Using F Reorganisations to Restructure Businesses Prior to a Sale

Introduction

M&A transactions involving the acquisition of an S corporation requires strategic pre-transaction structuring to ensure tax-efficiency. Often, this involves a reorganisation under Section 368(a)(1)(F) (an “F Reorganisation”) of the Internal Revenue Code of 1986, as amended (the “Code”). An F Reorganisation, when executed correctly, changes a company’s legal structure (for example, from a corporation taxed as an S corporation to a limited liability company (LLC), thereby enabling a buyer to obtain a stepped-up basis) in a tax-free manner and with little to no disruption to business activities. This article provides an overview of what an F Reorganisation is, the steps to implement an F Reorganisation, and explains why or when an F Reorganisation may be necessary.

In an M&A landscape, the F Reorganisation is a vital restructuring tool. For example, buyers typically prefer to acquire assets (through an asset purchase agreement), for the resulting step-up in tax basis which generates increased depreciation and amortisation deductions in future years. Sellers, on the other hand, generally prefer a stock sale to avoid the complexity of transferring individual assets and benefit from capital gains treatment on the entire purchase price. An F Reorganisation resolves this tension by allowing the transaction to be structured as an equity purchase for legal purposes (preserving operational continuity, employer identification numbers, contracts, licenses, and employee relationships) while simultaneously being treated as an asset acquisition for US federal income tax purposes.

In the cross-border context, it may be necessary to reorganise a business to ensure a stepped-up basis upon acquisition or  to optimise its structure for tax purposes. As such, a single-entity, tax-free reorganisation, such as an F Reorganisation, is a useful tool in any M&A or tax practitioner’s toolkit. Understanding how and when to use F Reorganisations is imperative when advising clients, particularly after the introduction of Global Intangible Low-Taxed Income (GILTI) and Foreign-Derived Intangible Income (FDII) in 2018.

What is an F Reorganisation?

An F Reorganisation is a type of corporate restructuring governed by Section 368(a)(1)(F) of the Internal Revenue Code (the “Code”). To qualify as a reorganisation under Section 368(a)(1)(F) of the Code, a transaction must result in a mere change in identity, form, or place of organisation of one corporation, however effected. A “mere change” can involve an actual or deemed transfer of property from one corporation to another but is only considered a “mere change” (and, therefore, a qualifying F Reorganisation) if the following six specific requirements are met.

• Requirement 1: resulting corporation stock is distributed in exchange for transferor corporation stock. 
• Requirement 2: identity of stock ownership.
• Requirement 3: resulting corporation must not hold any prior assets or tax attributes. 
• Requirement 4: transferor corporation must completely liquidated for federal income tax purposes. 
• Requirement 5: resulting corporation is the only acquiring corporation.
• Requirement 6: transferor corporation is the only acquired corporation.

The first requirement ensures that the resulting corporation’s stock is issued solely in respect to the transferor corporation’s stock, creating a direct exchange relationship between the old and new entities. In practical terms, this means that the shareholders of the original corporation must receive stock in the resulting corporation in exchange for their shares in the transferor corporation.

The second requirement mandates that the same person or persons must own all of the stock of the transferor corporation immediately before the reorganisation and all of the stock of the resulting corporation immediately after the reorganisation, in identical proportions. This requirement is not violated if the stock is of different classes or has different terms, provided it is of equivalent value, nor is it violated if either corporation distributes cash or other property.

The third requirement provides that the resulting corporation must not hold any property or have any tax attributes immediately before the transfer, subject to a narrow de minimis exception. The exception permits the resulting corporation to hold assets to facilitate its organisation, maintain its legal existence, or to hold proceeds of loans taken in connection with the F Reorganisation.

The fourth requirement states that the transferor corporation must completely liquidate for federal income tax purposes as part of the transaction, although a dissolution of the transferor’s legal existence for state law purposes is not absolutely required; the transferor may even retain a de minimis amount of assets for the purpose of preserving its legal existence (as discussed above).

The fifth and sixth requirements, which were added to the final regulations in 2015, further ensure that the resulting corporation is the functional equivalent of the transferor corporation. Specifically, the fifth requirement provides that immediately after the reorganisation, no corporation other than the resulting corporation may hold any property previously held by the transferor if the other corporation would, as a result, succeed to any tax attributes of the transferor under Section 381(c) of the Code. The sixth requirement provides that immediately after the reorganisation, the resulting corporation may not hold property acquired from a corporation other than the transferor if, as a result, the resulting corporation would inherit tax attributes of the other corporation under Section 381(c) of the Code.

Taken together, these requirements reinforce the statutory concept that an F Reorganisation involves a single operating entity undergoing a mere change in identity, form, or place of organisation.

