plaintiff will indemnify the defendant.
Is this a good idea? Does the defendant
even need any tax advice in this case?
The tax indemnity provision seems
to put the liability on someone else. If
so, the reasoning may go, there is no
need to worry about the size or scope of
the tax problems. Such thinking can be
shortsighted for several reasons.
Pursuing Third Parties
First, an indemnification obligation
does not prevent a tax problem, nor does
it bind the IRS or state tax authorities. If
you are the taxpayer, you have the problem, even if you can go after someone
else to try to cover your loss. An indemnification obligation is a third-party arrangement between contracting parties.
Thus, it is only as good as the cred-it-worthiness of the indemnifying party.
Moreover, it says nothing about the primary liability that the party to be indemnified has to the IRS or to state taxing
authorities. For example, consider the
question of tax withholding.
Tax withholding is required on wages
and on some other payments (such as
some payments to non-U.S. plaintiffs).
Where withholding is required, the payor is a withholding agent and fails to
withhold at its peril. Failure to withhold
liability can be significant, involving
liability for the payments themselves,
interest, and potentially steep penalties.
The fact that someone else (typically
the settling plaintiff) has agreed to step
in and repair the tax damage does not
mean they will actually step in. Even if
they do, they may not have the financial
ability to repair the tax damage. Suppose that a wrongful termination of employment case is settling for $1 million,
with the client receiving $600,000 and
the lawyer receiving $400,000.
Assume that the plaintiff receives a
Form 1099, agrees to pay any tax due,
and agrees to indemnify the defendant
for taxes. But what if the IRS claims the
$600,000 was wages subject to withholding? The employer has the liability for failure to withhold, which could
amount to $300,000 or so.
The IRS will not agree to go after the
plaintiff. The defendant can try to get
the plaintiff to step in, but how likely is
that? By the time the tax issues are examined and contested, the plaintiff may
be out of funds.
Besides, even if the plaintiff could
pay, he or she will probably fight it. It is
highly unlikely that the plaintiff will
agree that the indemnity obligation
he or she signed actually covers failure-to-withhold liability of the defendant. Many general indemnity provisions are unlikely to be read broadly
enough to actually cover the employer’s
As this withholding example sug-
Types of Indemnity
gests, there is also no guarantee that
the tax damage will be small. In that
sense, a tax indemnity provision may
lull you into a sense of complacency.
A common comment is that, “we have
indemnity from the other side for taxes,
so we are covered.”
Despite a tax indemnity provision,
you should understand the risks, tax
dollars, penalties, interest, and counsel
fees you are trying to guard against. But
aside from these cautions, are tax in-
demnity provisions a bad idea?
Some lawyers worry that a tax indemnity provision is a red flag to the IRS.
Some suggest that a tax indemnity provision is an admission to the IRS that
there is a tax game afoot. It is hard to
see how. Tax indemnity provisions are
common in numerous types of agreements, and are unlikely to be viewed as
red flags by the IRS.
In that sense, a tax indemnity provision probably cannot hurt. Nevertheless,
it may not help either. Such provisions
are of limited utility in many types of legal settlement agreements, especially in
settling employment litigation.
For example, if the defendant is a
business and the plaintiff is an injured
person or former employee, the prospect that the defendant will actually
pursue the plaintiff on the tax indemni-
The fact that someone has agreed to step in and repair
the tax damage does not mean they will actually step in.