Corporate & Tax attorneys Zachary M. Nolan, Michael Wiener, and Warren "Skip" Kessler published "F Reorganizations: The Good, the Bad, and the Wasteful" in Tax Notes Federal (Volume 177, Number 3) on October 17, 2022.
Excerpt:
F reorganizations, much like the game of Othello, can take a minute to learn but a lifetime to master. They are often a critical part of structuring the purchase and sale of S corporations. As part of an F reorganization, a target S corporation will file an IRS election to be treated as a qualified subchapter S subsidiary, or a QSub. While making a QSub election has become standard practice in F reorganizations involving S corporations, few practitioners have stopped to ask whether it is required in order to have an effective F reorganization. We explain why a QSub election isn't necessary to have a valid F reorganization.
- Introduction
F reorganizations, much like the game of Othello, can take a minute to learn but a lifetime to master. They are often a critical part of structuring the purchase and sale of S corporations. As part of an F reorganization, a target S corporation will file an IRS election to be treated as a qualified subchapter S subsidiary, or a QSub. While making a QSub election has become standard practice in F reorganizations involving S corporations, few practitioners have stopped to ask whether it is required in order to have an effective F reorganization. We explain why a QSub election isn't necessary to have a valid F reorganization. II. Background on F Reorganizations F reorganizations have become a commonly used structure in the market when buyers, especially private equity buyers, wish to acquire a closely held corporation in transactions involving tax-free rollover equity. The code defines an F reorganization as a tax-deferred reorganization that consists of a mere change in identity, form, or place of organization of one corporation, however effected.1 Although the language is short and sweet, its vague words provide plenty of ambiguities.
To clarify the ambiguous words in section 368, the IRS issued Rev. Rul. 2008-18, 2008-1 C.B. 674, which lays out the basic recipe for S corporations to achieve an F reorganization.2
In Rev. Rul. 2008- 18, the IRS blessed the following transaction as an F reorganization:
- Step 1: Create a new corporation (Newco) on day 1.3
- Step 2: Contribute stock in the historic company (Oldco) to Newco on day 2.
- Step 3: Make QSub election on behalf of Oldco, using Form 8869, "Qualified Subchapter S Subsidiary Election," on day 2.
- Step 4: Convert Oldco to a limited liability company on day 3.4
- Step 5: Sell Oldco on day 4.
To further illustrate, we have included figures 1-3, depicting a typical F reorganization of an S corporation.
In a continued effort to clarify section 368(a)(1)(F), in 2015 Treasury issued regulations that provide six requirements to qualify as an F reorganization for all transactions occurring after September 20, 2015.5 The regulations provided two key examples indicating that an S corporation can accomplish an F reorganization as described in Rev. Rul. 2008-18, without a QSub election.6 Examples 5 and 11 in the regulations read as follows:
Example 5: P owns all of the stock of S1, a State A corporation. The management of P determines that it would be in the best interest of S1 to change its place of incorporation to State B. Accordingly, under an integrated plan, P forms S2, a new State B corporation; P contributes the S1 stock to S2; and S1 merges into S2 under the laws of State A and State B.
Under paragraph (m)(3)(i) of this section, a series of transactions that together result in a mere change of one corporation may qualify as a reorganization under section 368(a)(1)(F). The contribution of S1 stock to S2 and the merger of S1 into S2 together constitute a mere change of S1. Therefore, the potential F reorganization qualifies as a reorganization under section 368(a)(1)(F) . . . The result would be the same with respect to qualification under section 368(a)(1)(F) if, instead of merging into S2, S1 completely liquidates or is deemed to liquidate by reason of a conversion in an entity disregarded as separate from its owner under section 301.7701-3 of this chapter.
Example 11: P owns all of the stock of S1. S1's only asset is all of the equity interest in LLC2, a domestic limited liability company. Under section 301.7701-3 of this chapter, LLC2 is disregarded as an entity separate from its owner, S1. Pursuant to an integrated plan to undergo a reorganization under 368(a)(1)(F), S1 and LLC2 undergo the following two state law conversions.
First, under state law LLC2 converts into S2, a corporation. Second, under state law S1 converts into LLC1, a domestic limited liability company. Under section 301.7701- 3 of this chapter, LLC1 is disregarded as an entity separate from its owner, P. As a result of the two conversions, S1 is deemed to transfer its assets to S2 in exchange for all of the stock in S2 and then distribute the S2 stock to P in complete liquidation of S1. The two conversions, viewed as a potential F reorganization, constitute a mere change of S1, and that potential F reorganization qualifies as a reorganization under section 368(a)(1)(F). The result would be the same if, instead of converting into S2 pursuant to state law, LLC2 elected under section 301.7701-3(c) to change its classification for federal tax purposes and be treated as an association taxable as a corporation, provided the effective date of the election (and its resulting deemed transactions) occurs before the conversion of S1.
As shown above, the IRS has blessed various F reorganization structures for an S corporation — some performed with QSubs and some without.
Download >> F Reorganizations The Good, the Bad, and the Wasteful (PDF)
Originally published in Tax Notes Federal, Volume 177, October 17, 2022
Footnotes
1 Section 368(a)(1)(F).
2 See United Dairy Farmers Inc. v. United States, 107 F. Supp. 2d 937 (S.D. Ohio 2000); Rev. Rul. 64-250, 1964-2 C.B. 333.
3 As discussed below, Newco will ultimately be treated as an S corporation because of S election continuity rules in Rev. Rul. 64-250.
4 If the state does not have a formless conversion statute for converting a corporation to an LLC (such as New York), a taxpayer must do a merger rather than a state law conversion if it wants to convert a corporation to an LLC. Taxpayers should always double-check a state's conversion statute before structuring an F reorganization. See David M. Steingold, "Converting a Corporation to an LLC in New York," Nolo.com (last visited Sept. 28, 2022)
5 Reg. section 1.368-2(m)(1)-(3).
6 Reg. section 1.368-2(m)(4), examples 5 and 11.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
