5 Management Buyout Tax Implications to Consider

If you’re acquiring or selling a business through a management buyout (MBO), there’s a lot to consider. From structuring the deal to changing positions and compensation, you’ll have seemingly endless details to work out. One of the most important aspects of the deal that may go overlooked is the management buyout tax implications. Without careful planning, unexpected taxes have the potential to throw a wrench into any MBO transaction.

What is a management buyout?

A management buyout is a type of acquisition in which the managers of a company purchase all or part of a business from its current owners. In most cases, the management team works with an external financial sponsor to secure debt financing and equity capital to fund the purchase and support further growth.

How is a management buyout structured?

The typical management buyout model involves the management team putting up a relatively small amount of equity capital and obtaining substantial debt financing from external sources. This is known as a leveraged management buyout. The debt ratio of these types of transitions can vary depending on the situation, but it can reach up to 90%, which can significantly increase the risk of the investment.

Financing for MBOs can be provided from a variety of sources, including traditional banks, mezzanine debt providers, and private equity funds. The management team must demonstrate the ability to repay the debt it agrees to borrow and have realistic plans for future growth in order to secure this financing.

How is the management team involved?

The management team obviously plays an important role in management buyouts. They typically need to actively participate in the negotiations and provide industry and market knowledge during due diligence. The management team will continue to operate the company after closing, so they are also responsible for developing a robust business plan, which outlines how the company will be operated and grow after the MBO is complete.

5 tax implications to consider

The tax implications of a management buyout structure must be taken into account when planning the deal. In addition, the structure of the business itself will affect how taxes are handled; limited liability companies (LLCs), partnerships, S-corporations, and C-corporations all have different tax implications. 

The taxes on an MBO deal will also vary depending on the financing structure of the deal. For example, the tax implications for an all-cash deal will likely be quite different from a scenario where the buyer receives seller financing, where payments are made over time to the seller.

Here are common tax implications to consider for both seller and buyer:

Tax issues for seller

Capital gains tax

Capital gains tax is payable by the seller on profits from the sale of shares or assets. These taxes are in addition to income tax and are dependent on the seller’s tax bracket. It is important to understand the different types of capital gains taxes, such as short-term capital gains and long-term capital gains, so that you can structure your deal for maximum efficiency. In addition, there may be tax advantages to creative deal structures, such as offering seller financing or earnouts that could delay or decrease taxes owed by the seller. (Learn more about taxes on selling a business.)

Depreciation recapture

Depreciation recapture is a gain that is taxed when the value of an asset has been reduced for tax purposes over time but then sold at a higher price. In an MBO, like any sale, the seller may be liable for taxes on that amount due to depreciation recapture at the sale.

Tax issues for management team

Employment taxes

A buyer will have to consider the potential employment tax implications of a management buyout. For example, all employees of the business have associated taxes. If a large hiring spree was part of management’s growth plan, they would be liable for increased payroll taxes, such as social security and Medicare.

Tangible assets

When a company purchases another business’s tangible assets, also known as business personal property, such as machines and equipment, the buyer may incur ad valorem taxes depending on where those items are located.

Corporate tax

The company purchasing the business will pay corporate taxes on profits generated from the buyout, which will vary depending on the structure of the business itself. 

©alfexe via Canva.com

Minimizing the seller’s tax burden in a management buyout

Thankfully, the IRS rules offer some ability to potentially reduce or eliminate some of the tax implications for the seller in an MBO. For example: 

• Installment sale agreements, earnouts, and seller financing can all potentially reduce or delay capital gains taxes by causing sellers to pay taxes on smaller sums of money over an extended period of time.
• ESOP (employee stock ownership plan) based buyouts may provide tax reduction opportunities. Depending on the structure of the business (S-corporation vs. C-corporation), the capital gain tax due as a result of a sale to an ESOP may be deferred, or the percentage of the business owned by the ESOP may not be subject to federal or state income tax.
• Traditional estate transfer techniques, such as various trusts and family planning approaches, may still be taken before exercising a management buyout. These steps may be used to defer or reduce taxes due upon the sale of the business.

Tax benefits of a leveraged management buyout

Leveraged buyouts can offer valuable tax relief compared with other types of buyouts. Interest paid on debt may qualify for a corporate expense deduction when compared to dividends given to equity shareholders, which cannot be deducted. The increased interest expense results in lower corporate profits and, therefore, lower tax due.

Tax planning is an essential component of any MBO and should be carefully considered to ensure the maximum financial benefit for all involved parties. 

Key takeaways

Management buyouts can be a great option for companies looking to sell, restructure, or expand under a skilled team with a keen interest and familiarity with the business. However, the tax implications of these transactions should not be overlooked, as they may have far-reaching effects on both parties. It is essential to consult with an experienced tax professional before entering into any MBO agreement in order to ensure that all potential tax liabilities have been properly considered and addressed.