The US Supreme Court's unanimous ruling in Connelly v. United States highlights the importance of understanding the tax portions of stock purchase agreements, especially key areas such as recitals, definitions, and purchase price mechanics.
A crucial issue in Connelly was whether a stock-purchase agreement could set the value of the company shares for federal estate tax purposes. Two brothers who co-owned a family business had executed the agreement that directed the business to redeem the shares of the first brother to die.
When that happened, the business used $3 million of life insurance proceeds to redeem the decedent's equity interest. The high court found that such proceeds must be included when valuing company stock for estate tax purposes. The estate was directed to pay nearly $900,0000 in additional tax as a result.
This decision underscores the need for tax lawyers to meticulously review, understand, and negotiate key tax portions of a purchase agreement such as recitals, tax representations, tax covenants, purchase price mechanics, and indemnification provisions to safeguard interests of buyers and sellers—and ensure a smooth and equitable transaction process.
Understanding the Deal
The first step in analyzing a purchase agreement's tax provisions is to review the letter of intent, recitals, and purchase price mechanics, all of which will help clarify the business deal and the parties' intended tax treatment.
The letter of intent contains basic deal terms and describes what should be included in the purchase agreement, emphasizing essential terms and conditions. Key terms may include a Section 338 election, a pre-closing tax indemnity, or representation and warranty insurance (or tax insurance).
Recitals outline the transaction's background, including parties involved, type of transaction, the intended tax treatment, and the agreement's purpose. The purchase price mechanicssection specifies whether the purchase price is paid in cash or equity and includes other provisions such as rollovers, earnouts, and gross-ups.
Key Tax Definitions
Tax definitions can greatly affect the purchase price calculation. Including taxes in the definition of "indebtedness" reduces the purchase price dollar-for-dollar, for example, while including taxes in the definition of "working capital" may cause a smaller reduction to the purchase price.
Whether a tax item runs through the indemnification provisions or as an adjustment to the purchase price can affect the total amount to be collected by the buyer. The key difference is that adjustments usually don't count toward the indemnification cap or baskets, potentially allowing for a larger recovery.
Tax Representations
Tax representations are assurances from the seller to the buyer that certain facts related to taxes are true. Collectively, tax representations tell the buyer that the seller has filed all tax returns and paid all taxes due.
Tax representations are critical in any purchase agreement negotiation as they allocate responsibility for certain taxes between the buyer and seller and ensure the buyer is protected against unforeseen tax liabilities. The scope of tax representations will vary depending on the specifics of the transaction and the type and size of the seller.
Any disclosure against a tax representation may exclude that representation from the representation and warranty policy. In such cases, sellers may purchase a separate tax insurance policy or self-insure with an escrow, holdback, or purchase price adjustment.
Tax Covenants
Tax covenants are enforceable promises for future tax-related actions. Below are some key tax covenants and the general market treatment for each.
Tax returns typically operate on an "our-watch your-watch" system, meaning the party liable for the taxes generally controls the preparation of tax returns. Three types are typically negotiated.
- Pre-closing tax returns are controlled by the seller, who should accept the buyer's comments in good faith. The seller usually controls because they bear all liability under the purchase agreement for pre-closing taxes.
- Straddle period returns are for periods spanning both pre- and post-closing. The buyer usually controls the returns, with consent rights for the seller.
- Post-closing returns are controlled by the buyer, with the seller having no consent rights unless indemnification claims are involved.
Tax contests are usually controlled by the buyer, but the seller should have participation and consent rights for audits requiring indemnification.
Tax refunds for pre-closing taxes or taxes for which the seller is liable generally belong to the seller, although the buyer controls the refund process and must remit the refund to the seller within a specified timeframe.
Transfer taxes are almost always split 50/50 between the buyer and seller.
Negative tax covenants restrict the buyer's post-closing actions regarding taxes, such as filing voluntary disclosure agreements without the seller's consent.
Cooperation provisions mandate cooperation during audits and generally should apply equally to both buyer and seller.
Tax treatment provisions describe the agreed-on tax treatment of transactions and generally require mutual agreement.
Purchase price allocation divides the total price paid for a business into different components and assigns them to acquired assets. Most agreements require mutual agreement on allocation, although this isn't required by law.
Such allocations are relevant in asset acquisitions or stock acquisitions that are treated like asset acquisitions for income tax purposes (such as with a Section 338 or Section 336 election or purchasing a single-member limited liability company).
Withholding is an optional requirement, but buyers generally must notify sellers prior to withholding to allow them to cure potential withholding issues.
Indemnification Provisions
Tax indemnification provisions address how to handle claims for breaches of tax representations or covenants. They may include a pre-closing tax indemnity, which provides extra coverage for pre-closing taxes and is commonly known as "belt and suspenders" coverage.
These provisions also clarify whether tax claims have a floor or a cap, the survival period for tax claims, and the method of payment. Tax representations are generally considered fundamental, meaning they usually have a higher cap and longer survival period than general representations. (They generally survive seven years, not three years.)
In some cases, known as "walk-away deals," sellers have no liability for tax representations or tax claims. This is usually the case when there is enough representation and warranty insurance or tax insurance to cover potential claims.
The case is Connelly v. United States, U.S., 23-146, 6/6/24.
Originally published by Bloomberg Tax
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
