A Look at Search Funds and Section 1202 Qualified Small Business Stock​

The tax benefits conveyed by Section 1202 of the Internal Revenue Code to owners of "qualified small business stock" (QSBS) have been available to small business owners in some form since Section 1202 was first enacted in 1993. However, because the tax benefits of Section 1202 are available only to owners of small businesses operated in C corporation form, for most years since Section 1202's enactment, attempting to capture the benefits of Section 1202 often came with the high tax cost of C corporation double taxation.¹ In recent years, however, Section 1202 has experienced a surge in popularity, likely due to the significant decrease in the C corporation income tax rate (dropping from 35 percent to 21 percent under the 2017 Tax Cuts and Jobs Act), which, in turn, significantly reduces the cost of double taxation in C corporation structures.²

Section 1202 has found particular popularity in the world of Search Funds (sometimes referred to as "entrepreneurship through acquisition") for at least a couple of reasons: 1) the size of business that is often acquired by Search Funds fits within the purview of Section 1202 (businesses with a value of less than $50 million) and 2) because of the "acquire, grow and sell" strategy typically employed by a Search Fund, the tax inefficiencies of C corporations are mitigated. Often under these structures, the Search Fund seeks to acquire a business, grow the business either through the investment of growth capital or organic growth through the reinvestment of operating profits and sell the business several years later without ever making dividend distributions of operating profits to the owners. Because of the lack of dividend distributions, the owners generally do not incur any dividend tax despite the C corporation structure (thereby avoiding double taxation often incurred by C corporation owners). Accordingly, the tax cost associated with a C corporation has generally been much lower in recent years in these types of structures, which, when viewed in light of the significant tax benefits under Section 1202 upon an exit sale of the business, makes the benefits of Section 1202 much more attractive to Search Fund sponsors and investors.

This Holland & Knight alert provides a general overview of Section 1202 in the context of a Search Fund and discusses a variety of issues that can arise due to the unique nature of the structure of a Search Fund.

Overview of Search Fund Structure and Acquisitions

The Search Fund model is an investment structure that has been in place since the mid-1980s and is designed to provide investors the opportunity to participate in the staged financing of an aspiring entrepreneur's (a Searcher's) search for and acquisition of an existing private company.³

Under the phased Search Fund model, Searchers will seek initial "search capital" from outside investors to fund a salary, along with administrative and deal-related expenses, for a 24- to 30-month search for a privately owned acquisition target. In exchange for their initial investment, investors will have the right, but not the obligation, to participate in financing of "acquisition capital" based on their pro rata ownership of the Search Fund at the time of an acquisition. As an incentive for investors to provide capital for the search phase, each investor's initial capital contribution will convert on a "stepped-up" basis (e.g., 150 percent of such investor's actual invested capital) into preferred equity of Topco LLC (as defined below).

At the time of an acquisition, the Search Fund vehicle – which is customarily a limited liability company (LLC) taxed as partnership for federal income tax purposes (Topco LLC) – will amend and restate its operating agreement to provide for three classes of equity: 1) Preferred Units issued to investors both in respect of their stepped-up search capital and new capital invested to fund the acquisition, 2) "profits interests" (Common Units) issued to the Searcher(s) and 3) a pool of "profits interests" (Class P Units) that are reserved for issuance as incentive equity for employees and other service providers of the acquired company.⁴ Common Units issued to the Searcher are typically divided into three tranches: 1) Common Units that vest upon closing of an acquisition, 2) Common Units that are subject to time-based vesting over a period of four years and 3) Common Units that are subject to vesting upon the achievement of certain performance-based objectives.

Where a Search Fund seeks to structure an acquisition to qualify for Section 1202, Topco LLC will often form a wholly owned C corporation subsidiary to be the buyer in the acquisition, with Topco LLC contributing cash to the C corporation in exchange for stock intended to be QSBS.⁵ The C corporation will then use the cash received in the initial capitalization from Topco LLC to acquire either the assets or the equity of the target business.

