What is tax indemnification agreement. Consequences?

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Sometimes a person or a business will compensation another for paying the tax liability of the former. An agreement for this arrangement is called a tax indemnification agreement. As an example, Company #1 compensates Company #2 for the taxes that were levied against Company #2. Company #1 might do this because the two companies have business activities together (e.g., one company may sell the products of the other). What is the tax treatment to Company #2 when it is compensated by Company #1—when it receives a tax indemnity payment?

The general rule for tax indemnity payments is that payments of a taxpayer’s tax liability, whether direct or indirect, is taxable as income to the recipient under Treas. Reg. Section 1.61-14(a). However, there are two exceptions to this.

First, that part of a tax indemnity payment is not included in gross income where the taxpayer pays more in federal income taxes than he would have due solely to the actions of a third party; this is because the payment only restores the taxpayer to the position he would have been in had it not been for the third party’s actions.

Second, certain reimbursements is not includable in gross income. In particular, where a return preparer makes a mistake and reimburses a client for any resulting additional taxes or penalties paid by the taxpayer, the reimbursement is not includable in gross income. Clark v. Commissioner, 40 BTA 333, 1939. As a planning matter, it is always advisable to have the client pay the tax first and then receive reimbursement from the return preparer to avoid inclusion in income. This is because if the return preparer initially pays the additional taxes or penalties incurred by the client, then that payment is taxable income to the client under Treas. Reg. 1.61-14(a). See Also Ltr. Rul 7749029.

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