Search Fund: LLC or C Corporation? QSBS, Search Costs and K-1s

LLC or C corporation: what is the main difference for the searcher and the investors?

An LLC HoldCo taxed as a partnership is taxed once, through investors' K-1s. A C corporation HoldCo pays 21% federal tax on its profit, and investors pay again on dividends or a sale, unless QSBS excludes the gain. The HoldCo is the company that buys the business, and its form sets how every investor is taxed for as long as they own it.

An LLC HoldCo usually fits US individual investors who accept yearly K-1s and state returns; a C corporation HoldCo usually fits IRA, tax-exempt, foreign or Canadian investors, or an exit gain that could qualify for QSBS. The choice is hard to undo once outside money is in. Converting later is possible, but some benefits run from the conversion date only (see the QSBS section below). For a business with one owner and no outside investors, the comparison is on LLC or C corporation.

What makes a search fund case need professional judgment: outside investors of different types (individuals, IRAs, foreign investors, Canadians), a target that is an S corporation, a seller who rolls equity, and search costs that span a failed deal and a closed one. Gather the search LLC agreement, the expense ledger with dates, the signed letter of intent date for each target, and the cap table.

Can investors and the searcher get QSBS, and what if we start as an LLC and convert later?

Qualified small business stock (QSBS) is stock of a C corporation only, so an LLC HoldCo taxed as a partnership gives no QSBS. For stock issued after July 4, 2025, a non-corporate holder may exclude 50% of the gain after 3 years, 75% after 4 years, and 100% after 5 years, up to the greater of $15,000,000 or 10 times the stock's basis, per company. 26 USC 1202(a) and (b) The corporation's gross assets (cash plus the tax basis of other property, counting the money raised) must not exceed $75,000,000 at any time before the stock is issued or right after. The assets of any company it owns more than 50% of count too. 26 USC 1202(d) A large purchase funded by the same stock issue can fail this test.

The general tests (active business, excluded fields such as certain professional services) are on LLC or C corporation. Four points matter for a search fund:

• Searcher shares can qualify. Stock received at original issue as pay for services to the corporation counts, the same as stock bought for cash. 26 USC 1202(c)(1)(B) The shares are usually taxable pay when received or when they vest (see the section on the searcher's pay below).
• A HoldCo that owns more than 50% of the operating company can qualify. For the business tests, it is treated as owning its share of a subsidiary's assets and running its share of the subsidiary's business. 26 USC 1202(e)(5)
• Corporate investors cannot use the exclusion. The exclusion applies to a taxpayer other than a corporation. An investor that is itself a C corporation pays full tax on its gain.
• Starting as an LLC and converting later starts the holding period at the conversion. When property such as an LLC's business goes into a corporation for stock, the stock is treated as acquired on the exchange date, and its basis for QSBS is at least the property's value on that date. 26 USC 1202(i)(1) Only growth after the conversion can be excluded. For search LLC units exchanged for HoldCo stock, the holding period usually starts at closing. How to convert is on changing your business structure.

Gain a partial exclusion leaves taxable is taxed at up to 28% federally. 26 USC 1(h)(4) and (7) States set their own rule: California does not allow the exclusion. California FTB: federal changes A sale before the holding period may be rolled into new qualifying stock under section 1045; see LLC or C corporation.

What is the asset step-up worth if we buy through an LLC?

The step-up does not need an LLC HoldCo: any buyer of assets, or of all of a partnership LLC, gets it. A step-up means the buyer's tax basis in the target's assets equals the price paid, so the buyer can deduct that price over time. Goodwill and other section 197 intangibles (customer lists, non-competes, trade names) are deducted evenly over 15 years starting with the month of purchase. 26 USC 197(a)

The step-up is worth the yearly deductions it creates. Most of a small company's price is usually goodwill, so the deduction is roughly the goodwill price divided by 15, every year. Equipment and other qualifying tangible assets bought can usually be deducted in the first year at 100% bonus depreciation. 26 USC 168(k) In an LLC HoldCo those deductions flow to investors' K-1s, usually as passive losses for investors who do not work in the business (suspended passive losses). In a C corporation HoldCo they lower the corporation's tax. The Example below shows the dollars. How the price is split among asset classes on Form 8594 is on buying a business.

We're buying an S corporation: F reorganization or 338(h)(10)?

Both give the buyer a step-up when buying an S corporation. The difference is who can buy and whether the seller can keep a stake.

• Section 338(h)(10) election. Only a purchasing corporation that buys enough stock to make a qualified stock purchase (80% of vote and value) can make it, together with all the S corporation's shareholders, including any who do not sell, on Form 8023 by the 15th day of the 9th month beginning after the month of the acquisition date. Instructions for Form 8023 An LLC HoldCo taxed as a partnership cannot use it. A section 336(e) election is a related route when the seller makes the election; its mechanics are on buying a business.
• F reorganization. The sellers form a new corporation, contribute the S corporation's stock to it, and the old company becomes a qualified subchapter S subsidiary (treated as part of its parent) that then converts to an LLC. The old S election continues for the new parent. Rev. Rul. 2008-18 The HoldCo, whether an LLC or a corporation, then buys interests in that LLC. Purchase mechanics are on buying a business.

