Beyond the Rollover Percentage - Tax Decisions That Drive the Deal

Private Equity and Law Firms

The Law Firm MSO Playbook

Article 5

Beyond the Rollover Percentage —Tax Decisions That Drive the Deal

The commercial terms may be agreed. The tax structure is not. This is the fifth article in Messerli Kramer’s series, “Private Equity and Law Firms: The Law Firm MSO Playbook.”

A law firm and private equity sponsor have agreed on the basic economics. The sponsor will acquire the administrative platform for cash, and existing owners will “roll” a portion of their value into the buyer’s parent company. The parties expect the rollover to be tax deferred. That expectation can change with the property transferred, the entity classifications, and the sequence of steps.

But the owners do not currently hold a separate MSO. The law firm owns the technology, employs the administrative personnel, maintains the vendor agreements, and operates the business. Before the sale can occur, the parties must determine which assets will move to the MSO, who owns them for tax purposes, what will be sold for cash, what will be contributed for equity, and which owners will receive rollover interests.

The tax result will not be determined by the percentage labeled “rollover.” It will depend on the property transferred, the tax classifications of the entities involved, the order of the steps, the liabilities assumed, and the economic rights ultimately received. The label is commercial shorthand, not a tax method.

The starting structure determines the available paths

A law-firm MSO transaction does not begin with a blank sheet of paper. The existing entities, tax classifications, ownership, assets, liabilities, and operating history determine which paths are available.

The law firm may be taxed as a partnership, S corporation, C corporation, or disregarded entity. It may operate through multiple professional entities or affiliates. Individual owners may hold assets used by the firm. The contemplated MSO may be a corporation or partnership for tax purposes, and the sponsor may acquire it through a multicompany holding structure.

Those classifications shape the alternatives before the parties choose the deal form. A rollover is a commercial result, not a single tax technique. It may involve a contribution to a partnership, an exchange for corporate stock, retention of existing equity, a sale followed by an investment, or a coordinated series of transactions.

Section 721 generally provides nonrecognition when property is contributed to a partnership in exchange for a partnership interest. Section 351 may provide nonrecognition for a transfer of property to a corporation in exchange for stock when the applicable control requirements are satisfied. The existence of one of those provisions does not make it applicable. The transaction must identify the property transferred, its owner, the interest received, other consideration, liabilities, and the relationship among the steps.

An LOI promising a “30 percent tax-deferred rollover” can promise a result before the parties know whether the sellers hold property capable of being rolled tax efficiently into the intended acquisition entity.

Build the asset that will be sold

The pre-closing separation can generate tax independently of the sale. Equipment, software, intellectual property, contracts, prepaid items, and other assets may need to move from the professional entity or its owners to the MSO. Some assets may be licensed rather than transferred. Employees may change employers, and liabilities may remain with one entity or accompany property. Each movement can affect tax before the private equity closing.

Each step carries its own tax character. An appreciated asset transferred through a taxable sale can generate gain before private equity acquires anything. A corporate distribution can produce consequences at the corporate and shareholder levels. A partnership distribution or contribution can change outside basis, capital accounts, and partner-level gain. A license may produce a continuing income stream rather than sale treatment.

Before choosing the transfer mechanism, the parties must identify the owner, basis, fair-market value, and associated liabilities for each material asset.

Sequencing can change the result. If the law firm transfers technology to a lawyer-owned MSO and the MSO later sells the technology to private equity, the seller and basis consequences may differ from a direct sale by the law firm. If the owners contribute the MSO equity to a holding partnership, the availability of nonrecognition depends on what they own at that moment and what they receive.  The restructuring and buyer-facing transaction must be modeled together. Optimizing one stage without accounting for the other can create tax where the parties expected deferral.

Equity in the buyer does not make the rollover tax deferred as a seller can finish the transaction owning buyer equity and still have made a fully taxable sale. The tax result turns on the steps, not the label attached to the equity. If the buyer pays cash for all of the seller’s property and the seller uses a portion of the proceeds to purchase an interest in the acquiring entity, the seller may have made a taxable sale followed by a new investment. Calling the reinvestment a rollover does not change the sequence.

A nonrecognition rollover usually requires a qualifying contribution or exchange. In a partnership structure, this may mean contributing property in exchange for a partnership interest under Section 721. In a corporate structure, Section 351 may be relevant if its control and other requirements are met.

The contribution must be examined in relation to the cash sale. What property is being contributed? Who owns it? Would the contribution occur without the cash transaction? Does the seller receive cash or a related distribution? Are the steps part of one integrated exchange?

