Code Section 1202 in the Search Fund Context: Structuring Acquisitions To Preserve QSBS Value

This article builds on the initial discussion of Section 1202 of the Internal Revenue Code (the Code) following enactment of the One Big Beautiful Bill Act (OB3) and focuses specifically on how Qualified Small Business Stock (QSBS) considerations arise in mergers and acquisitions, particularly in acquisition‑driven models such as search funds.

In acquisition transactions, Code Section 1202 planning is less about organic startup formation and more about transaction design. The structure implemented at the time of acquisition can determine whether future exit gains are ultimately eligible for partial or full exclusion under Code Section 1202.

Why Code Section 1202 Matters in M&A Transactions

In the M&A context, Code Section 1202 is most relevant where the buyer intends to hold equity for a medium‑ to long‑term growth period before a subsequent exit. Search funds and other acquisition vehicles are particularly well‑suited for QSBS planning because they typically acquire closely held operating businesses that fall below the applicable gross‑asset thresholds and pursue a staged growth‑and‑exit strategy without near‑term dividend distributions.

When structured appropriately, these transactions can produce exit gains that qualify for substantial — and in some cases complete — exclusion from U.S. federal income tax.

OB3 materially enhances this planning opportunity by introducing graduated gain exclusions for QSBS acquired after the applicable date, beginning at a three‑year holding period (50% exclusion after three years, 75% after four years and 100% after five years). This change meaningfully reduces downside risk in acquisition‑driven models, where exit timing is often dictated by market conditions, buyer interest or strategic considerations rather than tax objectives alone.

Original Issuance and the Use of Acquisition Vehicles

A foundational requirement of QSBS is that the stock must be acquired at original issuance. In an acquisition setting, this generally means that investors seeking QSBS treatment must invest through a domestic C corporation that issues stock directly to them in exchange for cash, property (other than stock) or services.

Stock acquired by purchase from existing sellers, even if the target itself is a C corporation, generally does not satisfy Code Section 1202’s original‑issuance requirement (absent a specific statutory carryover rule). As a result, QSBS‑oriented acquisition structures frequently take one of the following forms:

• An asset acquisition by a newly formed C corporation,
• A forward merger of the target into a newly formed C corporation, or
• A holding-company structure in which a new C corporation acquires equity of the operating target.

In each case, the key planning objective is ensuring that investor equity is issued directly by the acquiring C corporation at original issuance.

Code Section 1202 in the Search Fund Acquisition Stack

QSBS planning can be implemented in the typical search‑fund structure, i.e., an upper‑tier holding company (often an LLC taxed as a partnership, Topco) owning QSBS issued by a wholly owned C corporation acquisition subsidiary (the Buyer).

In these structures, the primary Code Section 1202 questions are often not “does the Buyer qualify for QSBS?” but instead:

1. Which Topco owners are eligible to claim the exclusion?
2. How do later capital raises and add‑on acquisitions affect eligibility and holding periods?
3. How should seller rollover equity be structured to preserve QSBS at the Topco level and properly allocate pre‑closing appreciation?

Each issuance requires coordination between deal, tax and investor teams.

Pass‑Through Ownership: QSBS Held Through Topco

Code Section 1202 can apply when QSBS is held through a pass‑through entity, including a partnership or LLC taxed as a partnership (such as Topco). When the pass‑through sells QSBS, its non‑corporate owners may claim the Code Section 1202 exclusion on their allocable share of eligible gain, provided both entity‑level and owner‑level requirements are satisfied.

At the owner level, eligibility is determined by reference to the owner’s interest in the pass‑through entity at the time the pass‑through acquired the QSBS, and the owner must remain a partner until the QSBS is disposed of. Practically, this means that Code Section 1202 benefits are tied to the partner’s ownership percentage on the acquisition date of each QSBS tranche.

