Does Your Company Need an F Reorganization?
April 7, 2022 - When you start a business you put a lot of thought into how to structure it from a tax perspective. Do you pick LLC? S-Corp? C-Corp? Some combination of multiple structures? Something not every business owner considers at their founding is how proceeds from a future sale will flow based on the structure you select. It will matter and if a sale, divestiture, or merger is potentially in your company’s future, now is the time to reexamine the structuring topic.
Do You Need an F Reorganization?
An F reorganization falls under the IRS Code Section 368(a)(1)(F) and covers changing a business from one type of form or filing entity to another. Here’s a quick refresher on the most common business structures:
Single level of taxation.
Most flexible entity type.
Easy to move things in or out in a tax deferred manner.
Easy for partners to adjust financial matters after the fact (comes with extra rules).
More rules and complexity.
Potential for abuse.
Single level of taxation.
Certainty on self-employment tax treatment of company profit.
Many more restrictions (limited to 100 shareholders, only allowed one class of stock, etc.).
Lowest rates on retained profits. Better rate for foreign profits.
Double tax (corporate profit taxed, then salaries/dividends taxed at the individual levels once it’s passed through).
A major part of planning and executing a successful business transaction is structuring it so the proceeds flow the way you want and the tax implications are as favorable as possible. This begins by having your company organized under the optimal structure and ideally should be a consideration several years before the transaction even takes place.
M&A advisors who have been involved in transactions that involve different business structures can help you select the one that is best for you.
Equity and Assets
In a typical transaction either equity or assets (or both) change hands. That may sound like a transfer of an ownership stake (equity) or a physical thing (an asset), but from a tax perspective, the line can be blurred. If a company is structured correctly and a transaction is planned appropriately, equity acquisitions can be treated as asset acquisitions in order to get the optimal taxation outcome.
For example, from a seller’s perspective, odds are it will be better from a tax standpoint to relinquish equity in a transaction. Selling assets generally results in a higher effective tax rate on the gain. This is especially true if you are a C Corporation and may face a double taxation situation (i.e. paying taxes on the entity level and again after gains are distributed to shareholders). Shareholders in C Corporations who own stock that qualifies as qualified small business stock have an additional incentive, with the potential for gain exclusions of up to 100% on a sale of stock.
You can have a sale of corporate stock structured as an asset sale under IRC Section 338(h)(10). Also, when made with respect to the sale of a C Corporation subsidiary, the deal can be treated as if it occurred while the target corporation is still part of the selling group. This means sellers can shelter the gain on the assets with operating losses or other tax offsets they have. This is only an option for corporate buyers that purchase at least 80% of the stock in an S Corporation or a C Corporation subsidiary in a consolidated group from an unrelated party.
IRC Section 338(g) provides a similar election for a qualified stock purchase of a standalone C Corporation. This election typically only makes sense when a C Corporation has significant tax losses or credit carryovers or with acquisition of certain foreign corporations. The election results in the target corporation being treated as having sold 100% of its assets at fair market value to a new corporation. The resulting corporation gets a step up in basis of the assets and eliminates the historic attributes, such as accumulated earnings & profits (which determine the taxability of dividend distribution). However, since the final tax return for the “old” corporation is due after the transaction, the buyer would be acquiring any tax liability resulting from the deemed asset sale.
Non-Corporate, LLCs, and QSubs
Non-corporate buyers (like partnerships or individuals) have a similar option for limiting tax liability by treating a stock acquisition as an asset transaction under Section 336(e) rules.
An LLC with just one member is treated as a disregarded entity for tax purposes. A sale of the equity of a disregarded entity is treated as an asset sale for tax purposes. This can give the buyer a basis step-up for future tax benefits.
It’s similar for some subchapter S Subsidiaries (Qsub). These are S Corporations wholly owned by another S Corporation. QSubs are treated like disregarded entities, as well.
Disregarded entities are a useful tool where the parties wish to treat a sale of equity as an asset deal and do not qualify for the elections under Sections 338 or 336(e) and/or where they wish to have a tax-free rollover of equity. (NOTE: The elections under 338 and 336e require an 80% stock purchase AND are treated as though they sold 100%, so they have to pick up gain on the rollover).
A common planning technique with S Corporations is to undergo an F reorganization. In these transactions the stock of an existing S Corporation (“the Company”) is contributed to a new Corporation (“NewCo”) which makes an election to treat the S Corporation as a qualified subchapter S subsidiary. The combination of these steps is treated as a tax-free reorganization under IRC 368(a)(1)(F) and results in the Company being a disregarded entity of NewCo. Subsequent to the filing of the Qsub election, the Company is converted under state-law to an LLC. The Buyer then purchases the equity of the Company from NewCo and the transaction is treated for income tax purposes as though they purchased a proportionate share of the assets.
If you are planning a merger, acquisition, or some other transaction (even several years from now), determining the tax implications will be a significant topic that you will need to explore. The rules can be complex and the path you choose for structuring your company will have a long-term impact, so getting advice from experts in the field is worth it.
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Christina Brooks, CPA
Christina Brooks is a director in the business tax services area at Redpath and Company. She provides tax consulting and compliance services to closely-held businesses. Christina is a member of the Construction, Real Estate and Engineering Practice Team. She has provided public accounting services since 2008 and has been at Redpath and Company since 2013.
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