Buying and selling companies can be risky business, especially in today’s economy. Both the buyer and seller want to make sure they are protected during the process, and a seller wants to know that cash will be generated from the sale.
Buying tax insurance is one way to give comfort to both parties during these transactions as to potential tax exposures.
“It’s a way to make a transaction more economically efficient,” says Gary P. Blitz, managing director with Aon Financial Solutions. “While there are certainly fewer mergers and acquisitions taking place in the down economy, the dollars spent and received are precious. Sellers want to make sure they generate some cash from the sale, and cannot afford to have funds tied up in escrow accounts for as long as seven years to protect a buyer against a potential tax exposure.”
Smart Business spoke with Blitz about how to use tax insurance and the risks that business owners can face if they choose not to purchase it.
What is tax insurance, and why is it important to have it?
Tax insurance allows the insured party to transfer the risk of a tax authority, like the IRS, challenging the intended tax treatment of a transaction or business situation. Even companies that handle their taxes very responsibly seek certainty and assurance that their (and, importantly, a target’s) federal, state and local, and foreign tax houses are in order.
The IRS can provide that certainty, in certain circumstances, through the private letter ruling process, but there are many areas where rulings are not provided and the ruling process can be excruciatingly slow when a transaction is pending. Tax insurance brings certainty to the system, assuring that a specific tax treatment will be received. For example, it might provide assurance that a tax-free reorganization or restructuring will be respected as tax free or that the limitations on net operating loss carry forwards have been properly applied.
Many business owners are selling companies or assets to generate funds, and it makes the transaction inefficient if some of that cash will be tied up in escrow. It’s a question of tying up assets or spending a relatively small amount to transfer that risk to an insurer. That’s where tax insurance becomes very effective, especially in this economy.
In what situations should a business owner purchase tax insurance?
Tax insurance is usually used in two types of scenarios. The first is during transactions, when buying and selling companies. A wide range of tax risks may be faced by such parties, including, for example, tax-free transactions, partnership issues, golden parachute excise tax issues, capital versus ordinary treatment, tax credits (low income, historic, solar and wind) and so on. Generally, if a tax expert can form a view on the tax treatment of a situation, a tax insurer should be able to consider it.
If it meets the insurer’s underwriting standards, which generally seek to determine whether there is a sound business purpose and the tax analysis is based on sound reasoning, a policy then would be offered. However, it is important to note that tax shelters and reportable or listed transactions cannot be insured.
The other situation deals with FIN 48 accounting rules. These income tax rules came into effect over the last couple of years, first for public companies and now for private companies, as well reporting under U.S. GAAP standards. These rules set stricter and more transparent methodologies for companies to report income tax obligations in their financial statements.
There’s a great deal of difficulty and uncertainty in applying these rules, as the tax rules are subjective and require a great deal of judgment by the experts. Companies are required to test every material tax position to determine how strong it is, both under the tax law and how it’s measured.
The company has to put up a reserve and make specific disclosures if there is not greater than a 50 percent confidence level. There’s a role for FIN 48 insurance to help mitigate some of the downside if those determinations are ultimately challenged and proven wrong.
How can business owners determine if their situation requires tax insurance?
There are two sides to determining if tax insurance is right for the situation. The first is in the context of a transaction or financing where a third party is looking for comfort. That should be an indicator that insurance can be used to ease the financial pain of providing that comfort through traditional escrows and indemnities. Tax insurance also can be an effective tool for a buyer to make a better offer to a seller for an asset because by using insurance, the seller can be relieved of having to provide an indemnity.
FIN 48 insurance also can be helpful if you’re a business with a sizeable tax situation that has been recognized (not reported) for FIN 48 purposes. These policies can help manage that risk such that if they should go wrong, it will not be a catastrophic situation to you or your financial statements.
What risks do business owners face if they choose not to purchase tax insurance?
Insurance provides a financial backstop for an unexpected tax liability. Business owners certainly can and should seek advice from their tax advisers. However, professional opinions typically have caveats and exceptions and are not intended to provide indemnity if the intended treatment is not ultimately upheld.
The insurance operates in a similar fashion to how a private letter ruling would work. The taxpayer provides the factual predicate to the insurer through reps, warranties or documents. The insurer then provides comfort through the insurance policy that the intended treatment will be respected, and that it will pay the tax, interest and penalties if it is not.
Gary P. Blitz is managing director with Aon Financial Solutions. Reach him at (212) 441-1106, (202) 429-8503 or firstname.lastname@example.org.