Often, Search Fund acquisitions may also involve "rollover equity" issued to the sellers of the target business. This is typically structured by the sellers contributing a portion of their equity (or assets) of the target business to Topco LLC in exchange for equity in Topco LLC, followed by Topco LLC's contribution of such target equity (or assets) to the C corporation subsidiary in exchange for additional shares in the C corporation. The C corporation shares issued to Topco LLC in the rollover transaction are also intended to be QSBS.

Overview of Section 1202; General Requirements

If the requirements of Section 1202 are satisfied, owners of QSBS can exclude from their taxable income gain recognized upon the sale of such stock, thereby allowing such stock to be sold free of federal income tax (subject to certain limitations). Specifically, for a taxpayer that acquired QSBS after Sept. 27, 2010, 100 percent of any gain from the sale or exchange of QSBS held for more than five years is excluded from gross income up to certain limits.⁶ Excludable gain on the sale or exchange of QSBS is limited to the greater of 1) $10 million (reduced by eligible gains from dispositions of QSBS in such corporation in prior taxable years) or 2) 10 times the taxpayer's aggregate adjusted basis in QSBS sold by the taxpayer during the taxable year.⁷ Notably, these two exclusion caps are applied on a per-taxpayer and per-corporation basis.⁸ Accordingly, QSBS can be sold at a significant multiple of invested capital without incurring any federal income tax on the sale.

To be QSBS, stock must meet several requirements set forth in Section 1202. QSBS is defined as any stock in a C corporation originally issued after Aug. 10, 1993, with respect to which the following requirements are satisfied:

1. The corporation that issues the stock intending to be QSBS must be a C corporation on the date of issuance and during substantially all of the shareholder's holding period.⁹
2. The corporation must be a "qualified small business." A corporation is a qualified small business if the corporation is a domestic (U.S.) corporation and, at all times prior to the date of stock issuance and immediately thereafter, the aggregate gross assets of the corporation did not exceed $50 million.  For this purpose, aggregate gross assets are generally defined as the amount of cash and the aggregate adjusted tax basis of other property held by the corporation; provided, however, that in the case of property contributed to a corporation, aggregate gross assets are determined by reference to the fair market value of such property (rather than the adjusted tax basis).¹¹
3. The stock was acquired at its "original issuance," meaning that the stock was issued directly by the corporation to the shareholder in exchange for money or other property (other than stock) or as compensation for services.¹² However, stock acquired in an exchange for a contribution of stock can be treated as QSBS if the contributed stock was also QSBS in the transferor's hands at the time it was contributed.¹³ See "Special Considerations Under Section 1202 for Search Funds – Pass-Through Entity Rules" below for discussion of how the "original issuance" requirement can be satisfied through an investment in a limited liability company or other pass-through entity (e.g., Topco LLC in the Search Fund context), which then acquires and holds QSBS.
4. The corporation is a qualified trade or business. The term "qualified trade or business" means any trade or business other than 1) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, 2) any banking, insurance, financing, leasing, investing or similar business, 3) any farming business, 4) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 or 613A, such as oil and gas and other mineral production businesses, and 5) any business of operating a hotel, motel, restaurant or similar business.¹⁴ The determination of whether the corporation is a "qualified trade or business" is a facts-and-circumstances inquiry, so a careful review of the target's business and review of existing private letter rulings issued by the IRS on this issue can inform this determination.¹⁵
5. The corporation satisfies an active business requirement during substantially all of the taxpayer's holding period for the QSBS. A corporation is an active business if at least 80 percent of the corporation's assets are used by the corporation in the active conduct of one or more qualified trade or businesses.¹⁶ For this purpose, a parent corporation is treated as owning its ratable share of its subsidiary's assets and as conducting its ratable share of its subsidiary's activities, provided that such parent owns more than 50 percent of the total vote or value of such subsidiary.¹⁷ To ensure compliance with the active business requirement, Searcher(s) and the board of directors of the Search Fund should regularly monitor the amount of cash-on-hand, along with the projected net working capital needs of the business, including periodic discussions at board meetings alongside managements' discussion and analysis of the financial performance of the Search Fund's operations. The existence of net working capital or other non-business assets (including portfolio securities investments and investment real estate) in excess of certain thresholds can cause the company to fail the "active business" requirement.
6. The corporation does not violate Section 1202's redemption rules. Stock can fail to qualify as QSBS if the corporation 1) redeems stock from a shareholder exceeding a de minimis amount within two years before or after issuance (which could invalidate QSBS held by the shareholder) or 2) if the corporation makes "significant redemptions" (i.e., more than 5 percent of the corporation's total stock) exceeding a de minimis amount within one year before or after issuance (which could invalidate all QSBS of the corporation issued during such two-year time period).¹⁸ In light of the redemption rules, very careful consideration should be given before granting an investor, a rollover seller or other equity holder a "put" right or other liquidity option, as these rights will typically be structured as redemptions, which, if not properly structured, could result in the stock held by the applicable investor (or other investors) to fail to qualify as QSBS.

