At a Glance
California businesses can change their entity type for various reasons, including ownership changes, growth plans, and exit strategies. As part of the restructuring process, companies and tax practitioners can apply for an F Reorganization. This type of reorganization can be helpful as a tax-efficient way to plan and restructure the company into a new distinct entity.
Explore the purpose, requirements, and benefits of an F Reorganization. Work with Windes businesses structure planning experts to discover if an F Reorganization is the right option for your business.
Why Business Entity Type Matters
Every company in California needs to carefully choose its entity type since this will affect the amount of taxes the entity and the owner(s) pay on an aggregate basis. The business entity type is also important because it impacts the ability to protect yourself from personal liability in the event of litigation. For example, a sole proprietorship does not protect the owner’s personal assets in a lawsuit. However, a limited liability corporation (LLC) or S corporation structure separates your personal assets from business assets if you are involved in litigation.
S corporations and LLCs do not pay corporate taxes at the entity level since they are treated as pass-through entities. However, S corporations do have to pay the 1.5% franchise tax on net taxable income if it is greater than the $800 minimum tax. In addition to the $800 annual minimum tax, LLCs are also subject to the annual LLC fee based on their California gross receipts.
The type of business entity chosen by a business owner affects its ability to grow in the future. Once you select a business entity, changing its type usually requires an official change with the IRS and, in some cases, a dissolution of the corporation, which may have adverse tax consequences to the shareholders.
As part of an M&A strategy, private equity firms and other buyers are more likely to buy assets versus stock. An election under Sec 338(h)(10) or Section 336(e) allows stock purchases to be treated as an asset purchase for tax purposes which can provide additional tax benefits to the buyer. However, even when Sec 338(h)(10) is made with a stock purchase, the buyer bears the risk that the target S corporation’s original election is invalid, opening the buyer to additional tax liabilities after acquiring the target. Private equity firms typically employ F Reorganization for pre-transaction restructuring of S corporation targets to mitigate that risk.
What is an F Reorganization?
An F Reorganization is an identity, form, or place of organization change, according to the IRS Sec. 368(a)(1)(F). It happens when a company transfers or is classified as transferring all of its assets to another company.
Typically, an F Reorganization occurs as a company prepares for a merger or acquisition transaction. The strategy is also used to help separate assets that a buyer or seller doesn’t want as part of the sale.
As beneficial as an F Reorganization can be for some businesses, the process is complex and can take several months or longer to fully complete. Although the IRS puts forth baseline requirements for the transition, it does not fully define all aspects of the strategy.
The reorganization ends when all the assets held in the existing company, or the Transferor Corporation, are distributed to the Resulting Corporation.
After the transfer, the IRS will consider the existing company fully liquidated for income tax purposes.
Requirements for F Reorganization
According to IRS Rev. Rul. 2008-18, an S corporation must follow the processes and timelines to achieve an F Reorganization while keeping its S corporation election.
The IRS published the final regulations under §1.368-2(m) in 2015 that outline six requirements to qualify as an F reorganization. The primary purpose of these regulations is to prevent acquisitions or divisive transactions from happening during the reorganization process. To accomplish a smooth transaction, only one continuing corporation is involved.
An F-Reorganization must meet the following six requirements to be a reorganization that is considered tax-free.
1. Transferor Corporation’s stock is exchanged for the stock of Resulting Corporation
Following the F Reorganization, the Resulting Corporation’s stocks are distributed to the Transferor Corporation’s shareholders. If necessary, the IRS can ignore a minimum amount of stock, also called “de minimis,” not owned by the Transferor Corporation. The laws do not define the term explicitly, but regulations state that 1% of the shares of a corporation could be permitted.
2. Stock ownership identity
All of the Transferor Corporation and the Resulting Corporation’s shares must be owned by the same persons in similar proportions before and after the transaction.
Stockholders who acquire shares of various governance rights, as long as all the shares are of equal value, or if they receive cash or other property in relation to the acquisition of the shares, do not violate the rule of stock ownership identity. They are also not in violation if they obtain a distribution from either the Resulting Corporation or Transferor Corporation.
3. Resulting Corporation’s existing assets or attributes
Before the F Reorganization, the Resulting Corporation might have no tax attributes. There is an exception to this rule that allows a de minimis amount of assets to be held by the Resulting Corporation to facilitate its formation and maintain its legal status and also hold the loan proceeds for the reorganization if needed.
In light of this rule, most F Reorganizations require the formation of a new corporation so that there are no carryover tax attributes in the Resulting Corporation.
