisdiction. This representation is redundant of the representation that all tax returns required to be filed have been filed, but this representation advances the diligence process by asking a direct question to the seller. Seller may not object to this representation as redundant, but should always remember its goal to limit the breadth of representations; for example, seller could limit this representation to only written notice from a jurisdiction, or notice received within a particular time period.
  • Target has complied with all obligations to withhold and remit taxes to the appropriate taxing authority. This representation may be viewed as redundant to the all taxes have been paid representation (particularly if the definition of taxes includes withholding taxes), but again this representation is used to advance the diligence function.


  • Representations relating to audit history (e.g., no exam/audit pending, no notice of intent to audit, no expectation of additional assessment, no waiver of statute of limitations to assess, etc.). These representations further the diligence process for buyer by highlighting specific issues that tax authorities may be considering and the potential period for exposure. The common negotiation points in these representations are (1) what type of notice must target have received and (2) if a knowledge qualifier is used, who’s knowledge or expectations are relevant for purposes of the representation.
  • Representations relating to post-closing detriments. In a stock sale, buyers often try to obtain insight and protection around the deduction target will be able to claim on its tax return for the year of sale and thereafter. In other cases, due diligence may suggest there may be a particular reason for concern. Thus, buyers often request representations relating to a specific provision of the Internal Revenue Code (e.g., target’s deductions will not be limited by Section 162(m) (relating to excessive compensation)). Conversely, buyers may also be concerned that target will be required to recognize income post-closing due to an event occurring prior to closing. Examples that would give rise to this result are changes in accounting methods (both voluntary and those triggered on the close), closing agreements with a tax authority, the consolidated return rules, prepayments, installment sales, and elections that permit the deferral of income (e.g., Section 108(i) relating to the deferral of cancellation of indebtedness income in certain specified situations)).4
  • Tax agreements. Similarly, buyers need to know whether target will be bound with respect to taxes post-closing by reason of an agreement executed pre-closing. Examples include tax sharing, indemnification or allocation agreements, as well as closing agreements and other rulings issues by tax authorities. Accordingly, buyers may seek a representation relating to existence of such tax agreements or that such agreements will be terminated on or before closing.

6. Representations relating to specific tax issues

  • Tax attributes. Buyer may seek to obtain insight into the specific tax attributes of the target in a stock-sale to (i) ensure it has appropriately valued the transaction and (ii) to maximize tax efficiencies post-closing (the second component of tax diligence). To obtain protection post-closing, it may ask seller to specifically identify and represent to the tax attributes of target, such as basis in assets, excess loss accounts and deferred intercompany gains under the consolidated return regulations, net operating losses, and unused tax credits. Seller may reject such a representation on the grounds that it should not make representations as to information available to buyer in its diligence, or, in any event, limit its indemnity obligation relating to this representation.5
  • Foreign operations. A target with international operations significantly expands the representations a buyer must obtain. Common representations include (1) that the foreign subsidiary is not subject to tax except in the country of its formation, (2) that the foreign subsidiary has no permanent establishment outside the country of its formation, (3) either that the foreign subsidiary is not a controlled foreign corporation or that buyer will not be required to include in income any amounts that would have been included by seller pre-closing but for the application of an exception (e.g., Section 952(c)(2)), and (4) that the foreign subsidiary is not a passive foreign investment company.6 Transfer pricing representations are also important in the international context.
  • S corporation issues. If target is an S corporation, the purchase agreement should contain a representation that target has always been an S corporation from the date of formation (or a specified later date) through the date prior to closing, or, if a 338 election is being made in the transaction, as of closing. As noted above, embedded in this representation is a host of potential pitfalls that traditional tax diligence should seek to uncover. In light of these numerous issues, the purchase agreement may contain more targeted representations designed to uncover potential S corporation qualification issues which are redundant of the broad representation above, but which advance the diligence function.

B. Tax Covenants

Covenants are promises to take action or refrain from taking an action in the future, and therefore differ from tax representations, which only seek the accuracy of a particular statement as of a particular date. Generally, there are three categories of tax covenants.

