PE Exit Tax Planning

The Typical PE Deal Structure

A typical middle-market PE acquisition is structured as a stock or LLC-interest purchase by a Newco entity formed by the sponsor. The sponsor's fund equity, the founder's rollover equity, and any third-party debt all flow into Newco's capital structure. Newco purchases the operating company, the founder receives mostly cash plus some Newco equity, and the deal is documented to maximize the buyer's basis step-up.

The standard architecture:

1. Sponsor forms Newco. The PE sponsor establishes a new acquisition vehicle, typically a Delaware LLC taxed as a partnership.
2. Sponsor contributes equity. The sponsor's fund contributes the agreed equity check (typically 35%–50% of the transaction value).
3. Lender provides debt. Acquisition lender provides senior debt (typically 40%–55% of transaction value) for the cash purchase price.
4. Founder rolls over equity. The founder contributes a portion of their selling equity (or sale proceeds, in some structures) to Newco in exchange for Newco equity. The rolled equity is typically structured to be tax-deferred under IRC § 351 (corporate Newco) or § 721 (LLC Newco).
5. Newco purchases the operating company. The deal closes with cash to the founder for the non-rolled portion and tax-deferred equity for the rolled portion.
6. MIU pool established. Newco's operating agreement allocates a pool of profits interests or MIUs to the management team going forward, typically 10%–20% of the Newco equity, structured to vest based on performance and time.

For S-corp or LLC targets, the F reorganization + LLC conversion structure (see our F reorganization attorney page) is often implemented pre-closing to deliver buyer-friendly asset-sale tax treatment. For C-corp targets with a corporate buyer, the §338(h)(10) election (see our 338(h)(10) election attorney page) is the standard tool.

The PE buyer's tax priorities — basis step-up, transaction cost deductibility, tax shield from debt-financed structure — drive most of the deal architecture. The founder's priorities — capital gain treatment, §1202 preservation if applicable, deferral of rollover equity, fair MIU structure — need to be advocated through deal negotiation. The two sets of priorities are not always aligned.

Rollover Equity — Tax-Deferred or Taxable?

Properly structured, the rollover-equity portion of a PE transaction is tax-deferred — the founder recognizes no gain on the rolled-over value at closing. Improperly structured, the rollover is fully taxable and the founder recognizes gain on the entire transaction price including the value of the rollover equity received.

The tax-deferral mechanisms:

• §351 rollover (corporate Newco). If Newco is a corporation and the founder contributes the rolled-over property in exchange for Newco stock, and the contributing group (the founder plus the sponsor) collectively owns at least 80% of Newco immediately after the exchange, the contribution qualifies under IRC § 351. The founder recognizes no gain on the rollover and takes a basis in the Newco stock equal to the basis in the contributed property.
• §721 rollover (LLC Newco taxed as partnership). If Newco is an LLC taxed as a partnership and the founder contributes property in exchange for an LLC interest, the contribution qualifies under IRC § 721 — no gain or loss recognized. The founder's basis in the LLC interest carries over from the contributed property.
• F reorganization rollover. When the deal structure includes an F reorganization of the target prior to sale, the rollover can be effected as a contribution to the same Newco that purchases the F-reorganized target's equity. The mechanics are slightly different but the tax-deferral result is the same.

The rollover-equity tax deferral is one of the most valuable features of a PE transaction. For a founder rolling over 30% of a $40M deal, the deferred gain is $12M — saving roughly $4M of federal and California tax that would otherwise be due at closing. That deferred tax becomes due eventually, but the time-value of the deferral plus the potential growth of the Newco equity often produces meaningfully better economics than direct sale.

Common failure modes that turn rollover into taxable:

• Founder receives cash for rollover instead of equity. Some deals structure the "rollover" as a contribution by the founder of cash sale proceeds to Newco. This breaks the §351/§721 mechanics — the founder has constructively received the cash, recognized the gain, and then made a separate (taxable) cash contribution.
• Boot issues. If the founder receives cash or other consideration in addition to Newco equity in the §351 contribution, gain is recognized up to the boot. Structuring rollover as part of a cash-plus-equity contribution requires careful boot management.
• Control failure. §351 requires the contributing group to own 80% of Newco immediately after the exchange. If the sponsor's structuring leaves the founder + sponsor with less than 80% (e.g., because of pre-existing third-party investors in Newco), §351 is unavailable and the rollover is taxable.
• Newco is not a "qualifying entity." Some Newco structures (REITs, RICs, certain holding companies) don't qualify for §351 nonrecognition or have additional restrictions.

§1202 in PE Transactions

For founders whose stock qualifies under IRC § 1202, the PE structure can preserve QSBS treatment on the cash-out portion if the deal is structured carefully. The rollover equity typically does not qualify for §1202 (because the rollover is into a Newco that is too large or structured as an LLC), but the cash-out portion can still capture the §1202 exclusion if the stock-sale character is preserved.

