How to Handle Compensatory Payments Post-Closing

Identifying responsibilities and liabilities for deal parties and how to solve for them.

Many selling companies in private M&A transactions have payees whose allocated transaction consideration is classified as income or compensation under IRS guidelines. Whether the individual cashes out options or restricted stock units (RSU), or is a participant in a management carveout or retention bonus plan, their portion of the transaction consideration will likely require income withholding. This creates post-closing responsibilities and liabilities for the buying company and surviving company that can be overlooked in the transaction documents or operationally post-closing.

Compensatory payments made at the time of closing are generally paid through the selling company’s payroll system, subject to applicable withholding. Funds that are placed into escrows or holdbacks, however, typically have not had any amounts withheld from them as they are not technically the payees’ property, but instead are often treated as owned by the buying company for tax purposes unless and until they are later paid to the applicable payees. As such, when the escrow or holdback is released, potentially years later, the funds will need to be processed through a payroll system that can conduct income withholding. Transactions with prolonged earnout or milestone periods could lead to compensatory payments becoming due five to ten years after the closing date.

Due to the time between closing and these post-closing payments being made, there are numerous logistical issues that can arise that delay the payment process and can be expensive to fix. One of these issues is the likely change of payroll providers after the acquisition. Generally, the buyer will not continue to use the seller’s payroll provider or system after closing. Information on former employees usually is not carried over to the new payroll provider, even though former employees will still need to be paid through the payroll system. Second, many of the individuals who remain employees at the time of closing will probably not remain employees through the entire escrow or earnout period. This could require the buyer to keep those individual’s in its payroll system after termination, often for the purposes of one final possible payment years from now, which can cost thousands of dollars per individual per year. This problem increases if employees leave the company and their information is not noted as needing to be saved. Even if an employee has left the company, the company’s tax department usually determines that certain remaining post-closing payments to that individual should be treated as compensation, even if the shareholder is no longer employed. This means the buying company will need to solicit the requisite information and re-input employees into the payroll system for a single payment, which can be a costly and time consuming process. Additionally, many transaction documents do not specifically state who is responsible for the employer portion of payroll taxes and whether such taxes are indemnifiable. This can cause potential disputes and unanticipated expenses for both sides.

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