4. Liquidation of the Transferor Corporation
A Transferor Corporation liquidates for tax purposes. According to state law, the company is not required to close. It may continue to operate as an independent entity. This is one benefit of an F Reorganization since the assets continue to the Transferor Corporation without the Resulting Corporation receiving a transfer of title.
5. The only acquirer is the Resulting Corporation
Under Section 381 of the Internal Revenue Code, if the Resulting Corporation receives the tax attributes of the Transferor Corporation, then only the Resulting Corporation holds the title to the Transferor Corporation immediately after the F Reorganization.
6. Only the Transferor Corporation has been acquired
After F Reorganization, if the Resulting Corporation obtains the tax attributes of the Transferor Corporation, they may not hold acquired property from another corporation aside from the Transferor Corporation. These requirements ensure that the Resulting Corporation only owns the assets from the Transferor Corporation after the F Reorganization. They also simplify the transaction involving multiple properties and tax attributes from various Transferor Corporations by making sure the Resulting Corporation is the only one with the tax attributes of the Transferor Corporation.
Transition Structure for Reorganization as an F Entity
An F Reorganization structure takes many forms. They comprise merging related entities or reincorporating a company in a different state. A frequent method of an F Reorganization is the establishment of a new corporation to serve as the holding company of the new business.
You must follow these steps to complete an F Reorganization:
Step 1: The individual shareholders who hold the equity in the existing company or the Transferor Corporation create a new corporation that becomes the Resulting Corporation.
Step 2: The shareholders put all their shares of the Transferor Corporation into the new corporation in return for all the Resulting Corporation’s issued and outstanding shares.
The Transferor Corporation becomes a subchapter S subsidiary of the Resulting Corporation, ultimately owned by the Transferor Corporations’ original shareholders. Upon transfer, the IRS disregards the Transferor Corporation, and it is no longer required to file income taxes.
Step 3: The Transferor Corporation becomes a state-recognized limited liability. It can also elect to become a limited liability company of the Resulting Corporation.
The shareholders now own the same proportion of their issued and outstanding equity in the Resulting Corporation as they did of the Transferor Corporation. The Resulting Corporation is the only member of the Transferor Corporation as an LLC.
Tax Compliance Issues for Reorganizing
If you use F Reorganizations with S corporations, consider the issues with tax compliance and how they may affect future tax filings. Significant considerations include employer identification numbers, S subsidiary elections, and income tax filings.
Employer Identification Numbers
The Resulting Corporation must receive an employer tax identification number (EIN) upon completing and filing Form SS-4. Although the Transferor Corporation files for a subchapter S subsidiary election, it still keeps its own EIN. There may be other non-income tax and business purposes for the Transferor Corporation to use its EIN, such as banking and employment taxes.
Timing of Subchapter S Subsidiary Election
The Transferor Corporation must file Form 8869 to become a subchapter S subsidiary before becoming an LLC. This is because the Transferor Corporation must still be a corporation and meet the requirements to be an S subsidiary at the time of the election.
Although the subchapter S subsidiary can be applied retroactively to the date when the Transferor Corporation existed as a corporation, the S subsidiary election can risk becoming ineffective if filed when it becomes an LLC.
In private letter ruling 201724013, the IRS concluded that a qualifying subchapter S subsidiary election was not valid after the subsidiary company became an LLC. The taxpayer was then given relief under the Internal Revenue Code Section 1362(f).
According to Example 5 of the federal Treasury laws, there will not be a qualified subchapter S subsidiary election if the Transferor Corporation will convert to an LLC after the shares are transferred to the Resulting Corporation. Companies do not need to pay taxes for an F Reorganization, and they do not need to elect subchapter S subsidiaries.
However, Form 8869 should be filed to avoid potential issues before converting the Transferor Corporation into an LLC. Since private letter rulings are confined to the facts of one taxpayer and cannot be used as a precedent, taxpayers should not depend on IRS leniency.
If the F Reorganization is completed on time, check the Transferor Corporation’s incorporation date before you complete and mail Form 8869. The form should be sent by certified mail to prove that your submission happened when it was still a corporation.
Income Tax Filings
The Resulting Corporation has to use its EIN for its upcoming income tax returns. The Resulting Corporation would have the same treatment as the Transferor Corporation if there were no reorganization, even when the Transferor Corporation files to become a subchapter S subsidiary.
When the Transferor Corporation becomes the Resulting Corporation, its tax attributes become its tax attributes. The Transferor Corporation does not need to file an alternate income tax return since its prior federal income tax return becomes its last.
