How to Use an F Reorganization When Buying a Business
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How to Use an F Reorganization When Buying a Business
In this post, we’ll be addressing F reorganizations.
But what exactly is an F reorganization? And when should I consider it?
Here’s what we’ll cover:
What is an F reorganization?
Why use an F reorganization when buying a business?
F reorganizations vs. Section 338(h)(10) & Section 336(e) tax elections
How to avoid common pitfalls
What language to include in your Letter of Intent (LOI).
What is an F reorganization?
An F reorganization is where a company undergoes a mere change in identity, form, or location. In the context of an acquisition, an F reorganization occurs prior to the closing.
Did that clear it up for you?
Of course not. It’s tax and a little wonky. Perhaps the best place to start is the why, rather than the what.
Why use an F reorganization when buying a business?
F reorganizations come into play when a buyer wants to purchase the stock of an S corporation, but still wants the benefits of an asset purchase for tax purposes.
Why would a buyer purchase stock rather than assets? We’ve covered this before. Common reasons include:
Assignment issues. Key contracts cannot be assigned.
Licensing issues. Critical licenses are difficult to transfer.
Convenience. The benefits of a smooth transition outweigh other considerations.
But purchasing stock comes with well-known downsides:
Liabilities. The buyer assumes the target company’s historic liabilities.
No step up. The buyer does not get to “step up” the tax basis of the target’s assets.
Again, we’ve covered this before.
An F reorganization allows the parties to treat the deal as an asset purchase for tax purposes. It solves for the second downside.
What is an F reorganization (revisited)?
Let’s revisit the what: In general, F reorganizations adhere to the following sequence of steps, which, again, occur prior to the closing.
Step 1: The shareholders of the target S-corporation create a holding company (HoldCo).
Step 2: The shareholders elect to treat the HoldCo as an S corporation, and contribute their stock in the target to the HoldCo.
Step 3: The shareholders elect to treat the target as a QSub (a qualified subsidiary of the HoldCo S corporation). As a result, the target becomes a disregarded entity; its assets and liabilities are treated as the Holdco’s for income tax purposes.
Step 4: The target is converted into a single-member LLC, and sold to the buyer. Because the Buyer is purchasing the equity of a single-member LLC, the purchase is treated as an asset purchase for tax purposes.
F reorganization vs. Section 338(h)(10) & Section 336(e) tax elections
Don’t Section 338(h)(10) and Section 336(e) tax elections also allow the parties to treat a stock purchase as an asset purchase for tax purposes?
Yes (once again we’ve covered this before). But an F reorganization may offer additional benefits to the buyer.
F reorganizations protects against the risk of an invalidated S election.
A key risk when acquiring the stock of an S corporation is that the target business invalidated its S election in the past. If an S corporation invalidates its election, it becomes a C corporation by default.
Dividends from a C corporation are taxed twice, once at the corporate level and once at the shareholder level. In contrast, S corporations are pass-through entities—distributions are only taxed at the shareholder level.
As a result, if the target has invalidated its S election, the buyer may be liable for the C corporation taxes that the target owed but never paid. And if you’re relying on the target’s status as an S corporation to make a tax election, you may not receive the stepped up basis that you seek (the tax authorities can deny the tax election).
An F reorganization circumvents this issue. It results in a clean tax history. The risk of an invalidated S election is mitigated.
F reorganizations result in LLCs.
At the end of an F reorganization, the target is left as a Limited Liability Company (LLC).
LLCs are more flexible than corporations. They can be taxed as corporations, partnerships, even disregarded entities.
This is particularly important if the buyer cannot or does not want to maintain S corporation status post close. The buyer can choose to have the target taxed as a partnership, for example, rather than a C corporation. In contrast, if the target is a corporation for state law purposes, the buyer won’t have that option.
Is there a “but” coming?
Yes, F reorganizations are not without their issues.
First, it costs more. F reorganizations are more complex. They require more of a lawyer’s time, and your lawyer has to be sufficiently experienced to properly execute the F reorganization.
Second, it bears repeating: F reorganizations are a little wonky. They occur prior to the closing, meaning you need the seller to agree to execute the F reorganization in advance. And they can be hard to explain, sometimes making them a hard sell, particularly if the seller’s broker has never come across an F reorganization before.
Here’s a general rule of thumb:
If a target’s S election looks valid, a Section 338(h)(10) or Section 336(e) election could be the path of least resistance.
If there’s any risk of an invalid S election, or if the buyer wants entity flexibility, push for an F reorganization.
How to avoid common pitfalls
Propose an F reorganization as soon as possible.
If the idea of an F reorganization is introduced late in the day, the seller may push back due to the additional complexity and cost. Moreover, some SBA lenders, some brokers, and even some lawyers have limited experience with F reorganizations. It may take time and education to get the necessary parties onboard.
Be ready to compensate the seller.
F reorganizations result in an asset purchase for tax purposes. When compared to a stock purchase, an asset purchase may be less tax advantageous for the seller. If you face push back, offer to gross up the purchased price to offset the seller’s tax impact. And be prepared to pay for the additional legal fees that the seller will incur in executing the F reorganization.
Work with experienced legal counsel.
Not all advisors are familiar with F reorganizations. And inexperienced advisors may make incorrect filings, or get the timing of those filings wrong. This can result in negative outcomes for buyers and sellers. Retain suitably experienced counsel. And regardless of the experience of seller’s counsel, have your lawyers monitor the process to make sure that the F reorganization is executed properly.
What language should I include in my LOI?
For those interested in pursuing an F reorganization, the relevant section of your LOI could include the following language:
Seller shall execute an F reorganization prior to the Closing in order to treat the Transaction as though Buyer were purchasing substantially all of the assets of the Company.
At the LOI stage, you may not have enough information to know whether you want to execute an F reorganization or make a tax election. The important thing is that you clearly signal that you want to treat the purchase as an asset purchase for tax purposes.
Buyer and Seller shall cooperate to treat the Transaction as though Buyer were purchasing substantially all of the assets of the Company.