What is an F Reorganization and Why Are They So Popular?

Introduction

F Reorganizations have exploded in popularity and become the preferred way to facilitate the sale of S corporations. As the owner of an S corporation hoping to sell your company, it’s critical that you understand what an F reorganization is and how it could benefit you. An F Reorganization enables you to command more proceeds for the sale of your business, and it facilitates the transfer of your business to the Buyer.

Understanding F Reorganizations

What is an F Reorganization?

An F reorganization is a type of tax-free corporate restructuring blessed by the Internal Revenue Service (IRS). It involves a series of steps where an existing S corporation (Target) becomes a subsidiary of a newly formed S corporation (Holding), essentially transferring the assets and operations to the Holding company. Often the final step is Holding transforms into a Single Member Limited Liability Company (SMLLC).

Steps in an F Reorganization

The first step is a new S corporation is created, a holding company (Holding). The shareholders of the Target corporation contribute their shares in Target to the Holding company in exchange for shares in Holding. Holding then makes an election for Target to be treated as a Qualified Subchapter S Corporation Subsidiary (QSUB Election). This step ensures that Holding is an S corporation, retaining the benefits of one level of taxation S corporations enjoy for their owners. Lastly, Target converts to an SMLLC, facilitating the transfer of the business from a legal perspective.

These steps allow the continuity of the business under a new legal structure, but they are completely transparent to Target’s customers and employees. The Target retains its Federal Employer Identification Number, for example.

Benefits of F Reorganizations

The principal benefits of an F Reorganization are to make the acquisition easier to structure, justify a higher purchase price for the business, and minimize legal risks and operational challenges for the Buyer.

How an F Reorganization Makes the Acquisition Easier to Structure

An F Reorganization provides the best of both worlds to the Buyer: the tax benefits of an asset acquisition and the operational continuity advantages of acquiring equity. We’ll discuss below why the Buyer wants to acquire assets for tax purposes.

By restructuring Target to a SMLLC, the Buyer has flexibility to use any mix of cash and equity to acquire Target from Seller. This is in contrast to the “old” ways Buyers often acquired S corporations that required the Buyer to be a C corporation or to use a minimum amount of Buyer equity to achieve tax-deferred rollover benefits for the Seller.

Before the F Reorganization, the Target was an S corporation. S corporations can only have U.S. individuals and certain trusts as shareholders. Many Buyers are comprised of LLCs, corporations, and foreign investors, so it’s often impossible for Buyer to purchase Target without terminating Target’s S election. Once Target is converted to a SMLLC via an F Reorganization, Buyer can purchase the equity of Target and retain Target’s legal structure.

Why an F Reorganization Can Mean More After-tax Sales Proceeds for Seller

An F Reorganization means Seller can negotiate more after-tax proceeds because an F Reorganization means the transaction will be treated as an asset sale for tax purposes.

The sale of the units of Target, now a SMLLC, is treated as an asset sale for federal income tax purposes. In most cases, a Buyer prefers to purchase assets for tax purposes because it gives the Buyer tax benefits such as accelerated depreciation on equipment and the ability to amortization intangibles such as goodwill.

The Seller usually gets a better tax result selling stock in an S corporation because a stock sale is all taxed at capital gains tax rates. But realistically the Buyer will rarely agree to purchase stock because of both tax and legal reasons.

The Seller will owe more income tax in an asset sale than a stock sale because the gain on certain assets will be taxed at ordinary income tax rates, and because depreciation recapture is taxed at ordinary income tax rates. Check out the blog post on Purchase Price Allocation for a deeper discussion of how this works.

So if an asset sale means more tax for the Seller how does an F Reorganization mean more after-tax proceeds for Seller?

Since the Buyer realizes the tax benefits of an asset purchase, often the Buyer will agree to pay a higher purchase price for the business. This higher purchase price to compensate the Seller for agreeing to sell assets is known as a gross up. The Seller should engage a tax specialist to calculate the gross up because it will be a key part of negotiating the sales proceeds. The detailed calculation is usually shared with the Buyer’s tax advisors to support the Seller’s request for additional sales proceeds.

How F Reorganizations Minimize Legal Risks and Operational Challenges for the Buyer

In some industries, Buyers must purchase equity to retain the regulatory licenses and contracts necessary to operate Target’s business. An F Reorganization allows Buyer to purchase equity (the LLC units) but still achieve the tax benefits of purchasing assets.

There are other methods of acquiring Target equity and achieving the tax benefits for Buyer of an asset purchase such as a section 338(h)(10) election or section 336(e) election. But these require that Target have a valid S election, a risk that Buyers are unwilling to assume.

How F Reorganizations Facilitate Seller’s Participation in the Upside After the Sale

F reorganizations can offer tax deferral or reduction for sellers wishing to retain some upside by rolling over into Buyer equity,. This aspect is particularly appealing to business owners looking for continued investment in their business post-sale.

Once Target is a SMLLC after the F Reorganization, it’s expedient for Buyer to purchase only certain LLC units and other LLC units continue to be owned by Holding. The tax advantage for Seller is the percentage of Target deemed rolled over to Buyer by Seller can be structured as tax deferred.

For example, let’s say after the F Reorganization Holding owns all of the LLC units of Target, and there are 1,000 units outstanding. Buyer purchases 800 units of Target for $10,000,000 cash. Holding continues to own 200 units of Target. At this point, Target becomes a partnership for income tax purposes because it’s an LLC with two owners. Holding recognizes taxable gain on selling an undivided interest in 80% of Target’s assets. That taxable gain, and the $10,000,000 cash, will flow through to Holding’s S corporation shareholders with only one level of tax. Buyer will receive a step-up in tax basis on 80% of the Target’s assets. Holding continues to own a 20% stake in Target and will receive a Form K-1, along with any distributions of cash flow generated by 20% of the Target business post-sale.

Conclusion

F Reorganizations are an elegant solution that solve a number of challenges for S corporation Sellers and Buyers. The key benefits, including maximizing after-tax proceeds for Sellers, post-sale tax benefits for Buyers, flexibility in structuring the sale, and continuity of the business’s identity, underscore why F Reorganizations are a popular choice. For business owners considering selling their S corporations, understanding and potentially utilizing F Reorganizations can lead to significant financial and operational advantages.