According to Treasury laws, the Resulting Corporation must file an F Reorganization statement with its federal income tax return. The statement must include the names of the parties and their EINs, the F Reorganization’s date, and the total value of the Transferor Corporation’s assets. It must explain the filing and show the new federal EIN of the Resulting Organization.
How F Reorganization Benefits Your Tax Strategy
You can plan your company’s growth without incurring any taxes through an F Reorganization. New investors can obtain a vested interest in the company, while owners can explore ways to restructure the business.
LLC Membership Interests
LLC asset transfers do not require third-party consent. Buying an LLC membership interest does not have the same restrictions as an S corporation. For example, S corporations cannot have second class of stock, more than 100 shareholders, or foreign investors. In addition, the LLC provides flexibility on the profit, loss, and distribution allocation.
Start a rollover equity transaction
A company may keep former owners through an equity rollover transaction. The business can undertake an F Reorganization first and then let some shareholders in the S corporation keep their shares as a tax-free rollover.
Instead of having all shareholders sell their shares and pay taxes on the entire gains, a portion of the proceeds can be reinvested in the acquirer. The Transferor Corporation can also offer earnings interests to the Resulting Corporation’s top workers.
Plan to sell a part of the company
Some owners may put a portion of their company on sale while keeping the rest. For instance, an owner of a line of pet food bakeries wants to keep the original bakeries but is interested in selling their other bakeries in another state to an interested buyer.
An F Reorganization of their company allows the owner to distribute the company’s assets to the Resulting Corporation. The original bakeries are in the existing company, but the new bakeries are now in the Resulting Corporation. Afterward, the buyer could buy the existing company from the Resulting Corporation.
Implement a corporate freeze
A corporate freeze involves the creation of at least two classes of shares, with one holding the company’s upside value. The preferred shares have a liquidation preference and a low return. Common shares store the company’s value, while the preferred stocks become frozen.
F Reorganizations let existing companies own preferred shares of a subsidiary company through a two-tier structure. The common shares can then go to the subsidiary’s new owners and investors.
Become a C Corporation to distribute qualified small business stock
Internal Revenue Code Section 1202 allows people to invest in small businesses by buying qualified small business stock (QSBS). The capital gains from these QSBS are not taxable under federal law. However, the only business entities to distribute QSBS are C corporations.
An F Reorganization is another option to get a company from an S corporation to a C corporation that can issue QSBS. A tax-free 351 transaction enables the transfer of the interest of a single-member LLC to a C corporation.
This transaction results in a C corporation owned by a three-tiered parent S Corporation that owns a single-member LLC. Thus, the QSBS has the S corporation as a shareholder.
Working With a Business Entity Consultant
If you want to restructure your business under an F Reorganization, work with a business structuring and tax planning firm to ensure a smooth transfer process.An experienced consulting firm with a background in handling multi-million-dollar corporate reorganizations can give you the professional expertise you need to make the right choice for your company.
Windes is a business structuring and tax planning firm that offers high-level companies corporate consulting services to maximize their business value during the merger and acquisition process.
Our goal is to help your business find the right M&A strategy to enhance its worth. We use our financial and tax expertise to help you plan and implement your reorganization so that you gain all possible tax benefits associated with your approach.
As part of our business entity services, we help you assess what type of reorganization your business needs and prepare for the transition. Our services include:
- Performing a cost-benefit analysis of a reorganization
- Helping you understand and negotiate the terms of a letter of intent
- Identifying financial and tax benefits of a reorganization
- Advising on legal implications of a reorganization
- Determining the most tax-efficient business structure
For business owners considering an F Reorganization, Windes has business structuring expertise to help maximize the value of your business. We can advise you on aspects of formation, timing, and tax filing to ensure you achieve the best possible results throughout the reorganization process.
We can aid in cash flow management, reporting compliance, allocation review, mergers and acquisitions, and entity selection and restructuring.
Our tax planning and consulting services will help minimize your tax liability and maximize available credits. We limit your tax exposure by staying on top of tax changes at the federal and state level.
Restructure With Windes
Reorganizing a business entity is a complex undertaking, but it may be the most tax-effective solution for your business. F Reorganizations let buyers in M&A transactions gain an advantage on the tax basis of the corporation’s assets without relying on it to keep its S corporation status. They also make rollover transactions more efficient while letting investors invest in the company’s future growth.
Working with Windes can help you facilitate an F Reorganization to take your company to the next level of its success. Contact us today to learn how we can help you get started on an F Reorganization for your company.