Will Hidden Taxes Derail your Succession Plan?

A new client asked us to help administer their new management buyout plan crafted by very qualified attorneys. Our review shocked her. I pointed out that her management buyout (“MBO”) plan directs 60% of succession capital to the IRS and only leaves 40% for her. Unfortunately this outcome is all too common.

The Good, Bad and Ugly of the Management Buyout

The management buyout (“MBO”) can be the ultimate emotional reward for the owner since it enables and perpetuates the company’s leadership, customers, and culture. This owner/founder characterized her particular MBO plan as elegant, motivating and fair.

However, the tax bite of a traditional MBO can threaten capital succession – leaving a forced sale or liquidation as the default succession pathway.

Let’s follow the money, especially the taxes with the typical management buyout in Virginia.  Executives buy the founder stock with after-tax profits from the company. For every $10M of pass-thru profits, the executive owners pay Federal & State taxes of approximately 45%, or $4.5M, leaving $5.5M available to pay the founder. The founder then pays 25% (roughly $1.5M) Federal & State capital gain tax on the sale proceeds. The founder ends up with $4M.

So for every $10M in profits, the IRS gets $6M and the founder keeps $4M. Ouch!

Avoiding the Tax Bite of the Plain-Vanilla Management Buyout

Luckily, the IRS gives us tools to reduce or eliminate the hidden tax drag of succession. Consider:

  • Restricted stock with 83(b) elections that may enable owner exchange at deep discounts (assuming proper planning).
  • Profits interest in an LLC enabling tax-free grant of equity upside value to execs.
  • Qualified profit sharing plans that can be used as tax-deferred buy-out capital.
  • ESOP elections that may permit tax deferred, or even tax free, buy-out of the founder.

When designing a succession plan, do your due diligence first. You would never buy a company without doing due diligence. Why in the world would you ever sell your company without the same diligence?

Do you have hidden surprises in your executive compensation, capital structure, succession and legacy plans? Please call us for a 2nd Opinion.

Please contact us to learn more.

A form with the question: Have you fallen into a tax trap along with boxes for yes and no.