If an investor later increases its Topco ownership (for example, by purchasing units from another investor or participating in a later capital raise), the incremental interest generally does not attach retroactively to QSBS acquired in earlier tranches. As a result, secondary transfers and reallocations can create a mismatch between economic ownership and Code Section 1202‑eligible ownership. This is an issue that should be managed intentionally, not discovered at exit.

Add‑On Acquisitions and Roll‑Up Strategies: Multiple Tranches, Multiple Clocks

Search funds frequently pursue add‑on acquisitions funded through additional capital raised at the Topco level. In a typical structure, Topco contributes new capital to the Buyer in exchange for newly issued C corporation stock, and the Buyer uses that capital to fund the add‑on acquisition.

Each such issuance generally creates a separate tranche of QSBS, with its own:

• Issuance date;
• Owner‑level eligibility determinations (based on the Topco cap table at that time); and
• Holding‑period clock for purposes of the three‑, four‑ and five‑year exclusion thresholds.

As a result, roll‑up strategies require intentional QSBS tracking. At a minimum, sponsors should maintain a contemporaneous schedule showing (i) each Topco capital raise, (ii) the corresponding QSBS issuance date, (iii) ownership percentages on that date, and (iv) the holding‑period start date for each tranche.

Seller Rollover Equity: Preserving Original Issuance Integrity

Seller rollover equity is common in acquisition transactions, particularly where sellers retain a minority stake post‑closing. While rollover equity can facilitate valuation and alignment, it presents unique QSBS challenges.

Because QSBS must be acquired at original issuance, the structure must ensure that C corporation stock is newly issued to Topco, rather than acquired from sellers. In a typical partnership over C corporation structure, a common QSBS‑oriented rollover approach is:

• Sellers contribute target equity (or assets) to Topco in exchange for Topco equity (often intended to qualify for tax deferral under Code Section 721), followed by
• Topco contributing the target equity (or assets) to the Buyer in exchange for newly issued C corporation stock (often intended to qualify under Code Section 351.

Under this sequencing, the Buyer’s stock is issued directly to Topco, supporting the Code Section 1202 original‑issuance requirement at the Topco level.

Care must also be taken with redemption or liquidity arrangements involving sellers. Issuer redemptions, whether occurring before, at or shortly after closing, can disqualify QSBS under Code Section 1202’s redemption limitations, including where redemptions involve sellers or related parties. These rules are mechanical and can affect other shareholders who otherwise had qualifying stock, making early coordination essential.

Gross‑Asset Limits and Post‑Acquisition Growth

QSBS eligibility depends heavily on asset measurements at the time of stock issuance and on compliance with the active business requirement throughout substantially all of the holding period.

OB3 increased the aggregate gross‑asset ceiling to $75 million for post‑applicable‑date issuances, which significantly expands the universe of acquisition targets capable of supporting QSBS planning. That said, gross assets for Code Section 1202 purposes are measured using tax basis rules, not enterprise value or GAAP balance sheets, which is an important distinction in acquisition modeling.

Post‑acquisition capital infusions, internal reorganizations and add‑on transactions must be evaluated carefully to ensure the issuing corporation does not inadvertently exceed applicable asset thresholds at the time of issuance or fail the ongoing active business requirement, particularly in roll‑up strategies.

Practical Takeaways for Deal Professionals

QSBS eligibility should be evaluated at the outset of an acquisition, not deferred until exit planning. In acquisition‑driven structures, Code Section 1202 outcomes are primarily driven by:

• Transaction structure and form
• Equity issuance mechanics
• Seller rollover and redemption arrangements
• Asset values at capitalization and issuance
• Cap‑table management over time

With the expanded flexibility and economic upside introduced by OB3, deal professionals who integrate QSBS considerations into acquisition planning can materially enhance after‑tax returns for founders, searchers and investors. Conversely, failing to address these issues upfront can permanently foreclose QSBS benefits, regardless of successful operational performance or length of the holding period.

For more information or questions, contact Will Howieson or Erik Splett.