Using an F-reorg to purchase an S-corp · Mainshares (2024)

When negotiating the purchase of a small- to medium-sized business, a common consideration is the tax consequences of the transaction. From the seller’s perspective, they want to avoid depreciation recapture and minimize the taxes they pay. From the buyer’s perspective, they want to be able to depreciate the assets they purchased, while protecting themselves from liabilities incurred by the previous owner.

One tool for achieving some of these goals is the F-reorganization. This post provides a brief overview of using an F-reorg when purchasing an S-corp.

What is an F-reorganization?

An F-reorganization has become an increasingly popular approach to acquiring an S-corp within the last few decades because of the tax benefits awarded to both sellers and buyers in a merger or acquisition transaction. This approach is called an “F” reorgnization because it is defined in Sec. 368(a)(1)(F).

The F-reog allows the buyer to have a stepped-up tax basis of the target’s assets so that he or she can depreciate them as well as continuation of the target’s EIN, and the seller is able to defer taxes on any equity rolled over.

This is in comparison to a Sec 338(h)(10) election, which has more stringent requirements: the buyer must purchase 80% or more of the target, must meet qualified stock purchase requirements, etc.

When should you use an F-reorg in a transaction?

First, the target needs to be an S-corp. Otherwise, the F-reorganization is irrelevant.

Second, the buyer needs to want to have a stepped up basis on assets. Nearly every buyer will want this, as they can then use depreciation to offset taxable income in the future.

Third, the seller needs to be incentivized with the tax deferral coming from the rollover of equity.

An Example of a common F-Reorganization:

The acquisition target (which is an S Corporation) forms a new firm called “NewCo”, which is an S corporation. Then the owners of the acquisition target transfer 100% ownership in the acquisition target S-corp to “NewCo”. Rather than directly owning the acquisition target, the sellers now own all of NewCo, which owns the acquisition target.

At that point, the acquisition target becomes a subsidiary of “NewCo” and files a qualified Subchapter S subsidiary election (“QSub”). This essentially performs a tax-free liquidation of the acquisition target into “NewCo” and extends S-corp status to the “NewCo.”

At this point, everything has been a nontaxable event: the formation of NewCo, the transfer of shares of the acquisition target to NewCo, etc.

Lastly, at least one day after the conversion, the acquisition target often is converted into an LLC, as it is the preference for most buyers.

The end result allows the owners of an S-corp to sell their “stock” (e.g., their equity in their new LLC) with buyers receiving a stepped-up basis on assets. This transaction would not be feasible without an F-reorg.

Benefits of an F-reorganization:

Buyer: There are two main benefits for buyers: (1) they can effectively purchase the "stock" of an S-corp while ensuring they have a stepped-up basis on the assets acquired, which will allow them to use depreciation in the future. Second, they are able to do so in a transaction involving an equity roll.

Seller: The major advantage to the seller is that they are able to roll equity in an M&A transaction involving an “ineligible” shareholder, without it being a taxable event.

Cons of an F-reorganization:

Buyer: Unlike a pure asset purchase, the buyer will be exposed to liabilities associated with the prior owners operating the business.

Seller: A major disadvantage of the F-reorganization is the cost and increase in complexity of the transaction. Anytime there is a reorganization, fees will be incurred and complexity of the institution increases.

Moreover, even if the buyer is requesting the F-reorganization, the legal validity of the F-reorganization typically falls on the seller. Therefore, it's an additional cost, whether implicit or explicit, that the seller must bear.

What are F-reorganizations becoming more popular?

In one word, flexibility!

An F-reorganization allows the buyer more flexibility than using an IRC Section 338(h)(10) election or an IRC Section 336(e) election. This includes the ability for the buyer to use a greater mix of cash and equity roll when acquiring an S-corp.

What are the costs associated with an F-reorganization?

The major cost associated with an F-reorganization comes from the tax attorneys needed to execute the re-org. It’s important the correct steps are followed, or else there could be a taxable event during the reorganization.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.