Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Tax Indemnity Trap That Cost a Seller $9 Million
Transcript
- Lucas: You sell a business for $50 million. Clean close, no drama. Six months later the buyer sends you a letter demanding $9 million back. Not a joke—that happened. Luna: $9 million out of a $50 million deal? That's nearly 20 percent of the purchase price. On what basis? Lucas: Tax indemnity. Specifically, a section in the purchase agreement that said the seller is responsible for any taxes attributable to periods before closing. Standard language, right? Every deal has it. Luna: Right, the 'pre-closing tax period' clause. But that usually covers things like unpaid payroll taxes or a pending IRS audit. How does that balloon to $9 million? Lucas: Because the buyer used a tax attribute that existed pre-closing—carryforward net operating losses, NOLs—to file an amended return for a prior year and got a refund. Then they argued that the refund belonged to the buyer under the purchase agreement, but the tax liability that created the NOL was the seller's problem. Luna: Wait—so the buyer got a cash refund from the government, but then turned around and charged the seller for the taxes that generated the loss in the first place? Lucas: Exactly. The buyer's logic: the NOLs were built during the seller's ownership. Those NOLs reduced the buyer's tax bill in a prior year when they carried them back. The buyer collected the refund. But the indemnity clause said any tax liability from pre-closing periods is the seller's obligation. They claimed the 'liability' was the full tax that would have been owed without the NOLs—so the seller owed the difference. Luna: That sounds like double-counting to me. The seller already bore the economic loss that created the NOLs. The buyer got a tax windfall. And then the seller pays again? Lucas: That is exactly what happened. And the seller's lawyers had not negotiated a so-called 'tax benefit' provision. That's the clause that says if the buyer gets a tax benefit from a pre-closing attribute, they have to share it with the seller or at least reduce the indemnity claim dollar for dollar. Luna: So the seller agreed to a standard tax indemnity, but the agreement was silent on who keeps the benefit of those NOLs? Lucas: Silent. The tax section ran maybe six pages—typical for a $50 million manufacturing deal. It defined 'taxes' broadly, including any tax liability for pre-closing periods. It did not define 'tax benefit' at all. The buyer's team argued that the plain language of the indemnity captured the hypothetical tax that would have been due if the NOLs had not existed. Luna: And the court bought that? Or did it settle? Lucas: It settled after the first round of discovery, because the seller faced an uphill battle. The contract said what it said. The seller's only argument was 'that's not what we intended,' which is a weak argument when the language is clear. They ended up paying $6.2 million to settle—plus legal fees—for a total hit around $9 million. Luna: So the remedy is a tax benefit provision. How do you write one that actually protects the seller? Lucas: Three elements. First, define 'tax benefit' as any reduction in the buyer's tax liability that is attributable to a pre-closing item—NOL carryforwards, tax credits, built-in losses, basis step-ups from a Section 338 election, anything. Luna: Second? Lucas: Include a mandatory sharing mechanism. The buyer must pay the seller the amount of any tax benefit realized within a certain period—typically 60 or 90 days after filing the return that claims it. And the payment should be treated as an adjustment to the purchase price, which is tax-free to the seller. Luna: And third? Lucas: Scope the indemnity so that any tax claim is reduced by the amount of any tax benefit that the buyer has received or could receive. That way, even if the buyer uses the NOLs in year three, they cannot come back and demand the full pre nol tax amount from the seller. The indemnity claim is net of benefits. Luna: What about the buyer's perspective? Is this a reasonable negotiation or is the seller asking for a gift? Lucas: It is absolutely reasonable. Most sophisticated buyers will accept a tax benefit provision because they know the alternative is litigation. But you have to watch for the carve-outs. Some buyers will agree in principle but exclude 'de minimis' benefits—anything under $100,000, for example. Or they will cap the sharing at the amount of the indemnity cap. Or they will insist that the benefit must be 'actually realized' on a tax return, not just 'reasonably expected.' Luna: So the seller's team needs to run the numbers before signing. If the company has $10 million in NOLs and a 21 percent federal rate, that benefit is worth over $2 million. That's not de minimis. Lucas: Exactly. And the negotiation should happen before the purchase price is locked, because the buyer will argue that they already paid for the NOLs through the price. The seller's response: 'If you already paid for them, then you should have no objection to sharing the benefit—because you are just getting back what you