In most private-target M&A transactions, a portion of the purchase price (typically 10%) is held in escrow for a period of time. One question that arises is who receives any interest income earned when the escrow is invested? And, secondly, how is that interest income reported to the IRS?

The escrow agreement typically contains a provision regarding the investment of the escrow fund. One or both of the Buyer and Sellers must make the decision as to whether the funds are invested and in what type of investment vehicle, based on their investment objectives. The investment objectives that drive the Buyer’s decision are preventing any risk of loss of principal and providing liquidity whenever required under the Merger Agreement, while receiving the best yield possible. If the investment that is selected generates interest income, this income is credited to the escrow funds and retained until the escrow agent disburses it. This is where the issue becomes murky – who should receive an interest payment and how is that interest payment reported to the IRS?

This investment provision in the escrow agreement should describe exactly who will receive the benefit of any interest income earned on the escrow funds. Generally, to keep it relatively simple, the Buyer will be the designated the owner of the escrow account and any interest earned will be reported as income to the Buyer, regardless of whether the Buyer actually receives any payment of this interest income. This, we will call, the “majority approach.” In effect, the escrow agent will post the interest income earned to the escrow account and will report 100% of those earnings to the IRS as taxable income assigned to the Buyer. The Buyer then reports this interest income on its fiscal year-end tax return and pays the appropriate taxes related to these earnings. Typically, in the provision, the tax rate is estimated at 40%. Consequently, when the funds are distributed, the escrow agent will pay the Buyer 40% of the interest, to cover the taxes paid on the full amount earned, and the Sellers will receive their pro-rata share of the remaining 60% of the interest.

For example, if there is total interest earned of $1,000 on the escrow funds in the tax year ended 2018, the escrow agent will report interest income on an IRS Form 1099-INT of $1,000 to the Buyer. The Buyer will report and pay tax in essence of $400 on this $1,000 as part of its 2018 taxes, even though the Buyer did not receive any payment of interest. Assuming the escrow funds, along with the interest earned, are distributed to the applicable parties under the escrow agreement in 2019, the Buyer will then receive a payment of $400, basically, negating the taxes paid, and each Seller will receive a payment of its pro-rata share of the $600, but the Seller will not owe tax on this amount. Taxes have already been accounted for and paid by the Buyer. Therefore, a Seller will receive a payment of a larger amount than what is reported on the Form 1099-B Gross Proceeds by the amount of interest paid.

This majority approach is only one of several methods that we have seen over the thousands of escrows we manage. In lieu of this approach, the parties to the escrow agreement can choose to eliminate this complication by electing a non-interest-bearing escrow account, but it would then appear that both parties lose in this situation because a large portion of the purchase price is being held without earnings potential. Clear on the other side, the Buyer could elect to allocate the ownership of the escrow fund to the Seller for purposes of taxes. This would require that the escrow agent to account for interest down to each Seller’s pro-rata share and then upon payment of both the escrow amount and interest earned, provide 2 tax reporting forms: 1) Form 1099-B for the gross proceeds received, and 2) Form 1099-INT for the interest amount received. This method is time consuming, cumbersome, and expensive for the escrow agent.

Recently we have encountered questions about the majority approach and whether the tax reporting is correct. Recall that, under this approach, the escrow agent is making a payment to the Sellers for the remaining 60% of interest earned along with the gross proceeds amount, but only reporting the principal on a Form 1099-B, so that the total amount Sellers received upon distribution does not reconcile to the Sellers’ tax reporting amount. However, we do not see a concern with this approach because the interest income was reported to the Buyer in the year in which it was earned, and tax was already paid by the Buyer. In our view, as long as a party to the transaction paid tax on these earnings (in this case the Buyer), all is accounted for.

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