Entity Choice: C Corporation vs. Pass-Through Entity

Considering the substantial tax benefits it provides, Section 1202 might influence a Search Fund's choice to own and operate its business through a C corporation or instead, forgo the benefits of Section 1202 in favor of a business owned and operated in a pass-through entity structure. The entity choice decision should be made with careful consideration of all relevant factors with realistic projections for the business, weighing the potential benefits of Section 1202 in light of projected tax benefits and costs. This often involves a modeling exercise comparing a C corporation structure to a pass-through entity structure, projecting taxes paid by the entity and the owners during the years of ownership and projecting taxes incurred upon the exit sale of the business.

Relevant considerations should include:

• Entity-level taxes of a C corporation (currently taxed at a tax rate of 21 percent) compared to tax distributions that would likely need to be made by a pass-through entity to allow the investors and sponsor to pay taxes on their share of the entity's taxable income (such distributions are likely to be made based on the current maximum individual income tax rate of 37 percent).¹⁹
• The likelihood of distributions of operating profits, which, in the case of a C corporation, would result in taxable dividend income to the shareholders but in a pass-through entity structure would generally not result in any additional tax since the operating profits will have been taxed on a pass-through basis irrespective of distributions. In general, a C corporation structure qualifying for the benefits of Section 1202 is most tax-efficient when there is no expectation that any dividend distributions will be made (thereby avoiding any taxes on dividends), and the only liquidation event is expected to occur upon the exit sale of the business (which qualifies for the Section 1202 exclusion).
• Another less determinable factor is the possibility that the purchase price on the exit sale might reflect a reduction in valuation if a buyer must acquire the C corporation due to the fact that the buyer will not receive a tax basis step-up in the acquisition of a C corporation. In order to reap the full benefits of Section 1202, a Search Fund must sell the C corporation in the exit sale. Because of the lack of a basis step-up in the acquisition of a C corporation, a buyer may apply a discount to its valuation of the business, reflecting the net present value of lost future tax benefits from the tax basis step-up. However, it is not always clear whether a buyer places any value on the tax benefits of a basis step-up, and a discount is generally less likely in a competitive sale process and, in many cases, if there is a discount, it will be much lower than the benefit of the Section 1202 structure.

Special Considerations Under Section 1202 for Search Funds

Pass-Through Entity Rules

Section 1202's gain exclusion can also apply to QSBS held through a pass-through entity (e.g., Topco LLC in a typical Search Fund structure).²⁰ A pass-through entity is defined as any partnership (including an LLC taxed as a partnership), S corporation, regulated investment company or common trust fund.²¹ When QSBS is held through a pass-through entity, the partners or shareholders of the pass-through entity share in the entity's Section 1202 gain exclusion when the QSBS is sold.²² In the context of a Search Fund, Topco LLC is typically the owner of the QSBS, and Topco LLC's pass-through owners share in Topco LLC's Section 1202 gain exclusion when QSBS is sold, if certain requirements are satisfied.