An F reorganization is the route that works with an LLC HoldCo or when the seller keeps a stake; a section 338(h)(10) election needs a corporate buyer. Either route moves tax onto the seller, so the price usually reflects it, and the route is usually set in the letter of intent.

What changes for investors who use IRAs, are tax-exempt or live abroad?

An LLC HoldCo that runs an operating business passes business income straight through, and that creates tax duties for three kinds of investors.

• IRAs and tax-exempt organizations. Their share of a partnership's business income is unrelated business taxable income (UBTI). 26 USC 512(c) IRAs are subject to this tax, and dividends are generally excluded from UBTI. Publication 598
• Foreign investors. A foreign partner is treated as doing business in the US when the partnership does. 26 USC 875 The HoldCo must withhold on their share of effectively connected income (income from a US business) at 37% for individuals and 21% for corporations, and each foreign partner files a US return. Details are on foreign partners' withholding.

The usual fixes are a C corporation HoldCo, which turns that income into dividends and stock gains, or a blocker corporation that only those investors invest through. See blocker corporations.

Can investors deduct search expenses before we buy a business?

Usually not yet. Costs of deciding whether to buy a business and which one to buy are start-up costs. Rev. Rul. 99-23 Start-up costs can be deducted only once an active business begins, and an acquired business begins when it is acquired. 26 USC 195

In the year the business starts, the taxpayer may deduct up to $5,000, reduced dollar for dollar once start-up costs exceed $50,000. The rest is deducted evenly over 180 months.

The search LLC's salary, rent and travel during the search are usually start-up costs. Which entity claims them depends on which entity paid and how the search LLC rolls into the HoldCo. Trace this before the first HoldCo return. General start-up rules are on your first business tax return.

Our search ended with no deal: what does the search LLC file, and who takes the loss?

The search LLC files a final Form 1065 by the 15th day of the 3rd month after the month the partnership ends, checks the "Final return" box in item G, and checks "Final K-1" on each investor's Schedule K-1. IRS: Closing a business

Whether investors can deduct the money spent depends on what it was spent on:

The IRS's last business-expense publication said an individual's general search costs are personal and nondeductible, while costs of trying to acquire a specific business are capital expenses deductible as a capital loss. It also said a corporation may be able to deduct all investigatory costs as a loss. Publication 535 (for 2022 returns)

The loss reaches each investor as their share on the final K-1, in line with the search LLC agreement's allocations. Do not assume the loss is ordinary: capital loss limits may apply, and an investor's deduction is also limited by their basis in the LLC. This is why the expense ledger needs dates and a target name for each cost.

On liquidation, basis above the cash returned may be a capital loss (26 USC 731(a)(2)); whether never-deducted search costs stay in that basis is not settled. The searcher still reports the search salary as income in the year paid, as wages or a guaranteed payment, even if the search LLC capitalizes it. 26 USC 707(c)

On a purchase, which search and deal costs are capitalized and which are start-up costs?

Costs for work done on or after the earlier of two dates facilitate the deal and are added to the purchase price: the date a letter of intent or exclusivity agreement is signed (a confidentiality agreement does not count), or the date the governing officials approve the deal's material terms. 26 CFR 1.263(a)-5(e)(1) Costs before that date for the general search are start-up costs.

Some costs are capitalized whatever their date: appraisals and fairness opinions, structuring and tax advice on the structure, drafting the purchase agreement, regulatory approvals and transfer taxes. 26 CFR 1.263(a)-5(e)(2)

A success-based fee (paid only if the deal closes) is presumed to facilitate the deal unless detailed records prove otherwise. The buyer may instead elect a safe harbor: treat 70% as not facilitating the deal and capitalize 30%, with a statement on the original return for the year the fee is paid. The election is irrevocable for that deal. Rev. Proc. 2011-29

How do the search LLC and the search capital roll into the deal?

Search capital usually converts into HoldCo equity, often at a premium set by the search LLC agreement. The tax result depends on the HoldCo's form.

• Into an LLC HoldCo taxed as a partnership: contributing property for a partnership interest is usually tax-free. 26 USC 721
• Into a C corporation HoldCo: contributing property for stock is tax-free only if the people transferring property (including cash investors buying stock in the same deal) own at least 80% of the corporation right after. 26 USC 351(a) Shares issued for services are not issued for property and are taxed as pay.

If search investors receive more HoldCo equity than their cash, check whether the extra is pay for services or value moved from some investors' capital to others'. That needs the actual agreements.

