Recent S corporation sales have increasingly used an “F Reorganization” structure this year. This article focuses on:
- The definition of an F Reorganization. (What is it?)
- The effect of the reorganization on both the Buyer and the Seller
- Why it is so popular
The definition of an F Reorganization. (What is it?)
An F Reorganization is defined in Internal Revenue Code (“IRC”) Section 368 (a) (1) (F) as a mere change of identity, form or place of organization of one corporation. In particular, this involves a tax-free reorganization of the target company (Seller) which is typically an S corporation.
An “S” corporation is a corporation which is a pass-through entity meaning that the corporation itself does not pay tax. With certain limitations, the income is passed through to the shareholders who pay tax as individuals avoiding the dreaded “double tax”.
S corporations can have a maximum of one hundred (100) shareholders. Those shareholders can only be individuals, single member LLCs, certain types of trusts. The individuals must be U.S citizens or U.S residents.
- The primary advantage of the F Reorganization for the Seller is that the Buyer in an F Reorganization has more flexibility than using an IRC Section 338 (h) (10) election or an IRC Section 336 (e) election. This includes the ability for the Buyer to use a greater mix of cash and Buyer rollover stock in the purchase price. The 338 (h) (10) election is to treat certain stock purchases as asset purchases. The 336 (e) election is for a corporation to treat the sale or exchange at all of the subsidiary’s underlying assets.
- For tax purposes, a stock sale is better for a Seller while an Asset Purchase is better for the Buyer. This is typically because the Buyer in an Asset Purchase can allocate part of the purchase price to depreciable assets providing a post-closing tax benefit. On the other hand, such an allocation may trigger depreciation recapture for the Seller which is ordinary income. The tax rates for avoiding income are higher than the tax rate for a capital gain on the sale of stock.
- The Seller avoids transfer tax and the need for legal consent by creating a 100% owned subsidiary that owns assets of the Target.
- The cost and risk of implementing the F Reorganization is typically on the Seller.
- The F Reorganization creates additional complexity the risk of which may not be discovered until months after the closing of the completion of the sale.
- Buyer gets asset purchase tax treatment while utilizing a Stock or Equity Purchase structure. In other words, Buyer receives a step up in the basis of the Target’s assets equal to the amount paid for Seller’s LLC interest.
- Buyer no longer needs to terminate Target’s S election at closing and reduces Buyer risk regarding Target’s existing S corporation election.
- Buyer may retain some Target attribute post-closing such as the operating history and credit worthiness.
- Buyer liability from Seller debts post-closing may be higher than in an asset sale. That can be mitigated in part by seller warranties and indemnities.
- The tax filings (largely prepared and filed by Seller’s counsel or team) are not approved and returned by the IRS until well after the actual closing. This can create unknown risks.
One other reason that the F Reorganization is so popular maybe that the restriction on S Corporation shareholders. Many of the F Reorganization/sales that we handled involved investment groups. These investment groups are in LLC’s or other entities that will not qualify as a Subchapter S shareholders. The F Reorganization may help solve the problem.