How an “F” Reorganization Can Help You Sell Your S Corporation

If you are negotiating the sale of your S corporation with a potential buyer, the buyer may insist that your corporation undergo an “F” reorganization prior to closing the purchase.  This technique is often used where the buyer is a private equity firm or strategic buyer and the transaction involves the owners rolling over a portion of their equity in the S corporation in exchange for equity in the buyer entity as part of the transaction ( i.e. “rollover” equity).

So what is an “F” reorganization, and why would a buyer insist that the seller restructure your company just prior to the sale transaction?

Overview of F Reorganization

The “F” reorganization gets its name from its location in subsection (F) of Section 368(a)(1) of the Internal Revenue Code (the “Code”), which provides that “a mere change in identity, form, or place of organization of one corporation, however effected” is a reorganization which is nontaxable to both the corporation and its shareholders.

The “F” reorganization technique can be a very useful tool for preparing an S corporation for sale, as it can overcome obstacles inherent in the S corporation structure and accomplish several tax and business related goals for both the buyer and the seller.

First,  only individuals, estates and certain types of trusts can own stock in an S corporation, so a private equity or other business entity buyer cannot purchase the stock of an S corporation directly without running afoul of the S corporation ownership rules.

Second, while buyers typically prefer to purchase assets rather than S corporation stock so they can get a stepped-up tax basis in those assets for depreciation purposes, sometimes it isn’t feasible to buy the assets, such as where there are a large number of non-transferable contracts, or where it is essential to retain the existing EIN of the business.

Finally, even where the parties agree to an asset purchase, this structure prevents the S corporation shareholders from deferring the gain on the rollover equity they are receiving in the transaction, meaning that the sellers pay tax on the sale of 100% of the assets and then invest in the rollover equity on an after-tax basis, which is not a tax-efficient result for the seller.

The “F” reorganization structure overcomes these issues by allowing the buyer of an S corporation to obtain a stepped-up tax basis in the s corporation’s assets while taking the legal form of an equity purchase, and allowing the selling S corporation shareholders to defer any gain on their rollover equity.  The “F” reorganization is one of those rare techniques that can lead to favorable tax results for both seller and buyer upon the completion of the sale. 

The “F” reorganization technique that we use in S corporation sales where the owner is taking rollover equity usually entails the following sequence of steps:  (i) the shareholders of the existing S corporation (“Target”) form a new corporation (“Holdco”) and contribute all of their Target stock to Holdco in exchange for all of the stock in Holdco, leaving Target as a wholly-owned subsidiary of Holdco, and (ii) Holdco files an election with the IRS to treat Target as a “qualified subchapter S subsidiary” (i.e. a “QSub”) of Holdings. This election results in a deemed tax-free liquidation of Target into Holdco, with Target becoming a “disregarded entity” (i.e. a part of Holdco) for federal income tax purposes. Under Revenue Ruling  2008-18, the IRS held that these two steps qualified as an “F” reorganization, with Target’s S corporation election continuing in Holdco. [1]

Next, Target is converted from a corporation to a limited liability company (“Target LLC”) under the appropriate state law entity conversion statute As a single member limited liability company, Target LLC remains a  “disregarded entity” for federal income tax purposes, just as it was as a QSub prior to the conversion, so the entity conversion has no federal income tax consequences.

Once the above “F” reorganization and entity conversion are complete, the buyer then buys some percentage of the membership interest of Target LLC from Holdco.  Since Target LLC is treated as a mere part of Holdco, the purchase of a percentage interest in Target LLC is treated as the purchase by the buyer of that same percentage of Target LLC’s assets, which it takes with a stepped-up cost basis in those assets.[2]   Holdings then retains the rest of the Target LLC interest, or contributes (i.e. rolls over) its remaining Target LLC interest to an upstream affiliate of the buyer (i.e. a private equity fund) in exchange for equity in that entity.  In either case, if properly structured the S corporation shareholders receive the rollover equity on a tax-free basis.  In a case where the buyer is a private equity fund and is only buying 90% of the equity of the Target LLC with the remaining 10% being rollover equity,  the buyer would be treated as purchasing 90% of the assets of Target LLC with a stepped up basis (which makes the buyer happy), and Holdco is not taxed on the 10% rollover equity it receives (which makes the seller shareholders happy). 

Conclusion

The F reorganization is an amazing little device that allows buyers of S corporations to obtain a step-up in the tax basis of the target’s assets while simplifying the transfer of contracts and other assets as compared to an asset sale, and allows the S corporation shareholders to defer gain recognition on their rollover equity.

The “F” reorganization used in S corporation sales is very technical and each step must be undertaken in a precise order.  Any failure to implement the steps properly may trigger adverse income tax consequences to the existing shareholders.  Thus, it is essential that the practitioner preparing and filing the documents and IRS forms implementing the “F” reorganization be well-versed in transactions of this type.

The tax and business team at Blue Sky Law has extensive experience in structuring “F” reorganizations in M&A transactions. We can advise you on aspects of formation, timing, and tax filing to ensure you achieve the best possible results throughout the “F” reorganization and sale process.

[1] See to Revenue Rulings 64-250 and 2008-18.  Even though this variety of “F” reorganization technically involves two corporations, Holdco is treated in this transaction in most respects as if it were the same entity as Target was immediately before the reorganization, so it still qualifies as an “F” reorganization.

[2] See Revenue Ruling 99-5