Once an expense fund has been created, the parties have to determine where to hold it. The most common options are to either hold it with an escrow bank or in an account controlled by the shareholder representative. There are pros and cons to each. If it is held with an escrow bank, the parties will typically need a separate agreement to document the arrangement, which adds slightly to the deal’s complexity. Additionally, banks will often charge fees to establish and maintain such an account, but may provide the parties the opportunity to earn some interest.
If the account is held by the shareholder representative, the arrangement is typically simpler. If this is done, however, ensure that the account is properly established. The money should be set up in client funds accounts that are not co-mingled with the representative’s own assets. In addition, the account should be titled as a fiduciary account. At SRS Acquiom, accounts are titled as “Shareholder Representative Services FBO Clients”. If done properly, the shareholders should also be protected against any risks of bankruptcy or insolvency of the representative, and increased FDIC insurance coverage may be available.
For expense funds held by an escrow bank, the stockholders will want to ensure that a few terms are included in the applicable escrow agreement. First the money should be released solely on the instructions of the representative without requiring any consent or input from the buyer. The expense fund is a set aside of stockholder money, and the buyer should not have anything to do with when or how it is spent. Second, the stockholders will want to make clear that the buyer does not receive any reports or updates regarding the balance in the expense fund. If the parties are in a dispute, neither side will want the other to know what resources they have available to pursue the matter.
When establishing the expense fund, shareholders should consider its tax treatment. In many cases, the shareholders would prefer the expense fund to be considered as part of an installment sale and only taxable upon ultimate receipt. The simplest way for this to occur is for the shareholder representative to forward any remaining expense funds to the buyer’s paying agent at the end of the transaction.
Taking advantage of installment tax treatment for expense funds might not be desirable or available in all deals. For instance, the buyer might not want to be involved with any of the necessary release logistics. This often occurs when there is a buyer hold-back rather than an escrow or where indemnification is limited to milestone payments. If installment sale treatment is not utilized, the expense fund will be deemed distributed by the buyer to the shareholders at closing. Selling shareholders should be aware that, in this situation, the buyer (or its paying agent) may issue a Form 1099-B that includes the expense fund amount despite the shareholders not receiving those funds. Because expense funds will continue to be at risk until released, selling shareholders should consult their tax advisors as to the appropriate tax treatment of such amounts.
When establishing an expense fund with an escrow bank, the shareholder representative is typically required to provide its own taxpayer ID. While any investment earnings belong to the shareholder beneficiaries and not the shareholder representative, the escrow bank will report such earnings to tax authorities under the taxpayer ID of the shareholder representative. In order to avoid paying taxes on income that does not belong to it or having unreported income generating a tax audit, the shareholder representative should treat such earnings on a “nominee” basis. Some escrow banks may honor such treatment and issue 1099s to each of the beneficiary shareholders rather than to the shareholder representative. Typically this status can be selected by properly filling out a W-9 tax form when the account is established. If the shareholder representative does receive a 1099 reporting such income under its taxpayer ID, it should report such income on its tax return as nominee earnings and show a deduction for that portion that does not belong to it. In addition, it should issue 1099s to each shareholder beneficiary to whom such earnings properly belong, which can be a substantial and tedious project.