“F” Reorganization – Understanding the Pre-Closing Transaction En Vogue for Strategic Buyer Acquisitions

When a business owner receives a letter of intent from a buyer to purchase their business, the business owner may be surprised to learn that the transaction is contingent on the underlying business entity engaging in an “F” reorganization.  The business owner may be curious as to why a potential buyer would want to restructure a successful business prior to a sale.  If done correctly, an “F” reorganization likely will lead to favorable tax results for both seller and buyer upon the completion of the sale.  

Most closely-held businesses being acquired in the current market are S corporations.  An S corporation is a qualifying small business corporation that makes an election to be taxed under subchapter S of the Internal Revenue Code of 1986, as amended (the “Code”).  An S corporation passes corporate income, losses, deductions, and credits through to its shareholders for federal income tax purposes.  Thus, a shareholder of an S corporation pays only one level of federal income tax.  There are certain limitations on who can be an owner of an S corporation.  Generally, only individuals, estates, or certain types of trusts can own stock in an S corporation.  By undergoing an “F” reorganization, a selling business owner opens up the world of potential buyers to private equity firms and strategic buyers taxed as regular, or C corporations, and partnerships.  Although implementing an “F” reorganization may seem daunting, initially, an “F” reorganization is not difficult to complete as long as the practitioner preparing the documents and IRS forms is diligent in performing the steps discussed in greater detail below in the correct order.  Failure to follow these steps may trigger adverse income tax consequences to the existing shareholders.

“F” Reorganization Steps

Under the Internal Revenue Code of 1986, as amended (the “Code”), a corporation and its shareholders do not recognize gain when undergoing certain qualifying reorganizations.  As explained in I.R.C. Sec. 368(a)(1)(F), an “F” reorganization is a “mere change in identity, form, or place of organization of one corporation, however effected.”  There are six requirements that must be satisfied in order to qualify as a tax-free “F” reorganization.  By taking the below steps, the six requirements of an “F” reorganization will be satisfied, and the reorganization will be tax-free to the corporation and its shareholders.

To implement a successful “F” reorganization, the following steps must be taken in sequential order:

1. The shareholders of the existing S corporation (“TargetCo”) form a new S corporation (“HoldCo”), which can be formed as a corporation or LLC under the applicable state law. It is advisable to form a new business entity to ensure it does not hold any property or have any tax attributes immediately prior to the “F” reorganization.  Although Rev. Rul. 2008-18 and Rev. Rul. 64-250 have determined that S corporation status is extended to HoldCo upon filing the Form 8869 (as described in Step 3), HoldCo, in its discretion, may file a “protective” Form 2553, Election by a Small Business Corporation, with the IRS to make the election to be taxed as an S corporation.  HoldCo must obtain a taxpayer identification number (“EIN”), which will be used for future income tax returns.
2. The shareholders of TargetCo contribute the shares of TargetCo to HoldCo in exchange for all of the stock in HoldCo. The TargetCo shareholders must own the stock in HoldCo in the same proportions that they owned the shares of TargetCo.  This contribution is usually evidenced by a contribution agreement describing the transaction as an “F” reorganization, which is signed by each shareholder of TargetCo.
3. Following the contribution described in Step 2, HoldCo elects to treat TargetCo as a “qualified Subchapter S subsidiary” (“QSub”) of HoldCo by filing Form 8869, Qualified Subchapter S Subsidiary Election, with the IRS. HoldCo can treat TargetCo as a QSub because HoldCo owns 100% of TargetCo’s shares.  The QSub election results in a deemed tax-free liquidation of TargetCo into HoldCo, meaning TargetCo will then be treated as a disregarded entity for federal income tax purposes.  TargetCo will retain its historic EIN for payroll tax purposes, at least.
4. For buyer to achieve its desired tax results, buyer will often request TargetCo to be converted from a corporation to a limited liability company under state law following the completion of the above steps. TargetCo shareholders should anticipate TargetCo undergoing a conversion when buyer is a pass-through entity (i.e., a partnership or an LLC taxed as a partnership) or if the TargetCo shareholders are rolling over a portion of their TargetCo equity in exchange for equity in buyer as part of the subsequent sale transaction.  The conversion of TargetCo from a QSub to a single-member LLC has no federal income tax consequences.  State law varies as to how the conversion is completed.  For example, if TargetCo is a Florida corporation and will convert into a Florida LLC, then TargetCo may file Articles of Conversion with the Florida Division of Corporations.  To avoid any issues with the “F” reorganization, the conversion should occur at least one day after the steps described above.  Thus, the practitioner should wait one day after filing the QSub election before filing the conversion documents with the applicable state agencies.  On the same date as the conversion, TargetCo, which is now an LLC, can file Form 8832, Entity Classification Election, with the IRS to elect to be classified as a business entity disregarded as separate from its owner.

Once these steps are taken, the “F” reorganization is complete.  The business owner and buyer can then complete the sale transaction.  As part of the due diligence process, buyer’s counsel likely will request copies of the filed IRS Forms to confirm that the “F” reorganization has taken place.

Impact of “F” Reorganization

An “F” reorganization is potentially a “win-win” situation for seller and buyer.  While a seller typically prefers to sell stock so they can receive capital gains tax treatment on the profit from the sale, unless buyer is an eligible S Corporation shareholder, buyer’s acquisition of equity in TargetCo will result in its loss of the favorable tax treatment S Corporation status provides. And, while that problem can be solved if buyer purchases 100% of the equity, that often is not the deal buyer wants.  Buyers typically want sellers to remain invested in the buying entity, to have “skin in the game”, so to speak, in the ongoing success of acquired business.

Similarly, while seller desires to maximize the amount of their profit that is taxed as long-term capital gains—the lowest rate applicable to such income; buyer wants to maximize their ability to write off the purchase price through depreciation and amortization.  To achieve buyer’s goal, the transaction has to be taxed as an asset purchase, even if it takes the legal form of an equity purchase.   Once TargetCo undergoes the “F” Reorganization, and converts to an LLC owned by HoldCo, buyer and seller have great flexibility to tailor the transaction to meet the needs of both.

To discuss whether an “F” reorganization, or other corporate restructuring, is appropriate for your business, please contact Devon Goldberg and the corporate attorneys  at Comiter Singer at (561) 626-2101 or toll free at (800) 226-1484.