Implementation of an F Reorganisation

Revenue Ruling 2008-18 is the foundational guidance from the Internal Revenue Service (IRS) on F Reorganisations. It provides practitioners with a roadmap on how to effectuate an F Reorganisation while navigating complexities and maintaining compliance with the relevant rules and regulations.

In accordance with Revenue Ruling 2008-18, the shareholder(s) of the target S corporation (the “Target”) will execute the following steps to effectuate an F Reorganisation:

• form a new corporation (the “Target Holding”) and apply for an Employer Identification Number (EIN), which will be used to file tax election forms and returns.
• contribute the shares of Target to Target Holding in exchange for all of Target Holding’s shares; and
• Target files IRS Form 8869, Qualified Subchapter S Subsidiary Election, to elect to be a qualified Subchapter S subsidiary (QSub), which effects a deemed tax-free liquidation of Target into Target Holding (and extends S corporation status to Target Holding, as per Rev. Ruls. 2008-18 and 64-250).

Tax elections

Three primary tax forms are associated with the F Reorganisation, each filed at a specific stage of the transaction.

First, Target Holding will make a protective S election by filing IRS Form 2553. While making an S election for Target Holding is not technically required, it may prove administratively useful. Under Section 1.381(b)-1(a)(2), in the case of a qualified F Reorganisation and without regard to whether such reorganisation also qualifies under any other provision of Section 368(a)(1), Target Holding is treated as Target would have been treated if there had been no reorganisation. Accordingly, a reorganisation under Section 368(a)(1)(F) does not terminate the S election, which remains in effect for Target Holding. Nevertheless, a protective election may simplify administrative matters, particularly in states that request copies of IRS confirmation of S election status.

Second, after the contribution of Target to Target Holding, Target Holding must file IRS Form 8869 to elect QSub status for Target. This election serves to extend S corporation status to Target Holding. Line 14 of Form 8869 should be marked “Yes” if the election is being made pursuant to a reorganisation under Section 368(a)(1)(F) and Revenue Ruling 2008-18. Once the QSub election is effective, Target is treated as a disregarded entity for federal income tax purposes.

Third, after Target undergoes a state law conversion or merger to become an LLC, Target Holding will file IRS Form 8832 to ensure Target is treated as a disregarded entity for tax purposes. This filing is not required when Target is already an LLC; however, a protective election could be useful as a method to update the IRS regarding the entity type and name change associated with the EIN.

Conversion of Target through state law conversion or merger

If Target is not already an LLC, it will become an LLC by way of conversion or merger. Some states have conversion statutes, meaning Target can convert into an LLC by filing a form with the requisite state agency. For states that do not have conversion statutes, Target will become an LLC by way of a merger between Target and a newly formed LLC. The merger requires the preparation of certain merger documents, such as a plan of merger and certificate of merger. Both merger documents will be filed with the requisite state agency, similar to jurisdictions with a conversion statute.

Reasons to undertake an F Reorganisation

The most common reason to undertake an F Reorganisation is when the target is an S corporation and the parties need to disregard the target entity without adverse tax consequences to facilitate a partial rollover transaction while obtaining a step-up in basis on the assets sold. Under Section 311(b), when a corporation makes a distribution of its property, the corporation is required to recognise a gain as if it sold the appreciated property for fair market value; this includes tangible and intangible assets where the basis is likely zero, and therefore the entire amount constitutes a recognised gain. Notably, this treatment is one-sided, meaning that only gain is recognised, and no loss may be claimed. The objective of an F Reorganisation is to preserve pass-through treatment while avoiding termination of the S election, which would result in taxation as a C corporation.

Another significant reason to pursue an F Reorganisation is to grant equity to key employees or personnel in the form of a profits interest. S corporations cannot have multiple classes of stock, and all distributions must be made on a pro rata basis. Consequently, practitioners who wish to offer profits interests or other classes of equity must form a partnership structure, which the F Reorganisation facilitates by converting the target into a disregarded entity held by a new holding company.

Conclusion

The F Reorganisation under the Code is one of the most versatile and effective pre-transaction structuring tools available in M&A practice, particularly when the target entity is an S corporation. As this article has demonstrated, the F Reorganisation uniquely bridges the divergent tax preferences of buyers and sellers, enabling an equity acquisition for legal purposes while simultaneously achieving asset-acquisition treatment for federal and state income tax purposes.

The regulatory framework governing F Reorganisations provides practitioners with a well-defined roadmap for structuring these transactions. The implementation steps, while mechanical in nature, demand precision. The formation of a new holding corporation, the contribution of target stock, the QSub election on Form 8869, and, where applicable, the conversion of the target to an LLC must be carefully sequenced and timely executed.

Ultimately, the F Reorganisation exemplifies of how careful tax planning can align the economic interests of all parties to a transaction. Its proper execution, however, requires the co-ordinated efforts of experienced tax and corporate counsel to navigate the technical requirements and ensure that the intended tax benefits are fully realised.