The §1202 considerations in PE deals:

• Cash-out portion. The founder's cash sale of stock to the buyer typically qualifies for §1202 if (a) the stock was QSBS at issuance, (b) the founder held it for more than 5 years, (c) the issuer met the gross-asset and active-business tests during the relevant periods, and (d) the sale is structured as a stock sale (not converted into an asset sale by §338(h)(10) election or F-reorg).
• §338(h)(10) trap. If the buyer makes a §338(h)(10) election, the cash-out portion of the founder's gain is recharacterized as gain on a deemed asset sale — not gain on stock sale. §1202 applies only to stock sales. The §338(h)(10) election effectively destroys §1202 treatment for the cash-out portion.
• F-reorg trap. Similar issue with F-reorg + LLC conversion. After the F-reorg, the founder owns Newco stock (which is QSBS-eligible if structured properly), but the sale to the PE buyer is documented as an LLC-interest sale — treated for tax purposes as a sale of underlying assets. §1202 doesn't apply.
• Rollover equity portion. The rollover into Newco LLC interests does not produce §1202-qualifying stock (LLC interests aren't stock). Rollover into Newco corporate stock might qualify if Newco itself meets the §1202 issuer requirements at the time — but Newco entities are typically too large or otherwise non-qualifying.

The negotiation strategy for §1202 founders in PE deals:

• Push for stock-sale documentation without §338(h)(10). The buyer's tax team will want §338(h)(10) for the buyer's basis step-up. The §1202 founder needs the deal documented as a pure stock sale (no election) to preserve the founder's §1202 exclusion. This is a real negotiation point with real value at stake — typically $1M+ per $10M of excluded QSBS gain.
• Gross-up negotiation. If the buyer insists on §338(h)(10) or F-reorg, the founder should negotiate a gross-up that compensates for the lost §1202 exclusion. The math: the buyer's tax savings from the basis step-up vs. the founder's lost §1202 savings. A founder leaving $2M of §1202 savings on the table should be paid at least that much in the gross-up.
• Partial stock sale + asset sale structure. Some deals split the consideration — pure stock sale for the §1202 portion (preserving the founder's exclusion), §338(h)(10) or asset structure for the non-QSBS portion (giving the buyer the basis step-up on the rest).
• Pre-deal stacking. If §1202 stacking trusts are not already in place, the time before LOI is the window for setting them up. See our QSBS stacking strategy guide.

Management Incentive Units and Profits Interests

Management Incentive Units (MIUs) — typically structured as profits interests in an LLC — are the standard PE compensation tool for the management team going forward. Properly structured, the MIU receives only future appreciation of the company (not current value), is taxed as long-term capital gain on eventual sale, and has no tax cost at grant under Rev. Proc. 93-27.

The profits-interest framework under Rev. Proc. 93-27 and Rev. Proc. 2001-43:

• Profits interest defined. An interest in an LLC (or partnership) that gives the holder a share of future profits and appreciation but no share of the existing capital. If the LLC were liquidated immediately after the grant, the profits-interest holder would receive nothing.
• No tax at grant. Under Rev. Proc. 93-27 (as modified by Rev. Proc. 2001-43), the grant of a properly-structured profits interest produces no taxable income to the recipient — because the recipient has received only a future-appreciation right with no current value.
• Long-term capital gain on sale. When the LLC is later sold (typically at the PE sponsor's next exit), the profits-interest holder's share is long-term capital gain — taxed at preferential rates (20% federal + 3.8% NIIT) rather than ordinary income.
• Vesting. Profits interests typically vest over time (commonly 4–5 years) and/or based on performance metrics (revenue growth, EBITDA targets). Forfeiture on departure before vesting is standard.
• §83(b) election (or not). Profits interests vesting on time typically do not require a §83(b) election under the Rev. Proc. 93-27 safe harbor, but many practitioners file protective §83(b) elections regardless to lock in the zero-value-at-grant characterization.

The MIU structure benefits both the PE sponsor (incentivizes management team to grow the business; recapture mechanism if executives leave) and the management team (significant upside potential at long-term capital gain rates, no current tax cost). For founders staying on as part of the management team after the PE sale, the MIU pool is typically a meaningful component of the total compensation package.

Pitfalls in MIU structuring:

• Profits-interest threshold value. The interest must be carefully structured so that, at grant, it has no liquidation value. If the company has accumulated value at the time of grant, the MIU must be a "carried-interest-style" interest in future appreciation only — not a flat percentage of total equity.
• Newco LLC structure required. Profits interests are partnership/LLC concepts. If Newco is a corporation, stock options or restricted stock are the alternative — both with different tax treatment.
• Vesting waterfall. The interaction of MIU vesting, time vesting, performance vesting, and acceleration on sale needs to be modeled. Bad MIU structures produce confusing or unfavorable outcomes at the next exit.
• 83(b) timing. If a §83(b) election is filed (or required), it must be filed within 30 days of the grant. Late filings are not curable.