1. Allocation of responsibility for tax compliance

  • Which party will prepare and file the tax returns of target? To properly draft this covenant, it is important to know the rules for tax-year ends. These rules differ depending upon the type of entity target is for tax purposes and the nature of the tax at issue. For example, if a buyer is acquiring 100 percent of the units of a limited liability company (an LLC) that is taxed as a partnership, the LLC’s federal income tax period will end on the day of closing,7 but its liability for sales, use, and property taxes likely is not connected to when closing occurs. Accordingly, the purchase agreement should address who is preparing and filing which tax returns for which periods. The negotiating issues that arise in the context of this covenant are: (1) will the non-preparing party of review/consent rights; (2) must the tax returns be prepared consistently with past practice; and (3) how disagreements among the parties as to a tax reporting position will be resolved.
  • Payment of taxes. The party responsible for payment of the tax does not need to be the party responsible for preparing and filing the returns. For example, a buyer of corporate stock likely will demand control of the preparation for the tax return that includes the closing date, but simultaneously demand that seller bear economically the tax for the portion of the year preceding the closing date. In such case, in addition to seeking review rights over the return, seller will need to determine the manner in which to fund the tax. At a minimum, this funding must be coordinated with any working capital adjustment contained in the acquisition agreement, but seller may simply want buyer to make an indemnity claim for the unpaid tax because this process defers payment until a later date and may also subject the obligation to the general limitations on indemnity (discussed below).
    • The acquisition agreement should contain a provision allocating taxes to the pre- and post-closing periods, so that the parties agree to the manner in which taxes will be borne ahead of time. Similarly, the agreement should contain a provision specifying which party bears the transfer taxes, if any, imposed on the act of the transfer of target by buyer to seller to avoid issues arising after the deal is done.


  • Cooperation. Typically, each party agrees to cooperate with the other to enable the other party to fulfill its compliance responsibilities. This includes making available any information in its possession or access to its personnel, but the requirements for information retention, notification before destruction, and the responsibility for the costs of such production/retention can make this apparently straight-forward provision one of contention. Following from this covenant is an agreement regarding who controls audits; while purchase agreements usually provide a general process for dealing with third party claims, the special nature of tax investigations often leads the parties to reach a specific agreement on tax audits. The party with a potential responsibility for the claim (economically or through the indemnity provision of the agreement) will want to control the tax audit, but where the result of such audit can impact future tax contests, a buyer that is fully indemnified for the tax at issue may nevertheless seek control or access.

2. Obtaining a specific tax result as part of the transaction

  • Covenants to assure the intended characterization of the transaction itself.
    • These covenants are most common in transactions structured as tax-free reorganization between two corporate entities. For example, each party would agree to take reasonable steps as needed to ensure the transaction will qualify as a reorganization, to not take or fail to take any action that would jeopardize that status, and to file all tax returns consistent with that status.
    • Another common example is a "qualified stock purchase" where the parties agree to make a Section 338(h)(10) election (an election to effectively convert a stock sale into an asset sale for tax purposes). In this instance, covenants could be included setting forth the terms for the execution and filing of the election, the allocation of risk should the election not be available (most common where target is an S corporation), the allocation of the purchase price among the assets of the target, and an allocation between buyer and seller of the extra costs incurred, if any, by reason of the election.

3. Actions of target during executory period

  • Covenants to ensure condition of target does not change in the period between signing and closing. From a tax perspective, buyer wants to know that the facts it learned during due diligence are not going to change by actions taken by sellers or target during the period between signing and closing. Consequently, buyers will often prohibit (often without the prior written consent of buyer) sellers from taking certain actions that relate to taxes. For example, target may covenant that it will not make, change or revoke any tax election. Another example is prohibiting target from filing any amended tax return or to settling any tax matter. Although these elections do not appear to be controversial, seller’s counsel should always check with target’s tax return prepares and in-house tax staff to make sure this covenant will not unduly restrict target, particularly where target is on the verge of concluding a tax examination, or, if target is expected to undertake a particular transaction, seller’s counsel can obtain buyer’s waiver for that particular transaction as part of the agreement.

