Tax treatment of expenses incurred by search funds
Frank van Lint & MK O’Connell - Search Fund Alliance
Introduction
Tax accountants of search funds deal in different ways with expenses incurred by the search fund. This memo is a brief analysis how the Search Fund Alliance suggests to deal with such expenses for income tax purposes only. For its internal record keeping, the search fund should use an accounting system (e.g QuickBooks) to track and record its expenses in a format at least consistent with its budget. This approach will be more consistent with its post-transaction GAAP reporting requirements.
Disclosure: this memo does not constitute tax advice. Please consult with a tax accountant to establish what applies to each investor’s and search fund’s specific situation.
1. During the search
Position of the search fund
A search fund (LLC) has no active business as a search to acquire a business does itself not constitute a business(see: Estate of Morgan v. Commissioner No. 592-18 U.S.T.C. August 23, 2021). The expenses incurred by the search fund in its search to find and acquire a company therefore qualify as start-up costs as meant in Section 195 (c)(1) of the Code. During the search phase expenses must be capitalized. In principle these capitalized expenses may be amortized over a 15-year period, but only after an active business started. This is usually only after closing an acquisition Assuming that the search fund does not generate any (interest) income during the search, the search fund should issue a K1 that shows ordinary income (loss) of nil. The capital account at the beginning of the year and at the end of the year are the same.
Position of the investor in the search fund
The investor in the search fund receives a K1 from the search fund that shows no ordinary income (loss). As such the investor does not report any income (loss) with respect to the investment in the search fund. The investor keeps the investment at cost for tax purposes.
2. At the end of the search
The search ends when:
a) The search fund does not acquire a company and is dissolved; or
b) The search fund acquires a company.
Sub a) The search fund does not acquire a company and is dissolved
Position of the search fund
At the end of the search, the search fund has no money anymore to continue its search. Therefore, the search is terminated, and the search fund is dissolved. As the search fund did not acquire (start) a business, the final K1 issued to its investors will still not report any ordinary income (loss). The capital account of the investor in the (final) K1 shows the original investment at the beginning of the year and at the end date of the search fund.
Position of the investor in the search fund
The investor in the search fund recorded the original investment in the search fund as the book value for tax purposes. When the final K1 is received and no distributions are received from the search fund, the investor reports a (long term) capital loss equal to the tax book value (the original investment in the search fund).
Sub b) The search fund acquires a company
When the search fund finds (and acquires) a business, the investor can decide:
a) To pass on the opportunity. In that case, the investor usually sees its initial search fund investment redeemed with a 50% mark-up. The K1 issued by the search fund to this investor will show a distribution of 50% of the original investment and repayment of the invested capital. The investor may consider treating the difference between cash received and the amount of original investment as a capital gain, either long- or short-term, depending on its holding period.
b) To invest additional capital to fund the acquisition. In post-transaction periods, the K1s issued by the search fund to this investor will show the amortized expenses as ordinary business loss in Part III box 1. Effectively, these costs are treated similar to the goodwill generated from the transaction. The additional capital invested in the deal is reported in Part II box L of the K1. The step up is not reported as it is not realized.
c) Not to invest additional capital but to keep the search fund unit. In post-transaction periods, the K1 issued by the search fund to this investor will show the amortized expenses as ordinary business loss in Part III box 1, similar to b) above. The step up is not reported as it is not realized.
When the search fund acquires a business (not an LLC or not via an asset deal) via purchasing shares of C-Corporation, the start up costs would not be amortized. They become part of the basis in the C Corp stock and only deductible when that stock is ultimately sold.