Deal Structure Negotiation Points

Several deal terms have material tax consequences for the founder and should be negotiated before the LOI is signed. The LOI typically locks in the basic structure; post-LOI changes are difficult.

The key negotiation points:

• Stock sale vs. asset sale documentation. Stock sales preserve §1202; asset sales (or stock sales with §338(h)(10) election) destroy §1202. For §1202-eligible founders, this is the most important structural negotiation.
• Rollover equity percentage. The percentage of value rolled over vs. taken in cash. Higher rollover defers more tax but increases the founder's exposure to Newco's performance. Typical range is 20%–40%; lower rollover is more founder-friendly on cash but loses tax deferral.
• Rollover equity structure. Common equity, preferred equity, or some combination. Preferred equity has liquidation preference (more downside protection) but typically less upside. Common equity has more upside potential but bears more downside risk.
• Earn-out structure and tax treatment. Earn-outs based on post-closing performance create timing and character questions. Properly structured, earn-out payments are treated as additional purchase price (capital gain). Improperly structured, they can be recharacterized as compensation (ordinary income subject to employment tax).
• Escrow and indemnity holdbacks. Typical holdback is 5%–15% of purchase price for 12–24 months to cover indemnification claims. Holdback structure affects when the founder receives cash and when gain is recognized — typically gain is recognized at closing on the full purchase price including the holdback, with a refund mechanism if the holdback is paid out.
• Working capital adjustment. Adjustment to purchase price based on the target's working capital at closing relative to a target. The adjustment is treated as additional/reduced purchase price, not as compensation.
• Non-compete and consulting agreement. Allocations between non-compete consideration (typically ordinary income) and stock purchase consideration (typically capital gain) materially affect tax. Founders should push for capital-gain allocation; buyers often push for amortizable non-compete allocation (which deducts over 15 years for the buyer).
• §280G golden parachute issues. For executives in the target with change-in-control benefits, IRC § 280G can produce 20% excise tax and lost employer deduction. Pre-closing 280G analysis and shareholder approval procedures (for private companies) can mitigate this.

Most of these negotiation points have material tax dollar value. A founder going into LOI negotiation without tax counsel typically leaves substantial value on the table — both because they don't know what to ask for and because the buyer's tax team has already optimized the structure for the buyer's benefit.

Pre-LOI Tax Planning Timeline

The optimal time for PE-exit tax planning is 6–18 months before the LOI is signed. Structural changes (F reorganization, S-to-C conversion, QSBS stacking, residency planning) generally take months to implement and need to be in place before the buyer is identified.

The typical pre-LOI planning sequence:

1. 18+ months before LOI: Entity-structure analysis. Is the current entity (S-corp, LLC, C-corp) the right structure for the contemplated exit? Are there §1202 opportunities being missed? Should we do an S-to-C conversion now to start the §1202 clock?
2. 12 months before LOI: Implement major structural changes. F reorganization for S-corps planning to sell. LLC-to-C-corp conversion for QSBS planning. State redomestication if appropriate.
3. 9 months before LOI: Personal-level planning. QSBS stacking trusts if applicable. Residency planning if a state-change move is in scope. Estate-planning gift transfers to take advantage of pre-2026 exemption levels.
4. 6 months before LOI: Pre-LOI tax modeling. Run after-tax proceeds projections for the likely transaction structures. Identify the §338(h)(10) gross-up requirement. Model rollover equity scenarios.
5. 3 months before LOI: Investment banker engagement and process. Tax counsel coordinates with the I-banker on buyer pre-screening for tax-structure compatibility (e.g., screening out buyers who insist on §338(h)(10) for a §1202-eligible target).
6. At LOI: Tax counsel reviews the LOI for tax provisions — structure, rollover treatment, earn-out structure, indemnification mechanics, MIU treatment. Material tax issues are negotiated before signing.
7. LOI to closing (typically 60–120 days): Definitive agreement negotiation, with tax counsel coordinating on all tax sections, schedules, and election filings.
8. At closing: Election filings (§338(h)(10) on Form 8023, §83(b) for MIU recipients within 30 days, etc.).
9. Post-closing: Tax return planning for the year of sale, allocation reporting on Form 8883, addressing any post-closing adjustments.

The most common failure mode in PE-exit tax planning is starting too late. A founder who first engages tax counsel after the LOI is signed has already locked in many of the consequential decisions. The pre-LOI window is where most of the value is created.