When approaching a major junction in a company's life cycle — such as implementing a succession plan or selling the business — corporate business owners may want to consider a tax-efficient restructuring. An F reorganization might be an option. In many cases, it's used to help preserve tax attributes, optimize the transaction or create a holding-company structure without immediately triggering federal income tax.
An F reorganization is a type of corporate tax restructuring. So, it generally applies only to businesses treated as corporations for federal income tax purposes — including C corporations and S corporations — rather than sole proprietorships, partnerships or limited liability companies (LLCs) taxed as partnerships. And to achieve the intended benefits, taxpayers must follow a series of technical steps. Here's some background if you're weighing an F reorganization for your business.
Under the federal tax code, the term "F reorganization" describes a type of business restructuring involving "a mere change in identity, form, or place of organization of one corporation." This kind of restructuring is appealing because it may allow a corporation to change its structure while substantially preserving business and tax continuity. It also avoids a potentially hefty tax bill because assets and liabilities are transferred (or treated as transferred) without triggering a taxable event.
In addition, depending on the structure, an F reorganization may help preserve administrative continuity for the business — including certain tax registrations, trade names, contracts, licenses, permits, leases and insurance policies. However, the treatment of these items varies by transaction, and some may require new filings, notices, consents or amendments.
IRS regulations lay out six requirements that must be satisfied for an F reorganization:
If the restructuring doesn't meet these requirements, it may fail to qualify as an F reorganization and could trigger taxable consequences or require analysis under another tax provision.
How F reorganizations are structured depends on the situation. For example, let's say the owner of an S corporation, OLD Corporation, is transferring noncontrolling business interests to two family members under the company's succession plan.
In this situation, the first step in an F reorganization would be to form a new corporation, NEW Corporation. OLD's owner would then transfer the company's stock to NEW in exchange for NEW stock. Next, NEW would file Form 8869, "Qualified Subchapter S Subsidiary Election," with the IRS to make OLD a qualified subchapter S subsidiary (QSub) of NEW. This would also make OLD a so-called disregarded entity for federal income tax purposes, and it would be treated as liquidated into NEW. As a result, OLD's assets, liabilities and tax items would be treated as those of NEW, the S corporation parent.
At that point, the QSub could convert from a corporation to a single-member LLC, another type of disregarded entity. This is critical because converting from one disregarded entity into another generally doesn't trigger federal income tax. Depending on the succession plan, the LLC may then issue carefully structured equity or "profits interests" to the family members.
Once it has multiple owners — the two new owners and NEW — the LLC generally would be treated as a partnership for federal income tax purposes. The LLC would now be taxed differently. But the earlier F reorganization would preserve tax continuity by treating the restructuring as a continuation of the same corporate enterprise rather than as a taxable sale or liquidation.
The basic F reorganization steps may be similar in a business sale, but the surrounding structure often differs — and for good reason. Sellers of closely held businesses generally prefer stock sales to asset sales. With a stock sale, they're often taxed at long-term capital gains rates (usually 15% to 20%) rather than ordinary income rates (up to 37%).
Buyers, on the other hand, generally prefer asset sales because they provide a step-up in tax basis on the acquired assets. This allows them to depreciate the assets and claim valuable tax deductions. Sellers, however, may resist asset sales because they can result in less favorable tax treatment, including ordinary income from depreciation recapture or, in the case of a C corporation, potential entity-level and shareholder-level taxes.
An F reorganization can be structured to balance these competing interests. It's also helpful if the buyer is a private equity firm and the target business is an S corporation. Private equity firms are frequently structured as partnerships, and partnerships generally aren't eligible S corporation shareholders. In a common structure, the historic operating company becomes a disregarded LLC owned by a newly formed S corporation holding company. The buyer then purchases LLC interests rather than S corporation stock.
This arrangement protects the buyer from any risks related to the possibility that the target's S corporation status is invalid. In some transactions involving rollover equity, the F reorganization structure may allow the seller to defer gain on the rollover portion, depending on the equity rollover structure and whether the applicable tax requirements are satisfied.
An F reorganization may be a tax-savvy move under the right circumstances. But make no mistake: It's a complex transaction. Work closely with your tax and legal advisors to explore the possibility. Should you decide to proceed, they can help guide you through the process.
Get in touch today and find out how we can help you meet your objectives.
