Structuring and Tax Efficiency for Search Funds

By Kelly A. Berardi, JD, LL.M
Gray, Gray & Gray, LLP

In the entrepreneurial landscape, search funds have emerged as a compelling path for aspiring business owners to acquire and operate established companies. As search fund activity continues to grow, entrepreneurs and investors alike face critical decisions regarding fund structure and tax planning that can significantly impact long-term returns. At Gray, Gray & Gray, we’ve guided numerous search fund entrepreneurs through these complex decisions, helping them establish efficient structures that maximize after-tax returns for all stakeholders.

Search Fund Structures

The journey toward tax efficiency begins with entity selection. Search funds typically operate through a two-phase structure: the search phase and the acquisition phase. Each phase presents distinct tax considerations that require careful planning from inception.

During the search phase, entrepreneurs typically form an LLC or similar pass-through entity to raise initial capital from investors. This entity funds the entrepreneur’s search activities and preliminary due diligence. The tax treatment of search expenses represents one of the first critical decision points. Search expenses are generally not immediately deductible by the fund or investors but are instead treated as investment expenses that must be capitalized if an acquisition occurs.

If no acquisition materializes, these expenses may be considered abandonment losses. Properly documenting these expenses from day one ensures maximum tax benefits regardless of outcome. Our experience shows that maintaining meticulous records of search activities and expenses creates valuable options for tax treatment later.

Acquisition Vehicle Must Balance Complexity with Tax Benefits

When a target business is identified, the acquisition phase introduces more complex structural considerations. The acquisition vehicle – typically a new entity formed to purchase the target company – must be carefully structured to balance administrative complexity against tax benefits.

A common approach involves creating a holding company (HoldCo) that acquires the target either through stock purchase or asset acquisition. This HoldCo can be structured as an LLC taxed as a partnership, an S-Corporation or a C-Corporation, each with distinct advantages.

The partnership model (LLC) offers pass-through taxation and tremendous flexibility in allocating economic benefits among different investor classes. This structure aligns well with the typical search fund model where investors receive preferred returns and the entrepreneur earns equity through performance. Furthermore, the LLC structure facilitates tax-efficient exits through potential 1202 qualification (if converted to a C-Corporation at the right time) or 1045 rollover opportunities.

S-Corporations present another viable option, particularly for smaller search funds with fewer investors. While S-Corporations face more restrictions on ownership and capital structure, they offer potential self-employment tax savings on a portion of the entrepreneur’s income – a consideration that can yield substantial savings over time.

C-Corporations, while introducing potential double taxation concerns, may prove advantageous in certain scenarios, particularly when qualified small business stock (QSBS) treatment under Section 1202 is available. This powerful tax incentive can provide up to 100% exclusion of federal tax on capital gains from the sale of qualifying stock held for more than five years, up to the greater of $10 million or 10 times the basis of the stock.

Optimizing the Search-to-Acquisition Transition

The transition from search entity to acquisition structure represents a critical juncture for tax planning. How search capital rolls into the acquisition entity impacts both the tax basis of investor interests and the treatment of search expenses.

Properly structured, search expenses can be capitalized into the basis of the acquired company, potentially creating future tax shields through amortization. Alternatively, in certain scenarios, these expenses might be treated as organizational expenses or startup costs, offering different timing of deductions.

For entrepreneurs utilizing seller financing or earnouts, the tax treatment of these arrangements demands careful consideration. Earnout payments structured improperly can trigger ordinary income treatment rather than more favorable capital gains treatment. These arrangements should be structured to ensure optimal after-tax economics for both buyers and sellers.

Entrepreneur Equity and Compensation Planning

Perhaps no area of search fund tax planning receives more attention than the entrepreneur’s equity and compensation structure. The traditional search fund model grants entrepreneurs the opportunity to earn significant equity through performance, but how this equity is taxed can dramatically impact ultimate returns.

Properly structured equity grants or options can allow entrepreneurs to pay tax at long-term capital gains rates rather than ordinary income rates, a potential tax rate differential exceeding 20 percentage points. Early filing of 83(b) elections when appropriate can lock in favorable tax treatment on equity that vests over time.

Many successful search fund entrepreneurs utilize a combination of approaches: modest salaries to cover living expenses, equity vesting tied to performance milestones and potential bonus structures tied to specific company achievements. This balanced approach keeps fixed compensation costs manageable while aligning entrepreneur incentives with investor returns.

Investor Considerations from Commitment to Exit

From the investor perspective, tax efficiency begins with the initial investment structure. Limited partners in search funds must consider whether to invest directly or through investment entities. For institutional investors, existing investment vehicles often dictate this decision. But individual investors may benefit from using self-directed IRAs or family investment entities.

Throughout the holding period, investors benefit from structures that minimize phantom income – taxable income without corresponding cash distributions. Our structures typically include tax distribution provisions ensuring investors receive sufficient distributions to cover tax liabilities on pass-through income.

Exit planning introduces additional complexities. Stock sales generally produce more favorable tax treatment for sellers, while asset sales typically benefit buyers through step-up in basis. Bridging this gap requires creative approaches such as section 338(h)(10) elections or tax receivable agreements that effectively share tax benefits between buyers and sellers.

Planning Beyond Federal Income Tax

While federal income tax considerations often drive structural decisions, comprehensive planning must address state and local taxes, employment taxes and potential international tax implications if expansion is contemplated. States vary dramatically in their treatment of pass-through entities and economic nexus rules.

Recent developments such as the expansion of state-level pass-through entity taxes (PTE taxes) in response to the federal state and local taxes deduction limitation create planning opportunities. These elective entity-level tax regimes can effectively convert non-deductible state income taxes into deductible business expenses at the entity level.

Integrating Planning for Maximum Efficiency

At Gray, Gray & Gray, we believe tax planning for search funds requires an integrated approach that considers both immediate and long-term objectives. The most effective structures align economic incentives among all stakeholders while creating flexible tax options as the business evolves.

In our experience, early planning yields substantial benefits. Entrepreneurs who engage experienced advisors before raising initial search capital position themselves for significantly higher after-tax returns throughout the search fund lifecycle.