MSOs as a Solution for Unfunded Liabilities

How Management Services Organizations create a tax-efficient capital platform to fund deferred compensation, executive benefits, and succession obligations.

Introduction

Every business makes promises — compensation for future performance, leadership retention, post-sale consulting income, or retirement payouts. But without a solid funding mechanism behind them, these promises can quickly turn into liabilities. Deferred compensation, phantom equity, earn-outs, and retirement bonuses often remain untracked or underfunded until the moment they’re triggered. That’s when the damage becomes real — to cash flow, enterprise value, and the seller’s personal balance sheet.

This is where a Management Services Organization (MSO) becomes more than a tax strategy. It becomes a strategic capital engine, creating liquidity to match obligations — and reducing the risk that unfunded liabilities compromise your legacy, succession, or transaction.

At Guardian Tax Consultants, we work with founders and business owners to fund these commitments intentionally — by combining MSOs with tools like corporate-owned life insurance (COLI) and nonqualified deferred compensation plans (DCPs). Done correctly, this turns business promises into business strength.

The Problem: Unfunded Liabilities

Unfunded liabilities are promises a business makes — but hasn’t secured the capital to fulfill. They often show up in:

• Deferred compensation agreements
• Executive retirement or severance payouts
• Phantom equity and retention bonuses
• Earn-outs or buyout obligations
• Consulting income or family succession support

These liabilities aren’t just bookkeeping issues — they represent future cash demands that may surface at precisely the wrong time: during a sale, merger, or generational handoff. They reduce buyer confidence, increase the need for seller indemnification, and often reduce the final enterprise valuation.

And if the business is structured as a pass-through entity (e.g., S-Corp or partnership), there’s no efficient way to build tax-deferred reserves. Income flows through to the owner’s 1040, where it’s taxed — regardless of whether it’s withdrawn. So many owners resort to hope: promising payouts, but lacking the liquid assets to deliver.

🧮 The Power of Tax-Efficient Cash Accumulation in the MSO

One of the biggest challenges for pass-through entities is the inability to retain capital tax-efficiently. Every dollar of profit must be reported on the owner’s individual tax return, often taxed at the top marginal rate of 37% — even if that cash remains in the business.

This creates a structural problem: it’s nearly impossible to accumulate reserves for future obligations without eroding your personal cash flow. And so, promises like deferred compensation or exit bonuses often go unfunded.

The solution? Structure an MSO as a C-Corporation.

A C-Corp MSO allows profits to be retained and taxed at just 21% federally. That’s a 44% reduction in federal tax per dollar retained compared to individual taxation. Over time, the difference is transformative.

🔹 Example:
A business retains $1 million annually. In a pass-through structure, $370,000+ is lost to taxes. But in a C-Corp MSO, only $210,000 is paid in corporate tax — leaving $790,000 of usable cash. Over five years, this creates nearly $4 million in reserves that can be allocated toward future liabilities, bonuses, or succession payouts.

And when paired with COLI (corporate-owned life insurance), this reserve becomes self-liquidating, growing tax-deferred and providing both cash value and death benefit protection.

⚠️ The Cost of Unfunded Liabilities at Sale

The consequences of unfunded liabilities are most severe during M&A or succession planning. When buyers conduct due diligence and discover unfunded promises:

• They discount the valuation to reflect future risk
• They may demand escrow or indemnification to protect against exposure
• Financing terms, earn-outs, or seller notes may be rescinded
• Post-closing litigation risk increases dramatically

Even worse, sellers may remain personally liable. We’ve seen cases where bonuses promised to executives had no backing assets — and after the sale, the seller had to cover payouts from personal wealth.

A properly funded MSO avoids this scenario by:

• Holding allocated reserves on the books
• Documenting formal DCP structures with triggers and timelines
• Owning COLI policies to back benefit obligations
• Housing the risk outside the operating entity and seller’s estate

This model improves transparency, maintains continuity, and supports maximum enterprise value.