C. Tax Indemnification

  • Defining the indemnity. The first issue the tax indemnification provision should address is for what claims relating to taxes are sellers providing indemnification. Where target is a public company, typically no tax indemnity is provided because public companies are subject to a greater degree of regulation and public disclosure. In private transactions (including the acquisition of a particular division of a public company for which separate financial statements and disclosures are not prepared) sellers may not offer a separate tax indemnity, arguing that their obligation should only arise under the general breaches of representations and warranties provision. Buyers, on the other hand, may craft a specific indemnity to cover all taxes of the target for periods ending on or before closing, including the pre-closing portion of a tax period that begins before, but ends after, the closing date. Buyers may also include indemnity for taxes of others for which target could be held liable, including as a transferee, successor, or other applicable law (e.g., the consolidated return regulations). This provision of the agreement therefore tends to be the most heavily negotiated provision of the agreement.
  • Limitations on the indemnity. Once an indemnifiable claim is defined, the purchase agreement often sets forth other limitations on what an indemnified party can be paid.
    • Liabilities taken into account in determining a working capital adjustment should reduce the indemnity, as seller has already borne the cost of the liability through the purchase price adjustment.
    • Baskets (or floors) and caps are also common in purchase agreements. A basket prevents payments from being due unless the aggregate indemnity claims exceed a specified dollar amount. A cap causes the indemnifying party’s obligations to cease once it has paid a specified dollar amount. Tax counsel must work with his or her client to determine whether taxes should be subject to these limitations.
    • Setting forth survival periods for claims is another means to limit indemnity. Generally, the survival period for tax claims survives the closing until some specified period time after the applicable statute of limitations has expired. Shorter periods, however, can be negotiated, and there is no requirement that the survival period for one type of tax (e.g., income taxes) be the same as the period for another type of tax (e.g., property taxes).
  • Right to indemnification is only as good as the ability to collect. An indemnified party must remember the practical issue of obtaining cash from the other party. To address this concern where the purchaser determines that sellers may not have the resources to satisfy potential claims, holdbacks, set asides (e.g., against or deferral of seller’s funded purchase price) and escrows are usually incorporated into purchase agreements. In this provision, the purchaser will set aside a portion of the purchase price until the indemnity period, or some portion thereof, has expired. An issue to keep in mind in this context is identifying which party will be taxed on the earnings of the escrow; a simple solution, regardless of the party bearing the tax, is to permit the escrow to release a portion of the earnings to the party bearing the tax to give that party the cash necessary to satisfy the tax.

III. Conclusion

Every deal is different. Every target is different. Accordingly, the due diligence process and the negotiation and drafting of an acquisition agreement will always provide different and new experiences. There can be, however, a basic framework for approaching due diligence and documenting the deal as it evolves. This outline, which is not intended to be comprehensive, should provide a basic approach to conducting diligence and should identify the most common tax provisions a deal lawyer should anticipate addressing in the final agreement.


1 Section 338 refers to a provision in the Internal Revenue Code (the Code) that permits particular parties to make an election for federal income tax purposes.

2 "Eligible Entities" are permitted to elect their classification as a corporation, partnership or disregarded entity for federal income tax purposes by filing Form 8832. Moreover, certain qualifying entities that are classified as corporations can elect to be taxed under Subchapter C of the Code (default treatment, which results in taxation at the entity level and again at the shareholder level upon distributions and stock sales) or under Subchapter S of the Code by filing Form 2553 (resulting in "flow-through" treatment where the income of the corporation generally is taxed only once in the hands of the shareholders).

3 However, buyer must keep in mind that there may be an overriding tax lien that covers all property of seller.

4 Section 108(i) permits cancellation of indebtedness income that otherwise would have been recognized in 2009 or 2010 to be deferred and included ratably over a five year period beginning in 2014. Thus, a target may potentially recognize income as late as 2018 with respect to a transaction that occurred in 2009.

5 For a recent example of negotiations involving tax attributes, see Marathon E.G. Holding Limited and Marathon E.G. Production Limited v. CMS Enterprises Company, 597 F.3d 311 (5th Cir. 2010) (seller held not responsible to indemnify buyer for taxes relating to subsequent reduction in net operating losses where definitive purchase agreement did not contain buyer’s requested representation relating to the amount of target’s net operating loss).

6 Under the rules applicable to controlled foreign corporations, taxpayers that are U.S. shareholders on the last day of the corporation’s taxable year are required to include in income the corporation’s Subpart F income. Thus, buyers that will be U.S. shareholders of a controlled foreign corporation target will be required to include the target’s entire year’s worth of Subpart F income, even if the buyer only acquired the stock in the last week of the corporation’s taxable year. The party to bear this tax cost is a matter for negotiation in the purchase agreement.

7 See Rev. Rul. 99-6, 1999-1 CB 432, Situation 2 (concluding that a tax partnership terminates and must file a final return when 100 percent of its interest are sold to single buyer). The tax year of a corporation does not close as a result of the sale of its stock, unless the corporation was a member of a consolidated group or was an S corporation that ceases to be an S corporation following the sale.

Steven D. Bortnick and Timothy J. Leska

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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