M&A Tax Shop Talk – “F reorganization”

The “F reorganization” has become the tax planning structuring technique of choice in today’s middle market M&A world. So, what does it mean to you as a seller?

First, F reorganization is only applicable in the context of corporations not LLCs. Second, in the middle market M&A world, which is still controlled by S corporation’s seller target, it means legally converting your existing S corporation to an LLC before selling.

The two major tax benefits to the seller are as follows:

• Permits partial equity rolled-over on a tax deferral basis that cannot be achieved under an asset sale tax election reporting structure transaction under Sec 338(h)(10), and/or Sec 336(e) with no permitted tax deferral rolled-over flexibility. Please note that under certain unique sets of facts and circumstances, there is an alternative planning opportunity to achieve somewhat comparable tax results to both the seller and buyer parties using Sec 351. We will cover this alternate structure in a future blog.
• Facilitates the handling of deferred compensation items to be assumed by HoldCo and administer, and satisfied from the collection of future indemnity hold-back and earn-out payout, etc.

The major tax benefit to the buyer is to achieve a stepped-up basis transaction that can be amortized over 15 years with absolute minimum tax exposure. The buyer via the transaction described has legally transferred all income tax-related exposure to the HoldCo shareholders.

The basic conversion process should be tax-free and it generally consists of the following sequence of steps:

Step 1: Form a new corporation hereafter referred to as “HoldCo”.

Step 2: All the S corporation shareholders (with no exception) will contribute 100% of its ownership to HoldCo. Need to apply for a separate employer identification number (EIN).

Step 3: Pursuant to IRS Revenue Ruling 2008-18, the old S election of the S corporation will automatically revert to HoldCo.

Step 4: Effective the same date as Step 2, convert the S corporation to a Qualified Subchapter S corporation (QSub) by filing IRS Form 8869 within 75 days. Entity will retain old EIN.

Step 5: Convert the QSub still a legal entity for state tax purposes, to an LLC via a formless conversion. Entity will retain old EIN.

In some cases, there may be additional steps required beyond the scope of this blog. For example, if the S corporation is not organized under a state that permits formless conversion process to LLC form. Further, any S corporation that is subject to unrecognized Net Unrealized Built-in Gains (NUBIG) tax under IRC Sec 1374, will not be triggered upon such conversion process but it will become the legal responsibility of the newly formed Hold Co.

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