Editor: Anthony S. Bakale, CPA
As merger-and-acquisition activity hit record highs in the past several years, F reorganizations grew in popularity as a means to provide tax benefits to buyers and sellers. This has been especially true for owners of S corporations seeking to maximize the sales price of their business and provide an avenue for tax-free equity rollovers. In addition, F reorganizations provide a simplified alternative to buyers and sellers seeking tax benefits of an asset acquisition while allowing for business continuity.
While federal guidance regarding F reorganizations is well documented, state and local jurisdictions have provided little to no guidance to date. Consequently, sellers may not comprehensively consider the state and local tax consequences of pursuing an F reorganization. Under Sec. 368(a)(1)(F), an F reorganization is a mere change in the identity, form, or place of organization of a corporation. The IRS in Rev. Rul. 2008-18 outlined the steps and timing an S corporation must adhere to in order to achieve an F reorganization while maintaining its S election. Under the guidelines of Rev. Rul. 2008-18, the owner(s) of an operating S corporation ("Target") routinely form a new S corporation ("New S Corp" or "HoldCo"). The owner(s) subsequently contribute Target stock to HoldCo in exchange for HoldCo stock.
HoldCo succeeds to the tax attributes of Target and is treated as if it steps into the shoes of Target. Rev. Rul. 2008-18 provides that Target's original S election continues when Target, an operating S corporation, merges into the newly formed HoldCo. Target's S election carries over to HoldCo and is not terminated. Upon the reorganization HoldCo must timely file Form 8869, Qualified Subchapter S Subsidiary Election, to elect to treat the Target subsidiary as a qualified Subchapter S subsidiary (QSub). As a QSub, Target's income and activities will be reported by HoldCo, the parent entity, on its Form 1120-S, U.S. Income Tax Return for an S Corporation. (See the chart, "Steps of an F Reorganization," below, for an illustration of the mechanics of an F reorganization as described in this discussion.)
Key state and local tax matters to consider
When an F reorganization as described above occurs, the new S corporation parent, HoldCo, must apply for its own federal employer identification number (EIN), while Target retains its EIN. There are several benefits of Target continuing to do business and retaining its EIN. For example, Target will not need to renegotiate current customer contracts and vendor agreements. Furthermore, most of Target's non-income tax accounts, such as employment taxes, sales taxes, excise taxes, and property taxes, will carry over, and Target will not need to re-register for most tax types.
Before the F reorganization, Target was the filing entity and prepared federal and state income tax returns. However, after filing the Form 8869 election, HoldCo becomes the filing entity and includes Target, a disregarded QSub. There are no short-period returns during the year of reorganization. Even when the transaction occurs midyear, the new parent entity, HoldCo, files one Form 1120-S that includes the income and activities of Target for the entire tax year, which includes the short period before the reorganization.
For federal tax purposes, HoldCo notifies the IRS that the QSub election is in combination with an F reorganization on its Form 8869 filing. There are no similar state notification procedures upon an F reorganization. Businesses are left to ponder a variety of state and local tax matters, including the following:
- How does a business notify each taxing jurisdiction of the reorganization?
- Does each jurisdiction conform to the federal S corporation and QSub elections, as well as follow the federal tax treatment of S corporations and QSubs?
- How will the gain on the sale of a QSub be treated for state and local income tax purposes?
- How will historical liabilities of Target be treated?
Notification to states: Target was previously the filing entity in each state taxing jurisdiction, but upon the F reorganization, HoldCo will step into Target's shoes unbeknownst to the states. Target most likely never filed, nor should it file, a final state or local income and franchise tax return. A business must notify a state that it is no longer required to file an income/franchise tax return but also be cautious not to impair the Target's non—income tax accounts that follow Target after an F reorganization. In addition, HoldCo must determine which states will require the new parent S corporation to register for an income tax account number prior to filing the current-year state income tax returns or making payments toward a tax liability. Furthermore, Target may have overpayments or credit carryforwards from the year prior to the reorganization that the business must suddenly determine if it may transfer to HoldCo's state tax account or whether and how Target could request a refund.
State conformity to federal elections and treatment: While many states generally conform to the federal F reorganization rules, a few states require separate state S and QSub elections. Others do not follow the federal passthrough entity treatment of S corporations or the disregarded nature of QSubs. A common state-specific requirement is one in which states, such as New York and New Jersey, do not automatically conform to a business's federal elections but require each entity to file separate state S or QSub elections. If state elections are not timely made in those states, HoldCo and Target will be taxed as C corporations by the state.