For the exclusion to apply to a partner or shareholder who owns an interest in a pass-through entity that owns QSBS, the partner or shareholder (other than a C corporation), in addition to satisfying the general requirements necessary to qualify as QSBS, must have 1) held an interest in the pass-through entity on the date that such pass-through entity acquired the QSBS (i.e., they must have been an owner on "day 1") and 2) continued holding such interest in the pass-through entity at all times before the disposition of QSBS by the pass-through entity.²³ A Search Fund owner's share in Topco LLC's Section 1202 gain exclusion is limited to the owner's interest in Topco LLC on the date the QSBS was first acquired by the fund, so the owner cannot indirectly increase its interest in the QSBS by acquiring a higher percentage in Topco LLC subsequent to the QSBS acquisition date.²⁴

It is also possible for the Section 1202 gain exclusion to apply in the context of QSBS issued as part of add-on acquisitions, including to execute on a Search Fund's roll-up strategy. In these instances, investors in Topco LLC will make additional capital contributions in exchange for Preferred Units of Topco LLC, and Topco LLC will then contribute the additional equity to its C corporation subsidiary in exchange for QSBS of such subsidiary, and the C corporation subsidiary would then use such funds to acquire the add-on target. Search Funds must make a careful accounting of the owners of the pass-through entity (in this case, Topco LLC) as of the date of each additional capital raise and the related issuance of each subsequent tranche of QSBS. For any such QSBS subsequently issued, Topco LLC will need to hold this tranche of QSBS for five years in order for any gain attributable to such subsequently issued QSBS to get the benefit of the Section 1202 exclusion.

Treatment of Searcher's Common Units

As previously discussed, a Search Fund structure typically involves the Searcher being issued Common Units of Topco LLC, entitling the searcher to a share of the future appreciation in value of the business if certain time-based and performance-based hurdles are satisfied. A searcher's Common Units are intended to qualify as "profits interests" for federal income tax purposes.

As discussed above with respect to QSBS held by pass-through entities, Section 1202(g)(2) provides that the gain exclusion granted by Section 1202 can apply only to a member of a pass-through entity if the gain from the sale of QSBS is allocated to the member by reason of the member holding an "interest" in the pass-through entity on the date on which the pass-through entity acquired the QSBS. Notably, the provision does not distinguish between "capital" or "profits" interests in a pass-through entity and, as a result, there is ambiguity in the context of Search Funds related to whether ownership of profit interests qualifies for Section 1202 gain exclusion. Specifically, the issue is whether, in the context of a pass-through entity that owns QSBS, Section 1202 applies only to a partner's "capital" interest (i.e., its invested capital interest) or whether Section 1202 would also apply to a partner's "profits" interest (i.e., its interest in profits beyond its capital interest).

On its face, Section 1202 applies to any "interest" in the pass-through (which would include both capital and profits interests), and there is no direct authority under Section 1202 that would limit the application only to a capital interest. In other words, Section 1202 does not expressly limit the ability for a Searcher's Common Units to qualify for the Section 1202 gain exclusion. However, ambiguity arises by the fact that the Section 1045 regulations contain more specific (and stricter) rules for determining what portion of a partner's Section 1202 gain is eligible for a tax-deferred rollover transaction if QSBS is sold before the 5-year holding period is met. Under Section 1045 regulations, a partner's share of gain from the sale of QSBS that is eligible for tax-deferred rollover is limited to the share of gain attributable to such partner's capital interest only, which would exclude any share of the gain attributable to a partner's profits interest. Some practitioners argue that this interpretation should also apply to a partner's "interest" under Section 1202(g)(2).

