Recent S corporation sales have increasingly used an F reorganization structure this year. This article focuses on:
- The definition of an F reorganization
- The effect of the reorganization on both the buyer and the seller
- Why F reorganizations are so popular
What is an F reorganization?
An F reorganization is defined in Internal Revenue Code 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.” A C corporation pays tax at the corporate level. When the C corporation distributes income to its shareholders as dividends, the income is taxed as a gain for the shareholders as individuals, the “double tax.”
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S corporations can have a maximum of 100 shareholders. Those shareholders can only be individuals, single-member LLCs or certain types of trusts. The individuals must be U.S citizens or U.S. residents.
Seller’s advantages
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 as a sale of all 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 considered ordinary income. The tax rates for ordinary income are higher than the tax rate for a capital gain on the sale of stock. With an F reorganization, the seller can have the transaction taxed as a stock sale while the Buyer may be able to treat the sale as an asset purchase for tax purposes.
The seller avoids transfer tax and the need for legal consent by creating a 100%-owned subsidiary that owns assets of the target.
Seller’s disadvantages
- 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 completion of the sale.
Buyer’s advantages
- The buyer gets asset purchase tax treatment while utilizing a stock or equity purchase structure. In other words, the buyer receives a step-up in the basis of the target’s assets equal to the amount paid for the seller’s LLC interest.
- The buyer no longer needs to terminate the target’s S corporation election at closing and reduces the buyer’s risk regarding the target’s existing S corporation election.
- The buyer may retain some target attributes post-closing, such as the operating history and creditworthiness.
Buyer’s disadvantages
- The buyer’s liability for the seller’s 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 the 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 may be that the restriction on S corporation shareholders is limited primarily to individuals, with very few exceptions. Many of the F reorganization/sales that we’ve handled involved investment groups. These investment groups are often formed as or include LLCs or other entities that will not qualify as subchapter S shareholders. The F reorganization may help solve the problem.
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