A Tax Indemnity policy, as the name would imply, protects parties to a transaction against losses arising from breaches of tax representations as well as other transactional tax exposures. Examples include restatements of earnings resulting in changes to prior year taxable income, and adverse IRS determinations with respect to the amortization of goodwill, depreciation schedules, deductibility of interest/dividends on "hybrid" securities, etc.

One additional exposure arises from a procedure very common in private equity transactions, the Section 338(h)(10) election. In certain situations, Section 338(h)(10) of the Internal Revenue Code permits a stock sale to be treated as an asset sale for tax purposes. The main advantages of a Section 338(h)(10) election include:

• For legal purposes, the sale is treated as a stock sale, resulting in ease of execution and a limitation on the seller's exposure to liabilities.
• The purchaser may receive a stepped-up basis in the target's assets, resulting in greater tax deductions and reduced taxes in the future.
• The seller should expect to receive higher after-tax proceeds than in a stock sale without the election as a result of the economic benefit of a stepped-up basis to the purchaser.

There are, however, a number of conditions that must be met in order to qualify for the election. Further, the filings associated with the election, most notably the Form 8023, must be completed accurately, signed by both the buyer and the seller, and filed within certain timeframes. Should all of the conditions not be met or procedures not followed precisely, the IRS could, in the future, determine this to be a "bad election," and reverse the previous and future expected tax benefits (plus interest and penalties, of course). A Tax Indemnity policy would provide protection against such a ruling.

The following is a summary of selected terms, conditions, and characteristics of Tax Indemnity policies:

• Coverage term - Intended to match the survival period of a tax representation in a sale (3-5 years), though we have seen examples of coverage periods up as long as 13 years.
• Premiums - Approximately 3-8% of the total coverage sought, depending upon the situation (e.g., known issues, reputable tax preparer, etc.)
• Deductibles - There is often no deductible associated with this type of policy. Depending on the carrier, there can be a deductible on top of the basket aggregate associated with the deal.
• Due Diligence Fees - Carriers will charge an up front due diligence fee of approximately $25,000 to $75,000, depending on the complexity of the situation. This fee covers the costs to retain outside tax counsel as part of the underwriting process.
• Exclusions - Losses associated with fraudulent, criminal or dishonest acts; changes in law (other than retrospective); and alternative minimum taxes due, are all excluded.
• Limits of Liability - Limits sought are usually based on the amount of tax representation indemnification provided in the deal or the total value of tax benefits resulting from a Section 338(h)(10) election.
• Timing - With proper deal related and tax filing documentation, the underwriting process can usually be completed in less than two weeks