paid.' Luna: That is a clean argument. Let me ask a practical question—does the seller need a tax specialist in the room, or can a good M&A lawyer handle this? Lucas: You want both. The M&A lawyer knows the deal language and the precedents. The tax lawyer knows how the NOLs interact with Section 382, the change of ownership rules, and state tax apportionment. In the case I mentioned, the seller's M&A lawyer was excellent, but the deal was done on a tight timeline and the tax due diligence was minimal. They did not model what would happen if the buyer carried back the NOLs. Luna: So the lesson is: run the tax attribute model before you sign, and negotiate the tax benefit provision as a core term, not a boilerplate afterthought. Lucas: Exactly. And if the buyer pushes back, ask yourself why. If they plan to use those NOLs aggressively, they should be willing to share the upside. If they refuse, maybe they are planning exactly what happened in that $50 million deal. Luna: I think this is one of those areas where the asymmetry of information is huge. The buyer's tax team knows exactly what the attributes are worth. The seller often does not. Lucas: Right. And that is why the seller should insist on seeing the buyer's tax model as part of due diligence. Not just the historical returns, but the buyer's projected post-closing usage. You can put a confidentiality agreement around it, but you need the data. Luna: Honestly, if today's episode saved even one seller from a $9 million surprise, that is worth more than the coffee it probably cost you to listen. And if it did, you know where to find us—buy me a coffee dot com slash fexingo. It keeps this show ad-free and independent. Lucas: Appreciate that. And just to be clear, that $9 million hit—it did not come from fraud or a hidden liability. It came from a clause that looked standard. So the next time your lawyer says 'this is market standard on tax indemnity,' ask them to define 'tax benefit' in the agreement. Luna: Okay, so assume the seller gets a good tax benefit provision. How do you handle the indemnity cap and survival period? Does the tax indemnity survive longer than the general indemnity? Lucas: Almost always. General indemnity typically survives 12 to 18 months. Tax indemnity usually survives until the expiration of the statute of limitations—so three years for most federal returns, sometimes longer for state or if there is an audit. And the cap is often the full purchase price, not the general indemnity cap. That is another negotiation point. Luna: So the seller could face an uncapped claim for years, unless they negotiate a sub-cap on tax benefits specifically? Lucas: Exactly. You want the tax benefit sharing to survive as long as the tax indemnity, but the sharing should not be subject to the same cap. If the buyer gets a $3 million benefit in year four, the seller should get paid regardless of whether the indemnity cap is exhausted. Luna: That is a nuance a lot of sellers miss. They focus on the indemnity cap going in, but they do not realize that the benefit sharing is a separate stream. Lucas: Right. And the deal I mentioned—the indemnity cap was $10 million, which seemed generous to the seller. But the tax benefit was worth $9 million. If they had a benefit sharing provision, they would have gotten most of that back. Instead, they paid it. Luna: Let me put a finer point on it. What one document should a seller ask for in due diligence to avoid this? Lucas: The buyer's projected tax attribute utilization schedule. That is a spreadsheet that shows how the buyer plans to use NOLs, credits, and basis step-ups post-closing. If the buyer says they do not have one, that is a red flag—they should have one. And if they refuse to share it, that is an even bigger red flag. Luna: And what if the seller is a pass-through entity, like an S-corp or LLC? Does the analysis change? Lucas: It does. Pass-through entities generally do not have federal NOLs at the entity level because the income flows through to owners. But they may have tax credits, built-in gains tax exposure, or state-level attributes. The same principle applies—you want a benefit provision for any pre-closing tax item that reduces the buyer's liability after closing. Luna: One last thing—what about the buyer's argument that the seller is trying to 'double dip' by getting paid for NOLs in the purchase price and then again through the benefit provision? Lucas: That is a negotiating point, but it is usually a weak one. The purchase price reflects the enterprise value of the business as a going concern. It does not necessarily attribute a discrete dollar amount to NOLs unless the parties explicitly agree on a tax valuation. The clean way to handle it is to put a dollar value on the NOLs in the purchase price and then agree that the benefit sharing only applies to amounts above that threshold. Luna: So you carve out the first, say, $2 million of benefit, and share everything after that. That gives the buyer their expected return and protects the seller from the tail. Lucas: Exactly. It is a reasonable middle ground. And it is way cheaper than a $9 million surprise.