Tax Advantages of a Leveraged Buyout

by Grant Houston
Leveraged buyouts can provide exceptional tax benefits when structured properly.

Leveraged buyouts can provide exceptional tax benefits when structured properly.

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Leveraged buyouts, or LBOs, were popularized in the 1980s by Michael Milken, of Drexel Burnham Lambert investment bank and were initiated in order to take public companies private. The leveraging process allowed smaller companies to obtain 90 percent of the capital required via bonds to buy out larger companies. This type of debt structure provides companies with tax advantages and other benefits, including quicker growth opportunities, increased market penetration, an enhanced customer base and improved economies of scale. When a leverage buyout is structured using an employee stock option plan, or ESOP, the company gets additional tax benefits.

Successful Buyout Factors

A successful LBO candidate will have certain characteristics that make the takeover target attractive. These include a positive balance sheet that provides access to capital, proven management that will continue operational management, a diverse customer base, market leadership and the potential to create cost reductions through synergies between the merged companies. A positive balance sheet will include such things as cash reserves or other tangible assets, including cash, securities, receivables and inventory.

Leveraged Buyout Tax Benefit

Leveraged buyouts create tax shields that, under the United States tax code, allow companies to deduct interest paid on debt as an expense, unlike dividends paid to equity shareholders, which cannot be expensed. For instance, a company that faces a large tax burden can benefit from increased debt financing because the interest is accounted for as an expense, which is tax deductible. Therefore, increasing interest expense results in a significantly lower tax obligation owed to the IRS.

Tax Benefits of ESOPs

ESOP-based leverage buyouts provide unique tax reduction opportunities. In an ESOP buyout, both the interest and principal repayment are deductible. Also, a private corporation can choose an S corporation tax status election, which shields the percentage of income owned by the ESOP from income taxation. Additionally, ESOPs that own 100 percent of the company stock, under the S corporation tax election, can avoid all federal income tax owed at both the corporate and individual shareholder level.

Other Benefits

If a company is a C corporation, any dividends used to pay ESOP benefits are tax deductible. Furthermore, leveraged buyouts of a privately-held company results in the ability of the sellers to defer capital gains taxes. Other benefits arise from leveraged buyout debt structures. For instance, the debt obligation is a non-recourse debt instrument under which investors can only recover losses from the acquired company if it goes bankrupt. The acquiring company assumes no debt responsibility and all investors are indemnified from loss.

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