Taxation of Interest Earned on the M&A Escrow Account: Actual vs. Imputed

Given the varied complex structures for M&A escrow investments, it is important to understand how interest earned on money in escrow accounts will affect taxation of M&A deal participants, and to clarify any misunderstandings with regard to tax reporting requirements for both the buyer and the selling shareholders. Many deal parties struggle with whether imputed interest should be reported and how to appropriately compensate Buyers for the interest taxation to which they are subject during the escrow period. Rather than choose a non-interest bearing account, parties may want to consider the following in structuring tax obligations for their escrow accounts.

In most M&A escrow transactions, investment earnings are generally deemed taxable to the buyer, yet any investment earnings on the escrow are typically credited to the escrow account. At the end of the escrow period, assuming no claims are made, the balance of the escrow account is distributed to the selling shareholders including any of the investment earnings previously credited to the account. As a result, it is not unusual for shareholders to ask how much of the escrow distribution is related to interest. In other words, how much of the distribution should be treated as capital gain and how much is recognized as ordinary income? Even though short-term interest rates have risen in the last few years, most escrows today are invested in accounts paying less than 10 basis points, and many pay no interest at all.

Taxes on Merger and Acquisition (M&A) escrow accounts earnings are complicated because while buyers typically receive a 1099-INT on actual interest paid to the escrow account, unless there is a claim, the actual interest is eventually paid to the selling shareholders as part of the escrow distributions reported to them on a 1099-B. Section 483 of the Internal Revenue Code, which applies to merger agreements that involve distribution of an escrow in a future tax year structured as an installment sale, requires the seller to allocate the escrow distribution between that part of the proceeds treated as a capital gain and that which should be treated as interest and taxable as ordinary income. If the merger agreement specifies a rate of interest to be paid during the escrow period, then the seller allocates the actual interest included in the escrow distribution as ordinary income. However, because most merger agreements do not specify a rate of interest to be paid during the escrow period, the recipients are required to ignore any actual interest included in the escrow distribution and instead impute interest on the total amount of the distribution based on interest rates published by the IRS, the so-called applicable federal rates (AFRs). Even if an escrow has earned no interest, as of September 2019, the IRS has set the short term AFR (used for periods less than three years) at 1.85%. As a result, a larger portion of escrow distributions end up being taxed as ordinary income than would be the case if taxes were instead based on actual interest earned.

At SRS Acquiom, buyers frequently tell us they are required to issue tax forms 1099-INT or 1099-OID for the imputed interest included in escrow distributions. But while IRC §483 and associated regulations require escrow recipients to impute and report a part of any installment proceeds received as interest, there is no requirement for buyers to calculate imputed interest or file any interest information reports to the IRS. In fact, the need to report imputed interest on funds held in escrow as security, or to guarantee performance, is specifically exempted under 26 CFR 1.6049. Nonetheless, payment administrators typically provide escrow recipients form 1099-B, which includes the full amount of the escrow release.

The interest earned on escrow accounts may also present complications for buyers as well. During the escrow period, buyers may receive a 1099-INT for interest credited to the escrow account and, therefore, may need to report such interest on its tax returns. Because including such interest might increase taxable income, buyers sometimes ask for a portion of interest paid to the account to be distributed to them to cover their additional taxes. However, the provision to pay the portion of the interest to the buyer is often unnecessary and may create an interest windfall for the buyer. Yes, the buyer may have to pay taxes on the interest so credited to the escrow account. But at the end of the escrow period, the buyer gets to take a tax deduction for the amount of the proceeds paid to the sellers. Therefore, in the end, while there may be a timing difference between when the income is taxable and when the distribution is deductible, the net tax to the buyer on escrow interest should be zero. To avoid this circumstance, buyers often invest escrows in non-interest bearing escrow accounts.

Merger parties should also consider when investment earnings become taxable. In most escrows, investment earnings are credited to the account on a monthly basis, and most bank systems assume that a taxable event has occurred at that time. The merger parties, however, may prefer to discuss with their tax advisors whether they can take the position that no taxable event has occurred at such time because the funds remain “locked up” under the terms of the escrow agreement. Therefore, the parties may assert that there has been no constructive receipt of funds by either party (or taxable event) until the escrow is distributed. If the parties wish to avoid this possible ambiguity on proper income recognition treatment, they should make it explicitly clear in the escrow agreement that tax reporting and withholding, if necessary, should only be done upon distribution and not when investment earnings are credited to the account. Alternatively, deal parties can use products that do not report investment earnings until the escrow period has ended or one that does not pay any interest at all.

Considering all the various and complex structures for M&A escrow investments, it is paramount to understand the tax effects of various escrow investment options and pick the one that fits the needs of the merger parties best. So don’t wait. Start the conversation with your tax advisor prior to engaging any escrow agent and selecting an investment option.

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