In M&A deals involving S corporations, it has become popular to engage in pre-transaction restructuring by making use of an ”F” Reorganization.
This provides the opportunity for the parties to receive the tax benefits provided by a purchase with a Section 338(h)(10) election without having to go through the election which has a number of requirements that may not be easily met.
The F reorganization also allows the target company to continue to use the same employer identification number which may be important in many cases.
What is an F Reorganization
Section 368(a)(1)(F) of the Internal Revenue Code defines an F Reorganization as “a mere change in identity, form, or place of organization of one corporation.”
Regulations further qualify that definition by stipulating that the corporation involved “must not change its capital structure, its assets, its business, or its shareholders.”
If a reorganization transaction meets the requirements, it will receive tax-free treatment.
What are the steps?
- The shareholders of the target S corporation (Target) form a new corporation (Holdco) by contributing shares of Target to Holdco in exchange for all of the shares of the Newco.
- Target elects to become a qualified Subchapter S subsidiary (QSub) which is a disregarded entity for federal income tax purposes (See our article about Disregarded Entities).
The QSub election results in a deemed tax-free liquidation of Target into Holdco. The IRS has also published rulings to indicate that S corporation status of Target will be extended to Holdco. (See, for example, IRS Revenue Ruling 2008-18).
The above can be accomplished on a tax-free basis because the transaction should be considered an “F” Reorganization.
Another common step after the F Reorganizations steps above is to convert Target from a corporation to a limited liability company (LLC) under state law.
As an LLC that only has one owner (Holdco), Target will continue to be viewed as a disregarded entity for federal income tax purpose and the conversion will therefore have no tax consequences.
Among other things, this extra step would protect the buyer’s step-up in Target’s assets should it is later determined that Target inadvertently did not qualify as an S corporation in the past or that Target did not properly execute the QSub election.
The diagram below shows a visual representation of Steps 1 and 2:
State and Local Issues
All of the tax consequences of “F” reorganizations described in this article thus far, such as a step-up in basis or zero recognition of gain or loss, are specific to federal tax consequences.
However, it is equally important to consider the various tax consequences that F reorganizations may have in different states. For example, some states require companies to file separate S corporation status elections and QSub elections for in-state tax purposes or they may tax gains on “F” reorganizations differently. Others, such as California, require separate taxes on QSubs.
Role of a Tax Advisor
An “F” Reorganization pre-transaction restructuring can create a lot of tax benefits for the parties involved.
However, it implicates a lot of complex tax rules each of which has to be properly complied. An experience M&A tax advisor will be invaluable to assist in the planning and execution of the strategy.
 IRC § 368(a)(1)(F).
 26 CFR §1.368-2.
 Hannah M. Prengler & Sara Britt, State and local considerations in using an F reorganization to facilitate an acquisition, The Tax Adviser (Aug. 1, 2020), https://www.thetaxadviser.com/issues/2020/aug/state-local-considerations-f-reorganization-acquisition.html.