It is important to note that the Section 1045 regulations apply only to Section 1045 rollovers and, therefore, do not constitute binding authority for purposes of the rules under Section 1202. In the absence of a specific limitation in Section 1202, the indication appears to be that Congress did not intend to confine "interest" to capital interests, but rather intended it to be a broader term encompassing profit interests.

Nevertheless, the Section 1045 regulations might be viewed as an indication of the IRS's view of how the Section 1202 rules operate and should be considered as one potential interpretation that should be considered and discussed with the Search Fund's legal and tax advisors.

In any event, a holder of Common Units should consider timely and properly filing a Section 83(b) election at the time the units are granted. This protective election will allow the Searcher to trigger taxable income on the fair market value of the Common Units at the time of grant (e.g., $0.00) versus the time of vesting and, in doing so, start the clock on the holding period for the Common Units on the grant date.

Target Rollover Equity

With respect to Search Fund acquisitions involving target rollover equity, Searchers should also be mindful of the "original issuance" requirement when discussing the Section 1202 structure with sellers. Original issuance requires that QSBS be acquired directly from the issuing corporation 1) in exchange for money or other property or 2) as compensation for services provided to the corporation.²⁵

When a Search Fund acquisition involves target rollover equity, proper steps should be taken to preserve the QSBS status of rollover equity issued to the seller. As described above, a Search Fund acquisition with rollover equity should be structured so that 1) the seller(s) of the target business first contribute the target equity (or assets) to Topco LLC in exchange for equity in Topco LLC (which should qualify for tax-deferred treatment under Section 721) and 2) immediately thereafter Topco LLC contributes the target equity (or assets) to the C corporation in exchange for additional shares of such corporation (which should qualify for tax-deferred treatment under Section 351). Under this structure, assuming all other Section 1202 requirements are met, the shares of the C corporation subsidiary issued to Topco LLC in exchange for the contribution of target equity would be eligible to be QSBS because such shares are originally issued to Topco LLC.

If, on the other hand, the rollover transaction were structured so that 1) the seller(s) of the target business first contributed the target equity (or assets) to the C corporation in exchange for shares of the C corporation and 2) immediately thereafter, the seller(s) contributed such shares to Topco LLC, then the shares in Topco LLC's hands would not be QSBS because these shares were not originally issued to Topco LLC.

In the context of a rollover transaction, including a contribution of noncash property (such as a contribution of target equity (or assets) of seller), Section 1202(i)(1) provides that 1) the QSBS received in exchange therefor shall be treated as having been acquired on the date of such exchange (despite the fact that the shares would have a tacked on holding period for non-Section 1202 purposes) and 2) the basis of such QSBS is equal to the fair market value of the property exchanged.²⁶ Accordingly, for Section 1202 purposes, the QSBS received in a rollover transaction is treated as having a new holding period commencing on the date of the exchange, and only the post-rollover appreciation in value in the QSBS will be eligible for exclusion under Section 1202. This means that the pre-rollover appreciation in value would still be subject to tax upon the exit sale.

To ensure that the rollover has a neutral effect on the non-rollover investors of Topco LLC, the applicable partnership tax rules under Section 704(c) will often ensure that the taxable gain attributable to the pre-rollover value appreciation can be allocated by Topco LLC to the rollover seller(s), so the resulting tax will be borne by such rollover seller(s).

Conclusion

The benefits of Section 1202 could provide significant value to Searchers, the Search Fund and its investors, but careful consideration should be made to ensure eligibility requirements are met. Understanding the nuances of Section 1202 and its interpretations are paramount to realizing potential investor value, and recognizing potential pitfalls – including the effect of Section 1202 on investors' equity holdings, the issuance of Common Units and "rollover" participation – will allow the Search Fund to make an informed decision regarding whether and if Section 1202 fits within the Search Fund's investment thesis.

For more information or questions, contact the authors or another member of the Holland & Knight Search Funds Team.

