F-reorganizations

“F” Reorganizations in Succession Planning and Business Purchase and Sale Transactions involving S Corporations

March 2024
Author: Andrew (Drew) Piunti
DPA Law PC
drew@dpalawyers.com

An “F” reorganization is a type of qualifying tax-free reorganization for corporations under Section 368(a)(1)(F) of the Internal Revenue Code (the “Code”) that changes a corporation’s “identity, form, or place of organization” of a corporation. To satisfy its tax-free requirements, the transaction must meet one of the statutory definitions of a “reorganization” while retaining the same essential ownership structure.

In advising small and medium sized business, I tend to use the “F” reorganization in two primary circumstances, each involving the conversion of an operating (as opposed to “holding”) company organized as an S corporation into a limited liability company.

In the first application, the “F” reorganization facilitates the sale – in part or whole – of the S corporation’s equity securities (think sale of a company’s stock or membership interests rather than assets) in a purchase and sale transaction where the buyer (or investor) is itself a business entity and, under applicable tax rules, prohibited from holding stock in an S corporation [see, below, The S corporation’ and ‘“F” reorganizations involving S corporations in business purchase and sale transactions’].

“F” reorganizations for succession planning

In the second application, the “F” reorganization becomes a vehicle to carry out a business succession plan – a strategy for passing leadership roles and ownership (typically in part) to a new group within the company that understands the value of the business. Here, the S corporation converts into a limited liability company with not one, but two different classes of equity securities (called “membership interests”), something not allowed under tax rules governing the S corporation. Each equity class has its own defined rights, preferences, and privileges. One class is owned and controlled by legacy owners (typically family member acting through a newly created holding company). The other is controlled by certain key service providers (generally employees) whose retention and participation in management are deemed vital to the business’ future prospects and growth. Shared management responsibility is carried out by having the holders of the two equity classes separately elect a designated number of managers to the LLC’s board of managers. The designated managers allocated to each equity class does not have to correspond, and likely won’t, with the two groups relative aggregate company ownership. For example, it may make sense to designate the same number of managers to each equity class even though the legacy holders own a larger share of the company.

When properly drafted, the LLC’s governing document (the “operating agreement” or, in some states, the “company agreement”) combines this separate election of designated managers with carefully crafted protective provisions – requirements that certain actions must be approved by a super majority of the board of managers, and/or by a majority (or super majority) of the members of one equity class or the other – or both. The result is an entity restructured for future growth in a tax-free event with provisions protecting the interests of legacy owners and key service providers.

Before addressing the sequential steps necessary to implement an “F” reorganization (see, Implementing the “F” reorganization), it’s helpful to review certain attributes of the S corporation, and then take a quick look at how the “F” reorganization can facilitate purchase and sale transactions of small and medium sized S corporations.

The S corporation

An S corporation is a corporation like any other established under state law, but which qualifies and has elected to be taxed under subchapter S of the Internal Revenue Code of 1986, as amended (the “Code”). Its primary advantage is its single level of taxation, avoiding the “double” federal income taxation imposed on C corporations: once at the corporate level on net profits, and again at the stockholder level on receipt of corporate dividends. Rather, the S corporation passes its corporate income, losses, deductions, and credits through directly to the personal tax returns of its stockholders pro-rata in accordance with their respective percentage ownership.

Congress adopted this “pass-through” corporate tax treatment to benefit small and medium sized corporations, and, because of this, imposed corresponding limitations.

The Code provides that an S corporation must:

  • Have fewer than 100 stockholders
  • Be incorporated domestically
  • Be owned by individuals, estates, and/or qualified trusts
  • Not be owned by corporations, partnerships, or nonresident aliens
  • Issue only one class of stock

The proscription on corporate ownership notwithstanding, one S corporation may own 100% of the shares of another S corporation, provided it treat the subsidiary as a qualified Subchapter S subsidiary or “Q-sub.” The Q-sub is no longer considered a separate income tax entity, and all of its profits and losses are included in the tax return of the parent S corporation – where they are passed through to parent corporation’s stockholders.

“F” reorganizations involving S corporations in business purchase and sale transactions

Most closely held small and medium sized businesses being acquired in the current market are taxed as S corporations. Many buyers are private equity firms organized as partnerships or so-called “strategic” buyers – larger corporations taxed as C corporations – neither of which can own stock in the selling S corporation.

This presents a challenge because sellers are typically better off in a straight stock or equity sale transaction, whereas buyers tend to view an asset sale transaction as the more beneficial. A stock sale allows sellers to receive preferential capital gains treatment rather than be subject to higher ordinary income tax rates. On the other hand, an asset sale enables buyers to achieve a step-up in tax basis on the purchased assets acquired, providing for greater future depreciation to offset taxable income. (Note, however, when a seller is assessing the tax impact between an asset and stock sale, the difference can be considerably less when the selling company is an asset-light business, and the majority of the purchase price consists of goodwill).

One solution to this stock verses asset sale preference is a Code section 338(h)(10) election. It permits the purchase and sale of an S corporation to be treated as a stock sale for legal purposes and as to the buyer, as an asset sale for tax purposes. But there are limitations inherent in a section 338(h)(10) election (a full discussion of which is beyond the scope here) which make it both somewhat risky and impose possibly undesirable restrictions on the ownership structure of the company post-sale. For this reason, I generally recommend the “F” reorganization instead.