Why MSOs Are the Ideal Funding Structure

Here’s how a properly structured MSO solves the funding problem:

✅ 1. Tax-Efficient Capital Retention

As noted above, the MSO retains capital at a flat 21% tax rate — preserving more usable cash to fund future obligations than any pass-through entity can provide. This cash becomes your reserve for obligations like:

• Executive compensation
• Succession packages
• Retirement transitions
• Earn-out payments

✅ 2. Nonqualified Deferred Compensation (NQDC) Plans

The MSO can sponsor custom nonqualified deferred compensation plans (DCPs), enabling:

• Unlimited contributions
• Tailored executive agreements
• Payout triggers tied to tenure, sale, or retirement
• Tax deferral until distribution

DCPs are perfect for “golden handcuffs,” post-exit income, or phased retirements — and they’re not subject to ERISA limits.

✅ 3. COLI: Corporate-Owned Life Insurance

COLI turns MSO cash into a tax-deferred asset with liquidity benefits:

• Cash value grows tax-deferred
• Policy loans or withdrawals fund future obligations
• Death benefit provides tax-free capital at key transitions
• Policies are often guaranteed-issue and institutionally priced
• Balance sheet is positively impacted within 12–24 months

Used inside the MSO, COLI backs DCPs or obligations with strategic flexibility.

✅ 4. Separation of Risk from OpCo

Liabilities tied to people — such as leadership, performance, and tenure — shouldn’t be parked in the operating company. By placing them in the MSO:

• The OpCo remains clean for sale or valuation
• The MSO becomes the funding engine for obligations
• DCPs and COLI remain in place regardless of OpCo ownership

This separation protects EBITDA and enhances deal confidence.

✅ 5. Strategic Post-Exit Flexibility

After a sale, the MSO can:

• Convert to an S-Corp for pass-through treatment
• Pay out DCPs to founders and executives
• Retain seller notes, licensing contracts, or consulting revenue
• House real estate or intellectual property for continued value

This flexibility supports multi-year income strategies with superior tax treatment.

Case Study: Solving a $5M Compensation Obligation

A founder promised $5 million in bonuses to key executives if the company sold. There was no plan or funding in place.

With Guardian’s guidance:

• An MSO was formed and retained ~$1.2M/year in C-Corp profits
• Funds were deployed into COLI to back the DCP
• At sale, bonuses were paid directly from the MSO
• The operating business sold cleanly, with no value haircut
• The founder used the MSO post-sale to generate consulting income and exit over time

Why This Matters: Value, Transparency, and Confidence

Buyers, partners, and heirs want predictability. A business that hides liabilities — or hasn’t funded them — signals risk. But when an MSO holds capital, owns the plan, and clearly documents the payout path, stakeholders are reassured.

And the owner? Gains a powerful wealth engine that converts liability into legacy.

Guardian’s MSO-Funded Liability Process

Here’s how Guardian Tax Consultants helps clients:

1. Analyze existing obligations and exposures
2. Design an MSO entity that aligns with long-term goals
3. Model tax savings and funding paths for DCPs or bonuses
4. Implement COLI to create tax-advantaged funding
5. Coordinate with legal, tax, and insurance advisors for clean documentation

✅ Summary: Key Benefits

• Retains capital taxed at 21% instead of 37%
• Funds deferred compensation with internal cash, not personal dollars
• Boosts transparency and valuation at sale
• Avoids personal liability for future payouts
• Turns promises into assets, not risks
• Offers tax-deferred growth and tax-advantaged distribution
• Reduces M&A friction and indemnity concerns
• Supports continuity for executives, heirs, or buyers
• Enhances deal certainty and post-exit wealth planning
• Centralizes long-term financial strategy for owners

Resources:

• Management Services Organization (MSO) Overview
• Exit Planning Services
• Tax Planning Strategies
• Estate Strategy Services
• How MSO Structures Fund Deferred Comp Plans

• Investopedia: Understanding Unfunded Liabilities
• Kitces: COLI in Nonqualified Deferred Comp
• The Tax Adviser: Tax Benefits of NQDC
• LIMRA: Funding Deferred Comp Plans with COLI
• Mercer: Nonqualified Deferred Compensation Considerations
• WTW: Deferred Compensation Funding Strategies
• NAPLIA: Phantom Stock Plans
• Advisor Perspectives: Selling Your Business and Retaining Value
• ERISA Practice Center: IRS Focus on Nonqualified Plans
• Wealth Management: Structuring Benefit Liabilities

MSO deferred compensation strategy

COLI funding for executive benefits

Management Services Organization tax planning

Phantom equity funding

Retained earnings tax efficiency

NQDC in small business

Executive succession planning

Earn-out funding structure

Post-sale income strategies

MSO and C-Corp tax strategy