When a Penny Saved Costs More Than a Penny Earned

During the life of the post-closing period, most escrows are invested in short-term, highly liquid instruments like bank money market accounts or money market funds. At the end of the escrow period, assuming no claims are made, the balance of the escrow account is distributed to the selling shareholders plus of any investment earnings. So, 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 do I treat as capital gain and how much is recognized as ordinary income?

In this interest rate environment, it would be easy to say “not much”. Most escrows today are invested in accounts paying 0.25% or less and many pay no interest at all. But when it comes to the tax rules, it’s not necessarily that easy. Enter the world of imputed interest and OID – original interest discounts.

When the merger agreement includes a distribution of an escrow in a future tax year, that transaction is typically considered an installment sale. Further, unless the merger agreement calls for a specific rate of interest to be paid (which most don’t), the actual interest earned through the investment choice is irrelevant for determining taxable interest. Instead, the IRS requires the recipient to “impute” interest based on the IRS’ own determination of applicable federal rate (so-called AFRs). So while the escrow itself may be earning nothing, as of August 2009, the IRS determined that short-term AFR (for terms of less than three years) is actually 0.83%! This results in more of the escrow distribution being treated as investment earnings, which is subject to ordinary tax treatment, than if the investment earnings were based on actual interest earned. This is just another example why it’s important to understand the transaction structure of your particular merger and to seek expert tax advice.