real world, the defendant may agree to
run the tax risk.
The defendant’s general counsel
may say to the tax adviser, “we are
managing risks, and the litigation risk
with this case is vastly greater than
the tax risk.” Businesses must weigh
these risks. What seems silly, though,
is if the defendant is convinced that
there is no tax risk because there is an
What about tax indemnities outside of
employment litigation? Tax indemnity
provisions can often be more helpful in
other contexts. For example, suppose
the defendant agrees not to issue an IRS
Form 1099, because the plaintiff claims
the payment is for personal physical injuries or sickness that is tax-free under
Section 104 of the tax code? 3
The defendant may believe that the
settlement payment is really a payment for emotional distress, and therefore taxable. The defendant might say
that in order not to issue a Form 1099,
the defendant requires a tax opinion
from the plaintiff, and a tax indemnity.
Here, the indemnity would presumably cover penalties for failure to issue
a Form 1099.
The main penalty for failure to issue
a Form 1099 is only $260, unless the
defendant is found to have been willful.
In that case, the penalty could be much
more serious— 10 percent of the settlement payment. In practice, though, such
10 percent penalty assertions are rare.
The penalty for intentional failure
to issue a Form 1099 seems to be reserved for situations where it was clear
the payor knew there was a reporting
obligation, and ignored it. In any event,
indemnity provisions in such situations may make more sense than where
wages and withholding are involved.
Tax Indemnities in Acquisitions
Tax indemnity provisions are also com-
mon in acquisition agreements. A pur-
chase of one company by another can be
handled in many different ways. Often,
there are tax issues that will remain de-
batable even post-closing.
There may be income tax, sales and
use tax, property tax, and foreign tax
issues. Whatever the issues, it is appro-
priate to allocate the risks. And unlike
in the context of litigation settlements,
enforcement may be a factor.
For example, unlike litigation settlements, escrows or hold-backs are common in such transactions. Often, they
may not extend for the entire statute
of limitations period that could bracket the time of potential tax risks. Nevertheless, an escrow or holdback may
materially help and can put real teeth
in the indemnity provision.
Lawyers are trained to ask for indemnity
and to cover as many risks for their clients
as they can. Tax indemnity provisions are
often written and debated by non-tax lawyers. That is to be expected. Everyone is a
little afraid of taxes and tax liabilities.
And like confidentiality provisions,
indemnity provisions—even about taxes—may seem pretty straightforward.
After all, a tax indemnity may seem to
reduce or even obviate the tax risks.
However, whenever possible, get some
tax advice even if you have a strong
There is a big difference between: ( 1)
feeling comfortable that a small penalty
will be covered by the plaintiff if it materializes; and ( 2) believing that a tax bill
for 40 percent of the settlement for failure to withhold taxes will be adequately
addressed via an indemnity that may
never be collectible. One can still ask for
indemnity. But understanding the type,
scope, and amount of the potential tax
problems is a good idea.
Tax indemnity provisions are not
one-size-fits-all. No matter how tightly
you write a tax indemnity provision,
there may be ambiguities. Even if the
scope and meaning of the indemnity
provision is clear, there may be big
questions (then or later) on whether the
indemnifying plaintiff will have any assets to pursue.
If you tell your clients the indemnity provision protects them, it can be
upsetting to have your client complain
several years later that an indemnity
provision you wrote or recommended
did not protect them. And that may
mean the lawyer who said, “Don’t worry, we’ve got indemnity” might end up
being asked to pay.
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