ArticleMembers of the baby-boomer generation who have reached or passed retirement age continue to divest from their closely-held businesses as part of an overall wealth planning strategy. The resulting “middle market” of target companies contains, in particular, numerous entities that are organized as S corporations for tax purposes. Accordingly, buyers and sellers should be aware, and consider the use of an efficient tax planning tool in connection with the purchase and sale of an S corporation: the F reorganization.
F REORGANIZATION
Without getting lost in the minutia, an S corporation F reorganization is typically accomplished through the following steps: (i) existing shareholders form a new corporation (”NewCo”) and contribute their shares in the existing S corporation (”OldCo”) to NewCo; and (ii) NewCo makes an election to treat OldCo as a qualified subchapter S subsidiary (”Qsub”). A third step is often employed whereby the Qsub is merged (or converts via state-law statute) into a limited liability company (”Target LLC”).
All of these steps are generally treated as being tax-free; NewCo succeeds to OldCo’s S corporation election; OldCo (or Target LLC, as the case may be) retains its EIN, but is otherwise disregarded for income tax purposes. As discussed below, the resulting structure is attractive to buyers and provides flexibility to sellers.
M&A TRANSACTIONS
Generally speaking, in the context of M&A transactions, buyers and sellers each have certain tax- and non-tax goals. Some or all of these goals may be met, depending on the transaction’s structure (e.g., whether stock or assets of the target company are bought/sold, and whether the seller retains some ownership, often in the form of rollover equity).
With respect to the purchase and sale of S corporation businesses, buyers generally prefer to purchase assets, which (i) often results in valuable tax depreciation and amortization deductions in the future; and (ii) helps insulate the buyer from certain historic tax exposures (such as those resulting from an invalid S corporation election). Sellers, on the other hand, often prefer an equity sale because it tends to provide for preferential capital gain treatment. Sellers also prefer tax-deferral on any rollover equity received as part of the deal.
By structuring a pre-sale S corporation F reorganization followed by an equity acquisition of the target business, buyer and seller may simultaneously accomplish several of their highest priority goals. For example, if structured correctly, the F reorganization:
- Provides the buyer with a step-up in the tax basis of the target company’s assets (i.e., for the portion of the business purchased, generally resulting in valuable tax depreciation and amortization deductions)/ and insulates buyer from certain historic income tax liabilities of the target company;
- Provides the seller with the ability to obtain tax-deferred rollover equity without the limitations that are present with other acquisition structures;
- Avoids burdensome legal issues that generally arise in traditional asset sales (e.g. novation of contracts); and
- Allows the target company to continue utilizing its EIN for employment/payroll tax purposes.
Thus, when discussing potential M&A transactions with clients, to the extent the target company is an S corporation, practitioners should keep the F reorganization in mind as a relatively simple, yet effective structuring tool.
This article provides a high-level explanation of a pre-sale F reorganization of an S corporation target company, including the reorganization’s potential benefits to both buyers and sellers, and the steps to effectuate the transaction. Having said that, structuring this type of transaction takes technical expertise; careful planning is required to ensure the F reorganization’s steps are timed and executed properly, such that its intended results are respected.
Adam Margulies is at Farrell Fritz, P.C. and provides domestic and international transactional tax advice to clients within the private wealth, insurance, banking, and asset management sectors. Adam is a member of the Nassau County Bar Association and the American Bar Association and can be reached at amargulies@farrellfritz.com.
Published in The Suffolk Lawyer, Vol. 40 No.3 April 2024
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1 Unlike C corporations, S corporations do not pay entity-level tax; rather, the company’s income generally flows through to shareholders, resulting in a single layer of tax at the shareholder level. According to IRS statistics, since 1997, the S corporation is the most common type of corporation utilized for closely held businesses. Even so, properly electing and retaining S corporation status takes a significant amount of planning and diligence and contains traps for the unwary along the way.
2 See I.R.C. Section 368(a)(1 )(F). A full discussion of the requirements for effectuating an F reorganization is beyond the scope of this article.
3 See Rev. Rul. 2008-18. See also, PLR 200542013; PLR 200701017; PLR 200725012.
4 Rollover equity (that is, ownership in the buyer or its affiliate) leaves the seller with “skin in the game” post-sale, which (i) motivates the seller to remain active in the company and ensure a successful transition to new ownership; and (ii) allows the seller to enjoy additional gains in the future (i.e., upon sale of the hopefully-appreciated equity).
5 The mechanism that allows for this is colloquially referred to as a “step-up” in tax basis.
6 Indeed, to the extent the transaction takes the form of an asset sale that results in ordinary income and/or a higher tax bill, sellers may require a “gross-up” payment to equalize the difference vis-a-vis a stock sale.
7 The purchase generally should be treated as an asset purchase for federal income tax purposes, which may require buyer to make a gross-up payment. As is typically the case, however, the present value benefit of future tax deductions far outweighs the cost of the additional payment.
8 Nevertheless, tax due diligence of the target company generally is still warranted, particularly in respect of non-income (i.e., sales and use, employment/payroll, real and personal property, etc.) tax matters.
9 For example, a joint Section 338(h)(10) election which, comparatively speaking, has strict requirements and significant limitations. A full comparison of these structures is beyond the scope of this article.