An “F” reorganization potentially presents a “win-win” for sellers and buyers of an S corporation. The primary benefit for buyers is the “F” reorganization it allows them to take advantage of a step-up in the tax basis of the selling company’s assets without requiring that seller maintain its S corporation status. The primary benefit for the sellers is they get to move forward with a purchase and sale structured as a stock sale – with corresponding tax benefits, while opening up the sale transaction to the world of private equity firms and strategic buyers taxed as C corporations or partnerships. Further, and this is important, the “F” reorganization allows the selling stockholders to defer tax on any equity rollover in the post-sale company – that portion of equity the sellers retain in the company post-transaction. Finally, in the “F” reorganization, the converting S corporation’s EIN flows through for continued use by the LLC into which it converts, often an important consideration for the buyer. And both seller and buyer benefit from being able to avoid some cumbersome legal considerations common in an asset purchase.

Implementing the “F” reorganization

There are generally five steps to convert an S-corporation to an LLC in a transaction that qualifies as a tax-free “F” reorganization. Successful implementation requires that these steps be taken in sequential order. Steps One through Four below, cover the requirements for, and reflect, the “F” reorganization. Step Five, the conversion to the LLC, occurs promptly (but no sooner than a day or two after) the “F” reorganization is complete.

Step One

The stockholders of the existing S corporation operating company (“OldCo”) form another corporation (HoldCo) (Diag. A) (Note: it is important that HoldCo be a new business entity to ensure it does not hold any property immediately prior to the “F” reorganization. This is because, other than de minimis assets – typically some money – to facilitate its organization, everything HoldCo owns post-“F” reorganization must be from OldCo.)

Diagram-A

Step Two

HoldCo obtains a new employer identification number (EIN), identifying on its EIN application its corporate form and intent to file an S corporation tax return. While, it is generally understood that HoldCo technically need not make an S corporation election on IRS Form 2553 (Election by a Small Business Corporation). This is because OldCo’s original and existing S corporation election/status continues in effect for HoldCo when it elects to treat OldCo as a “qualified Subchapter S subsidiary” (“QSub”) [see Step Four].

Step Three

The stockholders of OldCo contribute their shares of OldCo to HoldCo in exchange for all of the stock in HoldCo. (Diag. B). The OldCo stockholders must own their stock in HoldCo in the same proportions that they owned shares of OldCo. This contribution is evidenced by an equity contribution agreement which, among other things, describes the transaction as an “F” reorganization and is signed by Holdco and each stockholder of OldCo.

Diagram-B

Step Four

Following the contributions described in Step Three, HoldCo elects to treat OldCo as a “qualified Subchapter S subsidiary” (“QSub”) of HoldCo by filing with the IRS Form 8869 (Qualified Subchapter S Subsidiary Election). HoldCo can treat OldCo as a QSub because it owns 100% of OldCo’s shares. The QSub election results, for tax purposes, in a deemed tax-free liquidation of OldCo into HoldCo, meaning OldCo will then be treated as a disregarded entity for federal income tax purposes. OldCo retains its historic EIN, however. Once these steps are taken, the “F” reorganization is complete. (Diag. C).

Diagram-C

Step Five

To facilitate an equity sale to buyer – possibly to a private equity partnership or C-corporation, OldCo then converts from a corporation to a limited liability company under state law (Diag. D). As a single owner (member) LLC (just like as a QSub), the LLC remains a disregarded entity for federal income tax purposes. The statutory conversion of one disregarded entity (OldCo as a QSub) into another disregarded entity (a single-member LLC) has no federal income tax consequences. State law varies as to how the conversion is completed. But, to avoid any issues for the “F” reorganization, the conversion should occur at least one day after the steps described above. Timing here is critical. This means waiting one or two days after filing the QSub election before filing the conversion documents with the applicable state agency.

Diagram-D

After conversion, the structure immediately prior to the purchase and sale transaction has the former OldCo owners owning 100% of the issued and outstanding shares of NewCo, which, as a holding company, in turn owns 100% of the equity interest in the LLC. (Diag. E).

Diagram-E

The selling business owners and the buyer can then proceed with the sale transaction. Due to the reorganization, the owners of the LLC can sell some or all of their equity (now LLC membership interests) instead of their former equity (stock) in an S corporation, which buyer (organized as an entity) would have been prohibited from owning. Since the LLC is treated as a division of its parent HoldCo S corporation, the sale of an interest in a QSub is treated as a sale of an undivided interest in its assets for federal income tax purposes (corresponding to the amount of stock sold), which provides the buyer with a “step-up” in the basis of the acquired company’s assets equal to the amount paid for the LLC’s equity interest, which can then be used for depreciation and amortization purposes.

 Disclaimer: This summary is made available by DPA Law PC (the “firm”) for informational purposes only. It is not meant to convey the firm’s legal position on behalf of any client, nor is it intended to convey specific legal advice. Accordingly, do not act upon this information without seeking counsel from a licensed attorney engaged to provide advice based on your specific circumstances. This article also is not intended to create, and receipt of it does not constitute, an attorney-client relationship. This article is published “as is” and is not guaranteed to be complete, accurate, or up to date.