Tax treatment of post-transaction RWI payments
In an M&A transaction, the buying and selling parties each agree to various representations, warranties and covenants as part of the transaction agreement. For example, the seller often agrees to transfer the assets in good working condition or accurately disclose financial statements or earnings information relating to the condition of the company. These terms often also relate to post-acquisition activity; e.g., the seller promises not to compete with the buyer or solicit its customer base. After the transaction, disputes can and often do arise over a party’s breach of these terms, which may be resolved through a payment for damages, or settlement.
When the seller makes a settlement payment directly to the buyer related to a breach of the transaction agreement, the payment often constitutes a purchase price reduction rather than income to the buyer, assuming the claim itself relates to the purchase price of the company rather than future lost income. (See United States v. Gilmore, 372 U.S. 39 (1963) and Arrowsmith v. Comm’r, 344 U.S. 6 (1952).)
By contrast, if the parties to an M&A transaction obtain RWI, then the third-party insurer will pay damages when a seller or other party to the transaction breaches the terms of the purchase agreement. In this case, the core tax question is whether those payments from a third-party insurance company can constitute a nontaxable reduction to the stock or asset basis of the purchased company, instead of gross income to the recipient.
Case law has allowed a taxpayer to treat an indemnification payment from a third-party broker as a reduction to purchase price. (See Freedom Newspapers, Inc. v. Comm’r, T.C. Memo 1977-429.) Further, IRS authority indicates that a disaster relief or insurance payment compensating a taxpayer for a property casualty loss is a return of capital and is not included in income. (See Rev. Rul. 71-161, 1971-1 C.B. 76; and Reg. section 1.1016-2.)
However, there is no case law or IRS authority directly addressing the treatment of post-acquisition settlement payments made by a third-party insurer. Whether the receipt of RWI proceeds is a purchase price adjustment rather than a gross income inclusion is therefore uncertain, fact-sensitive, and dependent on a variety of factors. Factors to consider include:
- Whether obtaining RWI was a term in the purchase agreement (or integrally connected to the transaction)
- Which entity or parties are covered by the RWI policy and entitled to any proceeds (e.g., buyer, target, or ultimate investors)
- Whether the settlement payment compensates the buyer for lost profits or damages related to the goodwill or tangible assets of the company
- Whether the premiums and other costs associated with the RWI policy are properly capitalized to the assets or stock acquired under section 263(a) or treated as an ordinary and necessary business expense under section 162
Consider the potential effect of RWI payments in various M&A contexts. What are the consequences of treating an RWI payment as a reduction in basis instead of a current inclusion in gross income? One possible difference is whether the amount is characterized as capital versus ordinary. Another key consideration is the timing of income or gain recognition.
