In M&A and private equity transactions, buyers and sellers are consistently looking for ways to maximize value, which requires a critical focus on structuring the transaction in a tax-efficient manner. This pursuit of tax efficiency can be the difference between a successful deal and a missed opportunity, making it imperative for all parties to think critically and employ various strategies and tools to secure the best possible outcomes in their transactions. A reorganization under Section 368(a)(1)(F) (an F reorganization) can be a powerful tool used to efficiently structure an acquisition of a target that is treated as an S corporation for tax purposes (a Target S Corp).[1] By understanding the benefits of an F reorganization and how to implement it, buyers and sellers alike can achieve significant tax benefits and enhance their deal structures.

This article provides a high-level summary of the steps necessary to implement a pre-transaction F reorganization on a Target S Corp. It also explains how an F reorganization provides a buyer with the ability to obtain a step-up in the tax basis of the Target S Corp’s assets while at the same time affording the parties the ease of selling a single entity in an equity acquisition.

What Is an “S Corporation”?

Many privately owned companies are organized as S corporations for US federal income tax purposes because of the numerous tax benefits they offer to their owners. One of the most important tax benefits is that S corporation income and gains are generally taxed only one time — at the shareholder level. In contrast, C corporation income and gains are taxed at the entity level, and then any distributions of that C corporation income and gain are taxed again at the shareholder level. However, there are limitations associated with the S corporation tax status that limit its applicability, including rules providing that an S corporation can only have a single class of stock (e.g., different classes of stock with different distribution preferences would be treated as a second class of stock) and various shareholder limitations (e.g., no more than 100 shareholders, no foreign persons as shareholders, no corporations or partnerships can be shareholder entities, and only certain types of trusts can be shareholders).

How Do You Implement an “F Reorganization”?

An F reorganization is defined in Section 368(a)(1)(F) as a “change in identity, form, or place of organization of one corporation, however effected.” Although the definition is quite simple, there are many requirements that need to be satisfied for the change to be properly treated as an F reorganization. While this article will not address each of the various requirements that must be satisfied, one notable requirement is that immediately after the F reorganization, the same persons must own all of the stock of the surviving entity in identical proportions as they did prior to the F reorganization.

The following steps are required prior to the closing of the transaction to implement an F reorganization with respect to a Target S Corp:

Step 1: Create a new corporation or limited liability company (“Newco”).

Step 2: Target S Corp shareholders contribute the stock of the Target S Corp to Newco in exchange for equity of Newco (at this point, the Target S Corp is a wholly owned subsidiary of Newco, and the former shareholders of the Target S Corp are now the equityholders of Newco).

Step 3: Newco makes a qualified subchapter S subsidiary (QSub) election, by filing an IRS Form 8869, to treat the Target S Corp as a QSub (Target QSub).

All of the above-listed steps are nontaxable events. The three steps together are considered an F reorganization and result in Newco being treated as an S corporation (maintaining the historic S corporation status of and treated as a successor to Target S Corp) and Target QSub being treated as a QSub that is disregarded for US federal income tax purposes. Importantly, the Target QSub will retain the historic EIN.

One additional step that is typically implemented after the F reorganization and in advance of the closing of the transaction is to convert the Target QSub (that is a disregarded entity for tax purposes) into a limited liability company (Target LLC). This conversion is typically implemented under the appropriate state statutes (to the extent the state does not have a formless conversion statute, the parties must implement a merger into a limited liability company rather than a conversion). The Target LLC remains a disregarded entity for US federal income tax purposes, and the conversion is also a nontaxable event. It is important that this final step of conversion takes place at least one day after the filing of the QSub Election so that the Target QSub is treated as a corporation at the time the QSub Election is made. The conversion step is often preferred when the buyer is treated as a passthrough entity for tax purposes (e.g., a partnership or LLC taxed as a partnership), and the buyer would prefer not to own a C corporation target post-closing. As discussed in more detail below, private equity buyers are generally treated as passthrough entities for tax purposes, which generally makes it easier for sellers to structure to receive rollover consideration (e.g., equity of buyer) on a tax-deferred basis. In addition, the conversion protects the buyer’s tax basis step-up if the Target S Corp inadvertently failed to qualify as an S corporation in the past or the QSub election was not properly executed. 

It is important to note that while many states generally conform to the federal F reorganization rules described herein, a few states require separate state S corporation and QSub elections, and other states do not follow the federal passthrough entity treatment of S corporations or the disregarded nature of QSubs.

What Are the Benefits of Implementing an F Reorganization?

1. Tax Efficiency

Step-Up in Tax Basis

The most significant benefit of an F reorganization is tax efficiency. Where the business and assets being acquired are owned by an S corporation, implementing an F reorganization prior to the consummation of the transaction enables the buyer to purchase membership interests in a single-member LLC (i.e., the Target LLC discussed above) rather than stock of the S corporation (i.e., the Target S Corp). By purchasing membership interests in the Target LLC, the buyer is treated as acquiring assets for US federal income tax purposes (notwithstanding that the legal documentation is for an acquisition of all of the equity of the Target LLC). Therefore, the transaction results in a step-up in the tax basis of the assets held by the Target LLC at the time of acquisition. The stepped-up tax basis generally is equal to what the buyer paid for the Target LLC (as opposed to inheriting the historic tax basis of Target S Corp’s assets), and such step-up generally is allocated among the assets of the Target LLC in a manner similar to that which would apply if the transaction were structured as an asset sale.