The acquirer’s tax objectives matter as well. Private equity may seek a basis step-up for acquired assets but a tax-deferred contribution may preserve carryover basis on the rolled portion. As a result, the sponsor and rollover owners may have competing interests concerning recognition of current gain and future deductions. Therefore, the term sheet must not treat the tax result as a footnote to the rollover percentage.

Cash and debt can recharacterize the rollover

A partnership contribution becomes more complex when the contributor receives cash as part of the same overall transaction.

The disguised-sale rules under Section 707 may treat formally separate contributions and distributions as a sale when their facts and timing show an integrated exchange. Receipt of partnership units does not prevent sale treatment if the contributor effectively receives cash for the property transferred. The disguised-sale regs under Section 707 provide the operative rules, and transfers occurring within two years are presumed to be part of a sale absent facts establishing otherwise.

Debt can produce similar complications. If property is contributed subject to liabilities, the resulting liability shifts can affect outside basis. If the partnership borrows and distributes proceeds, the distribution may interact with disguised-sale rules or produce gain if it exceeds basis. A decrease in a partner’s share of partnership liabilities may be treated as a distribution of money.

These rules prevent the parties from analyzing the rollover, cash purchase, debt financing, and post-closing distributions independently. Any model should analyze the cash and property moving at each step, the tax basis before and after the movement, and the allocation of liabilities. A transaction that works from a deal perspective can produce unanticipated tax results when the debt shifts are included.

Basis benefits are deal economics

Tax deferral for sellers may reduce the buyer’s basis step-up. A buyer generally values additional basis because it can support future depreciation and amortization. Property received in a nonrecognition contribution may carry over its historic basis, while assets purchased for cash may receive a new cost basis. The parties must quantify the tradeoff. A seller’s tax deferral has value, and the buyer’s lost deductions have a cost. The purchase price, rollover amount, and asset allocation may need to reflect that difference.

The character of the assets also matters. Receivables, work in process, equipment, covenants, technology, contractual rights, and goodwill may carry different tax treatment. A law firm using the cash method may hold economic value in uncollected receivables or work not yet included in taxable income. The sale or allocation of those items may produce results different from the sale of goodwill, technology, or depreciable property.

Goodwill affects these economics, but Article 2 addressed the threshold question of whether goodwill associated with the law firm or its lawyers can be owned by or transferred to the MSO. Because lawyer noncompete restrictions may limit the conventional means of transferring personal goodwill, the transaction may instead rely on other identifiable intangibles and contractual rights, such as technology, brand or naming rights, non-solicitation provisions, exclusivity commitments, name-image-and-likeness rights, service obligations, and rights under the MSA. The tax model should identify which of those assets and rights are actually transferred, licensed, or created rather than assume that all value associated with the law firm or its lawyers is transferable goodwill.

Once that transaction perimeter is established, the form of transfer determines the basis consequences. Intangibles purchased for cash may generate amortizable basis under Section 197 if they constitute amortizable Section 197 intangibles, while property contributed in a qualifying nonrecognition transaction generally retains its historic tax basis. A contribution of appreciated goodwill or other intangible property may also create book-tax differences that must be reflected in capital accounts and addressed under Section 704(c). The parties must therefore identify each transferred intangible, determine its owner and tax basis, support its fair-market value, and distinguish a transfer of ownership from a license, service commitment, or contractual payment right.

The transaction must distinguish enterprise value from tax basis. A high-value MSO may hold assets and contractual rights with limited historic basis, making the buyer’s step-up especially important. Conversely, sellers may place greater value on deferral when transferred goodwill or other intangibles have substantial built-in gain. The parties should model those consequences using a supportable allocation of the value actually acquired because a purchase-price allocation cannot create ownership or tax basis in goodwill or another intangible that was not transferred. These issues must be negotiated as part of the deal economics, not resolved solely through the purchase-price allocation after closing.

A rollover percentage does not describe partnership economics

If the post-closing parent is taxed as a partnership, the owners’ tax position depends on much more than their stated equity percentage. For example, a 20 percent rollover interest may be junior to a sponsor’s preferred return, subject to a catch-up, diluted by incentive equity, and entitled to distributions only after debt repayment or return of invested capital. The actual economics depend on the waterfall and liquidation rights.

Tax allocations must support those economics. Section 704(b) capital-account principles seek to align allocations with the partners’ economic arrangement. Section 704(c) addresses built-in gain or loss when contributed property has a basis different from its fair-market value. Assume the law-firm owners contribute appreciated MSO property while the sponsor contributes cash. The owners may receive 20 percent of the post-closing equity, but pre-contribution appreciation generally must remain associated with them under Section 704(c). The selected method can affect when, and in what amount, that built-in tax is recognized.