Primary Contacts:

Kevin Christmas, Co-Head
John Gilson, Co-Head
Mike Miller, Co-Head

Notes

¹ The double taxation problem means that a C corporation pays corporate income tax on its income; thereafter, the C corporation will pay its owners dividends from its after-tax income, and its owners will then pay personal income taxes on these dividends.

² It will be important to monitor how future legislative proposals may impact corporate income tax rates for C corporations and the related impact on Section 1202's popularity.

³ For a detailed overview of Search Funds, readers are encouraged to consult with the latest Search Fund Primer penned by the Stanford Graduate School of Business Center of Entrepreneurial Studies. Note that the focus of this article is on "traditional" investor-backed search funds. Aspects of this article may apply to self-funded search funds as well, but it will be important to consult with your legal and tax advisors to confirm.

⁴ Depending on whether there is a single Searcher or a team of two (or more) Searchers, Preferred Units typically range from 70 percent to 75 percent of the issued and outstanding Units of the Search Fund as of the date of closing of an acquisition, and Common Units, subject to vesting requirements noted above, typically range from 25 percent to 30 percent of the issued and outstanding Units of the Search Fund as of the date of closing of an acquisition (subject, in each case, to dilution for subsequent issuances of incentive units under an equity incentive plan adopted by the board).

⁵ The C corporation can also be formed as an LLC that elects to be classified as a corporation for federal income tax purposes.

⁶ I.R.C. § 1202(a)(4). Taxpayers that are themselves C corporations do not qualify for the exclusion under Section 1202.

⁷ I.R.C. § 1202(b)(1).

⁸ I.R.C. § 1202(b).

⁹ I.R.C. § 1202(c)(2)(A).

¹⁰ I.R.C. § 1202(d)(1)(A); I.R.C. § 1202(d)(1)(B).

¹¹ I.R.C. § 1202(d)(2).

¹² I.R.C. § 1202(c)(1)(B).

¹³ I.R.C. § 1202(h)(4)(A).

¹⁴ I.R.C. § 1202(e)(3).

¹⁵ While private letter rulings generally are not authoritative guidance, they are helpful indications of how the IRS views certain issues and can be particularly helpful in fact-driven analyses where there is otherwise a lack of helpful guidance.

¹⁶ I.R.C. § 1202(e)(1). Assets used in the active conduct of a qualified trade or business include 1) assets used in startup activities, 2) assets used in research and experimental expenditures under Section 174 and 3) assets used in in-house research expenses described in Section 41(b)(4).

¹⁷ I.R.C. § 1202(e)(5).

¹⁸ I.R.C. § 1202(c)(3). In the context of the first rule, a stock purchase exceeds a "de minimis amount" if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of the stock held by the taxpayer and related persons is acquired. Treas. Reg. 1.1202-2(a)(2). In the context of the second rule, a stock purchase exceeds a "de minimis amount" if the aggregate amount paid for the stock exceeds $10,000 and more than 2 percent of all outstanding stock is purchased. Treas. Reg. 1.1202-2(b)(2). However, these redemption rules do not apply if stock is acquired as a result of termination, death, disability or mental incompetency, and divorce. Treas. Reg. 1.1202-2(d).

¹⁹ The impact of state income taxes should also be considered but is not the subject of this alert.

²⁰ I.R.C. § 1202(g)(1).

²¹ I.R.C. § 1202(g)(4).

²² I.R.C. § 1202(g)(1)(B).

²³ I.R.C. § 1202(g)(2).

²⁴ I.R.C. § 1202(g)(2)(B). The exclusion is limited to the gain that would have been allocated to the partner or shareholder attributable to its ownership interest in the pass-through entity on the QSBS's acquisition date (i.e., any gain attributable to an increase in the taxpayer's ownership interest in the pass-through entity after such acquisition date would not qualify for the exclusion under Section 1202).

²⁵ I.R.C. § 1202(c)(1)(B).

²⁶ I.R.C. § 1202(i)(1).

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.