A step-up in the tax basis of the assets of the Target LLC allows a buyer to offset future taxable income with increased depreciation or amortization deductions resulting from the step-up in tax basis.[2] This economic benefit can be quite important for buyers and private equity sponsors, particularly in the early years following an acquisition, when private equity sponsors are often focused on improving cash flow and financial performance.

F Reorganizations vs. 338(h)(10) Elections

We are often asked if implementing an F reorganization is preferable to making a Section 338(h)(10) election that would treat a qualifying acquisition of target stock as an asset acquisition for tax purposes, resulting in a step-up in the tax basis of the assets held by a target. While it is true that a Section 338(h)(10) election also allows a buyer to achieve a step-up in the tax basis of the assets held by a target, there are certain drawbacks that exist when making a Section 338(h)(10) that are not present when an F reorganization is implemented. For example, in a Section 338(h)(10) election, the step-up in tax basis is dependent on the validity of the target company’s original S corporation election. If that original S corporation election is not valid at the time that the Section 338(h)(10) election is made, there would be no step-up. Implementing an F reorganization allows buyers and private equity sponsors to avoid the risk that the target company inadvertently failed to be treated as an S corporation (e.g., if the target company inadvertently is treated as having a second class of stock or does not comply with the shareholder limitation, as discussed above). It is still important, however, for buyers to conduct due diligence on a target company’s S corporation status in order to avoid potential exposure under successor liability rules that may apply if the target company failed to be treated as an S corporation.

Beyond the certainty of obtaining a step-up in tax basis, an F reorganization can also more easily facilitate a tax-deferred “rollover” investment by the seller (often an important component of an acquisition by a private equity sponsor) as compared to a transaction involving a Section 338(h)(10) election, which is generally incompatible with achieving a tax-deferred rollover. Further, unlike a Section 338(h)(10) election that requires the buyer to purchase at least 80% of the target company’s stock, an F reorganization has no threshold amount that must be acquired by the buyer. This is again particularly beneficial to private equity sponsors who may seek to purchase less than 80% of the target company’s stock and permit the existing equityholders to remain invested in the future success and growth of the target.

2. Ability to Implement the Acquisition Via an Equity Purchase

As described above, an F reorganization has the effect of treating the acquisition as an asset purchase for tax purposes while practically being implemented as a stock purchase (from a legal perspective). The buyer will acquire the target entity via a stock or equity purchase agreement, but the buyer gets the tax benefit as if it had acquired the business via an asset purchase. By purchasing the equity interests outright, there may be less of a legal and compliance burden with respect to obtaining third-party consents from governmental authorities or other third parties as there would be in an asset purchase transaction. The assets remain in the target for legal (non-tax) purposes, and it is just the beneficial ownership of the target that will now change. This continuity of assets and operations can also be helpful for employee retention in a transaction since any employees will remain employees of the same entity with the same benefits (subject to post-transaction business changes).[3] Further, from a tax perspective, the buyer of a Target LLC would not need to worry about the shareholder limitations associated with owning S corporation stock or the form of equity issued to buyer shareholders (discussed above).

Related Planning for Rollover Investments Post-F Reorganization

Buyers (especially private equity sponsors) often want the sellers to retain a small equity ownership interest in the acquired company so that they have “skin in the game.” Similarly, sellers often want to retain some ownership to benefit from the potential of the future growth of the target under the private equity ownership. To allow sellers to receive rollover consideration on a tax-deferred basis, as part of the acquisition and following the F reorganization, Newco can contribute some of the equity in the Target LLC into the buyer’s acquisition vehicle while the remaining equity in the Target LLC is acquired directly by the buyer’s acquisition vehicle.[4] This typical transaction structure is treated as a partial rollover and a partial taxable sale of an undivided interest in each of Newco’s assets. The partial rollover can easily be achieved on a tax-deferred basis as long as the buyer’s acquisition vehicle is treated as a partnership for US federal income tax purposes. Keep in mind that the step-up in tax basis will be limited to the portion of the Target LLC that is acquired by the buyer acquisition vehicle directly (and not the tax-deferred rollover portion that is acquired through the contribution of these equity interests by Newco). Moreover, in order to retain the benefit from the tax deferral, the owners of Newco generally will need to hold their rollover consideration through Newco, as a distribution of the rollover consideration from Newco to the owners could trigger the gain in the rollover consideration for tax purposes.

Conclusion

F reorganizations offer a powerful tool for optimizing M&A transactions, providing significant benefits to both buyers and sellers. When F reorganizations are strategically planned and executed, both parties can achieve a more efficient and favorable transaction, paving the way for a successful integration and long-term value creation. That said, structuring an F reorganization is complex and requires careful planning to ensure that it is properly implemented. Please reach out to your M&A or tax professional at Mintz if you have any questions relating to the use of F reorganizations.