Future depreciation and amortization may therefore be allocated differently for book and tax purposes. The buyer may obtain deductions attributable to purchased assets while contributed assets retain historic basis and create Section 704(c) layers.

The operating agreement must coordinate capital accounts, Section 704(c), the preferred return, waterfall, tax distributions, dilution, and liability allocations. A commercially viable waterfall paired with generic tax-allocation language can create unexpected results. Detailed tax provisions that do not reflect the agreed economics are equally problematic. The tax exhibit must not be the last document delivered after the business terms are final as it is a key part of the economic agreement.

Tax distributions may not match the tax

Rollover owners accustomed to law-firm partnership distributions may assume the MSO parent will distribute enough cash to pay their resulting taxes. That assumption can be wrong and must be tested against the operating agreement. A tax-distribution provision commonly uses an assumed tax rate. It may not account for each owner’s state of residence, other income, deduction limitations, tax attributes, or actual character of allocated income. Distributions may be subject to lender restrictions, available cash, reserves, or board discretion. They may also reduce future distributions under the waterfall.

Section 704(c) allocations and special items can further separate taxable income from cash economics. One owner may receive more taxable gain because of contributed-property history without receiving a proportionate distribution.

These differences may be acceptable, but rollover owners must understand them before agreeing that a stated percentage of consideration will remain invested. Deferral at closing postpones tax on the qualifying contribution but it does not make later allocations tax free or guarantee that distributions will match an owner’s individual tax liability.

Equity incentives add another layer after closing

Private equity may expect to use MSO equity to retain senior lawyers, reward younger partners, and incentivize professional management, and what form of incentive provided matters.

A capital interest generally conveys existing liquidation value and may produce current compensation income. A qualifying profits interest generally participates only in future growth and may receive favorable treatment if the applicable requirements are satisfied. Rev. Proc. 93-27 and Rev. Proc. 2001-43 provide the framework under which a qualifying profits interest is not treated as a taxable event at grant, provided it does not relate to a substantially certain and predictable stream of income, is not disposed of within two years, and is not an interest in a publicly traded partnership. Options, phantom equity, and cash-based incentives produce different consequences.

Vesting adds another layer. A recipient may need to consider a Section 83(b) election when receiving a substantially nonvested interest. The tax consequences of making or not making the election depend on value, forfeiture risk, and future appreciation.

A person treated as a partner generally is not treated as an employee of that same partnership for federal tax purposes. That can affect withholding, estimated taxes, benefits, payroll reporting, and tax distributions.

The law-firm MSO structure can separate where services are performed from where equity is granted. A lawyer may provide professional services to the law firm while receiving equity in the MSO parent, resulting in the lawyer receiving W-2 wages and able to participate in certain benefit plans even though a partner in the MSO.  The documents must explain which services support the award and how continued employment, professional ownership, departure, and vesting interact.

An incentive pool also dilutes rollover owners. Its size and placement in the waterfall must be modeled when rollover economics are negotiated, not left for post-closing implementation.

The documents must tell the same tax story

The restructuring agreement, asset purchase agreement, contribution documents, MSA, operating agreement, purchase-price allocation, financial model, and tax reporting must tell one consistent story.

If the rollover is a contribution, the documents must identify the property and contributor. If the buyer receives basis step-up on some assets and carryover basis on others, the model must show both. If the MSO owns particular technology or intangible property, the transfer documents must establish that ownership.

As discussed in Article 4, the management fee must fit the transaction as well. If the financial model assumes a particular fee to support the purchase price, the MSA and tax analysis must support the services and pricing. Similarly, if the law firm retains significant professional assets and risks, its post-closing income must reflect those functions.

Tax planning is most effective when it shapes the transaction rather than validates it after the commercial structure is fixed. A rollover, asset separation, management fee, and partnership waterfall can each be technically defensible in isolation and still fail to operate coherently as one transaction.

Contact Messerli Kramer

A tax structure can be technically elegant and still leave the parties with unpriced exposure if the rollover, basis, fee, and ownership documents do not align. Messerli Kramer works with law firms, private equity sponsors, family offices, accountants to model the restructuring and the continuing tax relationship between the law firm and MSO. Modeling the steps, basis, allocations, tax distributions, and incentive equity early is the prudent way to avoid discovering after closing that the commercial bargain and tax outcome diverge.

Contact Michael Britten to test the tax structure of a proposed law-firm MSO transaction before the term sheet hardens the result.

This article is intended for general informational purposes and does not constitute legal or tax advice. Applicable ownership, fee-sharing, professional-responsibility, and tax requirements vary by jurisdiction and depend on the specific facts and structure. Reading this article does not create an attorney-client relationship.