Also of note are states such as New Hampshire and Tennessee, which do not follow the federal income tax treatment of QSubs and will require a QSub with nexus to file a state return independent of its parent S corporation. In addition, a handful of states impose a separate franchise tax or a gross receipts tax on QSubs. States imposing these progressive taxes on QSubs include Alabama with its business privilege tax, California with its QSub annual tax, and Georgia and North Carolina with their franchise taxes, among others.
Recognition of gain on sale of QSub: Often, the most material consideration of an F reorganization is not even contemplated. Many sellers do not fully vet the potential impact an F reorganization may have on a subsequent sale of the QSub and any gain recognized. It is important to look at the differences in state tax treatment of a sale of S corporation stock by the owners pre-restructuring, versus a sale of QSub stock by HoldCo upon the F reorganization.
When a reorganization is not pursued presale, an individual owner that sells S corporation stock is considered to have sold intangible property. The gain on the sale is recognized directly by the individual owner and allocated to the individual owner's resident state. The tax treatment of a sale of stock is respected by many state taxing authorities, which classify the sale as nonbusiness intangible income subject to allocation.
However, when a seller undergoes an F reorganization that inserts an S corporation holding company into its structure prior to sale, the F reorganization complicates the state tax treatment of the gain. Under federal law, when an S corporation sells the stock of its QSub, the sale is treated as a sale of assets and is reported by the new S corporation parent on its Form 1120-S. States often classify the sale of business assets as apportionable business income. Not only may some states attempt to apportion the proceeds on the sale of a QSub, but also other states will subject the gain to an additional layer of entity-level tax. The proceeds are reported and taxed at the new S corporation parent level and also at the upper-tier individual owner(s) level, resulting in double state taxation.
While it was noted that states such as New Hampshire and Tennessee tax S corporations and QSubs separately, states such as California and Illinois impose a state tax on both the S corporation and the S corporation's owners on their distributions. So, while a sale of S corporation stock owned directly by an individual is subject to tax only in the individual's home state, the sale of QSub stock may be subject to multiple layers of tax, depending on the jurisdictions where the S corporation does business. While S corporations can further evaluate each state's rules around classifying the gain of a QSub sale as nonbusiness income subject to allocation, many states have begun aggressively pursuing taxpayers reporting similar large gains not apportioned to the state.
States are divided on the treatment of QSub proceeds for the calculation of their sales factor apportionment rate. HoldCo must evaluate if the sale proceeds or net gain from the sale of business assets is included in the sales factor denominator. It is not uncommon for states to exclude gains from the sale of capital and other assets when the gain would distort the sales factor. Consequently, sellers must include the gain as apportionable business income, but they do not receive the benefit of factor dilution from that gain. The result is higher state income tax liabilities.
Inheritance of historical liabilities of Target: As discussed above, under federal tax law, when an S corporation sells the stock of its QSub, the sale is treated as a sale of assets and is reported by the new S corporation parent on its Form 1120-S. Historical federal income tax liabilities of the QSub remain the seller's responsibility. Through their adoption of the Internal Revenue Code, most states conform to this treatment for state income tax purposes; however, that treatment does not generally apply to non-income taxes, such as sales and use taxes, which will likely be inherited by the buyer. Sellers should expect a buyer to thoroughly examine historical non-income tax liabilities and pursue opportunities to mitigate successor liability.
Carefully evaluate all pluses and minuses
Advisers often focus on the benefits of an F reorganization, which undoubtedly can be an effective method to defer federal income taxes on a transaction. However, there could be material state and local tax liabilities that may impair a seller's ability to realize the entirety of the anticipated benefits. Foresight of the potential state tax implications of an F reorganization will allow a seller to evaluate the lesser-known hazards.
Owners contemplating an F reorganization must carefully consider not only the immediate tax costs and benefits to implement the reorganization plan but also the deferred tax liabilities that may not arise until the lower-tier QSub is sold. This awareness provides a seller an opportunity to weigh the net benefits of additional transaction options during an anticipated sale process. In addition, a knowledgeable seller may seize upon the opportunity to educate a buyer and possibly negotiate an increase in the purchase price to allow a seller to recoup any added state and local tax liabilities created as a result of a buyer's preferred transaction structure.
Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at firstname.lastname@example.org.
Contributors are members of or associated with Cohen & Company Ltd.