Is the searcher's pay a W-2 or guaranteed payments, and do I file an 83(b) on earned equity?

In a C corporation HoldCo, the searcher who works for the company is an employee paid through payroll on Form W-2. In an LLC HoldCo taxed as a partnership, a searcher who is also a member is usually not its employee (the same holds for the search LLC during the search): the IRS's position is that bona fide partners are self-employed, not employees. T.D. 9766 Fixed pay is then a guaranteed payment: deductible by the LLC, ordinary income on the searcher's K-1, no income tax withheld. Publication 541 Guaranteed payments for services are self-employment income. 26 USC 1402(a)(13)

Searcher equity that vests in tranches is usually restricted property. A section 83(b) election, filed within 30 days after the shares are transferred, taxes the value at grant instead of at each vesting date. Form 15620 can be used to make it. Form 15620 The deadline cannot be extended. A profits interest in an LLC HoldCo has its own rules; see splitting ownership between LLC partners. How long a promote (an extra share of profits) must be held for long-term rates is on the three-year rule, and an independent sponsor's fees are on independent sponsor fees and promote.

Who prepares the HoldCo's return and investors' K-1s, and how do a 1065 and an 1120 compare?

The HoldCo files its own federal return every year, and so does the search LLC while it exists. The search LLC's and HoldCo's returns and investors' K-1s are prepared each year; see fund and investment vehicle tax services. The operating company's books and payroll are usually a separate engagement.

Two rules can make someone pay another's tax. An LLC HoldCo's audit tax is assessed on the LLC in the year the audit ends, so current investors bear tax for earlier years, unless the partnership representative named on the return elects within 45 days of the final notice to push it out to that year's investors. An LLC with 100 or fewer K-1s, all to individuals, C or S corporations or estates, can elect out of this on each timely return; an IRA or other trust investor rules that out. 26 USC 6221(b), 6225 and 6226 And a person responsible for the HoldCo's payroll or foreign-investor withholding, often the searcher, who willfully fails to pay it over is personally liable for 100% of it, generally assessed within 3 years. 26 USC 6672

Cost drivers are usually the number of investors and states for an LLC HoldCo, and the operating company's complexity for both. Penalty figures: Rev. Proc. 2025-32. Tax distributions and yearly K-1s are on SPV and co-invest vehicle tax returns; state filings are on fund state returns and nonresident withholding.

I'm a searcher or investor in Canada: what changes?

Canada treats a US LLC as a taxable corporation, even when the US taxes its members as partners. CRA: IC71-17 A Canadian investor in an LLC HoldCo is taxed by the US each year on their share, while Canada may tax only distributions, so timing and foreign tax credits may not line up and double tax can result. A C corporation HoldCo is a corporation in both countries, which avoids that particular mismatch; dividends from it still carry US withholding and Canadian reporting, and QSBS does not reduce Canadian tax on a Canadian resident's gain. Income Tax Act s. 2(1) See Canadian partner in a US LLC and buying a US business as a Canadian.

Example

All figures are in US dollars and illustrative only.

QSBS: C corporation HoldCo against LLC HoldCo

An investor pays $400,000 for C corporation HoldCo stock issued this year. The HoldCo qualifies, and the stock sells for $3,400,000. Gain is $3,000,000.

• Sold after 5 years: all $3,000,000 is excluded.
• Sold after 3 years: $1,500,000 is excluded; $1,500,000 is taxable, at up to 28% federally.
• Same investment through an LLC HoldCo: none of the gain is excluded. In exchange, the business's profit was taxed once, on investors' K-1s, instead of at the corporate rate and again when paid out.

Step-up: yearly deduction

An LLC HoldCo buys a company's assets for $6,000,000, of which $4,500,000 is goodwill. Goodwill gives $300,000 of deductions for each full year over 15 years ($4,500,000 ÷ 15), prorated by month in the year of purchase, shared among investors' K-1s. Buying the same company's stock without an election gives none of that.

Failed search

A search LLC raises $500,000. It spends $350,000 on salary and screening, then $100,000 on diligence for one target after a letter of intent; the deal fails. The $100,000 is usually a loss in the year abandoned, passed out on the final K-1s. The $350,000 general search cost is often not deductible for individual investors; the rule here is not settled. The $50,000 not spent goes back to investors as a return of their own money, not income.

Different for you?

• You want LLC and C corporation modeled for your deal, or need the search LLC's and HoldCo's returns and K-1s filed: see fund and investment vehicle tax services.
• The HoldCo is closed and you need its yearly corporate return: see corporate tax services.
• You are the searcher and need your own return with K-1s, guaranteed payments or equity: see individual tax services.
• Asset or stock purchase, Forms 8594 and 8023: see buying a business.
• IRA or foreign investors need a blocker: see blocker corporations.
• A Canadian buying a US business or investing in the LLC: see buying a US business as a Canadian and Canadian partner in a US LLC.