F-Reorganization Explained

S corporations, being passthrough entities, are generally not directly liable for federal income taxes. Instead, the income or loss is taxable to its shareholders. Private-equity transactions often involve equity purchases rather than direct asset purchases. Sellers prefer equity sales due to the expectation of preferential capital gain treatment and typically require compensation for any ordinary income tax liability on a deemed asset sale. Conversely, buyers generally avoid buying stock since it doesn’t provide a step-up in the tax basis of the corporation's assets. Elections under Sec. 338(h)(10) or Sec. 336(e) offer a compromise by providing buyers the convenience of a stock purchase with the tax benefits of an asset acquisition, though these elections have their own requirements and limitations. These elections often require coordination between buyers and sellers regarding the election and other legal matters. Additionally, sellers cannot achieve tax deferral on any rollover portion of the transaction, which is common in private-equity deals where buyers want sellers to retain a stake in the post-close business. Sellers, meanwhile, often desire potential future upside under private-equity ownership.

A major concern for buyers is maintaining a valid S corporation election for the target of the Sec. 338(h)(10) election. Both Secs. 338(h)(10) and 336(e) transactions are legally stock sales/purchases, but for tax purposes, the buyer is treated as acquiring the target's assets. If the S corporation election was inadvertently invalidated before closing, the buyer would have acquired the stock of a C corporation. To mitigate this risk, pre-transaction restructuring using Sec. 368(a)(1)(F) has become common among private-equity firms.

The F reorganization provides several benefits:

1. A step-up in the tax basis of the target's assets for the purchase portion of the transaction.

2. Similar treatment to sellers as under a Sec. 338(h)(10) election, without the need for an 80% change and with the possibility of tax deferral on the rollover.

3. Avoidance of legal complexities common in asset purchases.

4. Continuation of the target's employer identification number (EIN), often important for buyers.

An F reorganization eliminates the limitations associated with the Sec. 338(h)(10) election, such as the requirement for an 80% or more purchase and the taxation of 100% of the gain, which is disadvantageous in partial rollover transactions.

F Reorganization Defined

Sec. 368(a)(1)(F) defines an F reorganization as a mere change in identity, form, or place of organization of one corporation. However, specific requirements must be met to ensure the transaction qualifies as an F reorganization. The IRS issued final regulations in 2015, identifying six requirements to qualify as an F reorganization:

1. Resulting corporation stock distribution: Ensures that the transferor and transferee corporations have essentially the same stockholders.

2. Identity of stock ownership: The same person(s) must own all the stock of both corporations before and after the reorganization.

3. Prior assets or attributes of the resulting corporation: The resulting corporation must not hold any property or have any tax attributes immediately before the reorganization.

4. Liquidation of the transferor corporation: The transferor corporation must completely liquidate for federal income tax purposes.

5. Resulting corporation as the only acquiring corporation: No other corporation may hold the transferor's property immediately before the reorganization.

6. Transferor corporation as the only acquired corporation: The resulting corporation may not hold property from another corporation, ensuring it succeeds only to the transferor’s tax attributes.

The third and fourth requirements ensure that the resulting corporation's post-reorganization assets come solely from the transferor and that the transferor terminates for tax purposes. The fifth and sixth requirements prevent complexities involving multiple acquisitions of property and tax attributes.

The IRS has historically confirmed that the step-transaction doctrine should not cause a failure of an F reorganization when part of a larger transaction. This clarification provides comfort for a pre-transaction F reorganization strategy followed by an acquisition.

Pre-Transaction F Reorganization Strategy

This strategy has gained popularity in private-equity transactions involving S corporations. Generally, it involves:

1. The shareholders of a target S corporation (Target) form a new corporation (Target Holding) by contributing Target shares to Target Holding in exchange for Target Holding shares.

2. Target elects to be a qualified Subchapter S subsidiary (QSub), resulting in a deemed tax-free liquidation of Target into Target Holding, extending S corporation status to Target Holding.

These steps are treated as an F reorganization under federal tax law. An additional step could involve converting Target to a limited liability company (LLC), making it a disregarded entity for tax purposes. This conversion is typically done when the buyer is a passthrough entity, ensuring Target does not become a C corporation post-closing. This also protects the buyer’s basis step-up if Target failed to qualify for S corporation status or if the QSub election was improperly executed.

After the pre-transaction restructuring, multiple acquisition options are available to the buyer. One option involves a partial rollover and a partial taxable sale, resulting in a basis step-up in Target’s assets. Another option is forming a partnership via distributing an interest in Target, making it a multimember LLC treated as a partnership for tax purposes. This allows a basis step-up under Sec. 743 in connection with a Sec. 754 election.

Compliance Matters

Following the F reorganization strategy, the QSub election treats Target as a disregarded entity for tax purposes. Target Holding elects to treat its subsidiary as a QSub by filing Form 8869, with the election date coinciding with the contribution of Target shares. The timing of this election is crucial, and the buyer would typically request a copy of the executed Form 8869 during tax due diligence.

If Target Holding was formed before the contribution, there might be a time gap between its formation and the contribution/election date. The IRS has granted relief for inadvertently invalid QSub elections, confirming that a new S corporation election for Target Holding is not required since Target's original S corporation status continues.

Costs and Benefits

Pre-transaction restructurings via an F reorganization offer several benefits:

1. For sellers: Defers gain recognition on rollover equity, benefits from transaction costs, and defers gain recognition on deferred payments.

2. For buyers: Provides a step-up in the tax basis of Target’s assets, avoids dependency on S corporation status for a valid Sec. 338(h)(10) election, and avoids legal complexities of asset purchases while preserving Target’s EIN post-closing.

Disclaimer: Golden Shield Business Brokers does not provide any tax or legal advice. The proceeding topic is for information purposes only and you should seek your own legal or tax professionals.