Editor: Howard Wagner, CPA
Prior to the COVID-19 pandemic, the merger-and-acquisition (M&A) market had a string of years of strong activity. Seemingly overnight, COVID-19 changed the M&A landscape, as many transactions were put on hold or altogether abandoned. As economic recovery ensues, private-equity firms will be eager to be first to act quickly as deal premiums fall and more distressed target opportunities become available. The M&A market is poised to regain its pre-COVID-19 activity levels as many business owners continue to seek to exit their closely held businesses or explore strategic alternatives as part of their long-term financial plans. One popular transaction that could emergeis Sec. 368(a)(1)(F) reorganizations (F reorganizations) of S corporations.
Congress created S corporation status in 1958. While S corporation status provides tax benefits such as corporate income and gains being taxed only once, at the individual level, it is subject to several limitations. Perhaps the most important is a limit on the number of shareholders; however, that restriction has been relaxed over time. The number of shareholders was originally capped at 10, but that limit has since been increased a number of times, most recently to 100 in 2004. As restrictions were eased, S corporations became the most common type of entity filing a corporate federal income tax return as of 1997. S corporations continue to be the predominant type of corporation for closely held businesses. As a result, many of the closely held businesses that private-equity firms wish to acquire these days are S corporations.
Inasmuch as S corporations are passthrough entities, they are generally not directly liable for federal income taxes. Generally, under U.S. federal income tax law, the income or loss of an S corporation is taxable to its shareholders. Many private-equity transactions are structured as an equity purchase rather than as a direct asset purchase. Sellers often prefer an equity sale because they expect to receive preferential capital gain treatment on any resulting gain and typically require a gross-up for any ordinary income tax liability on a deemed asset sale. At the same time, buyers generally prefer not to buy stock, since they do not receive a step-up in the tax basis of the corporation's assets. An election under Sec. 338(h)(10) or Sec. 336(e) provides a buyer of corporate stock the convenience of a stock purchase with the tax benefits of an asset acquisition; however, each election has its own requirements and limitations. Not only might it require coordination between the buyer and the seller with respect to the election and various other legal matters, but also sellers cannot achieve a tax deferral on any rollover portion of the transaction, which is generally a norm in these private-equity transactions where buyers wants sellers to have "skin in the game" for some percentage of the post-close business. Similarly, sellers generally might want some potential of continued future upside under private-equity ownership.
One of buyers' main concerns is making and maintaining a valid S corporation election for the target of the Sec. 338(h)(10) election. Secs. 338(h)(10) and 336(e) transactions are both stock sales/purchases for legal purposes; however, for tax purposes only, the buyer is treated as acquiring the target's assets. If the target's S corporation election was inadvertently invalidated at some point before closing, the buyer will have acquired the stock of a C corporation. To mitigate that potential risk, pre-transaction restructuring for S corporation targets using Sec. 368(a)(1)(F) has become a common technique used by private-equity firms.
The F reorganization allows: (1) a step-up in tax basis of the target's assets for the purchase portion of the transaction (even if under 80%); (2) the same treatment to sellers under a Sec. 338(h)(10) election but without the need for an 80% change and with the ability to achieve tax deferral on the rollover; (3) the avoidance of cumbersome legal considerations common in an asset purchase; and (4) continuation of the target's employer identification number (EIN), which is often an important consideration for a buyer. A purchase after an F reorganization has none of the limitations that come with the Sec. 338(h)(10) election — for example, an 80% or more purchase; taxation of 100% of the gain, which is of course disadvantageous to sellers in a partial rollover transaction; the qualified stock purchase requirements, etc. The F reorganization potentially provides a better solution if a tax-deferred rollover is inherent in the transaction and if the buyer wishes to obtain a step-up on the corporate assets it acquired.
F reorganization defined
Sec. 368(a)(1)(F) provides that an F reorganization is a mere change in identity, form, or place of organization of one corporation, however effected. Although the definition of an F reorganization seems short and simple, it does leave ambiguity as to the specific requirements. There might be other changes within the steps of an F reorganization, and these questions become more important to avoid potential gain recognition and to retain the tax-free nature of the F reorganization. The IRS issued final regulations in 2015 (Regs. Sec. 1.368-2(m)) in which it identified six requirements that must be satisfied for a transaction that involves an actual or deemed transfer of property by a transferor corporation to a resulting corporation to be a mere change that qualifies as an F reorganization. The underlying goal is to ensure that only one continuing corporation is involved and that the transaction is not acquisitive or divisive in nature. Four of the six requirements had been included in proposed regulations dating back to 2004; the fifth and sixth were added in the final regulations to ensure that the transferee corporation would be equivalent to the transferor corporation.
The six requirements are:
- Resulting corporation stock distributed in exchange for transferor corporation stock: The goal is to ensure the transferor and transferee corporations have essentially the same stockholders. A de minimis amount of stock issued by the resulting corporation other than in respect of stock of the transferor corporation to facilitate the organization of the resulting corporation or maintain its legal existence is disregarded.
- Identity of stock ownership:The same person(s) must own all of the stock of the transferor and the resulting corporation before and after the potential F reorganization. The key is that they must do so "in identical proportions." The regulations do provide some leniency with respect to the identical-proportion requirement whereby the stockholders are permitted to exchange their shares of the transferor for a different class of shares of the resulting corporation, as long as they are of equivalent value and the existing stockholders can receive a distribution of money or other property from either the transferor corporation or the resulting corporation, whether or not in exchange for stock in the transferor corporation or the resulting corporation.
- Prior assets or attributes of resulting corporation: The resulting corporation may not hold any property or have any tax attributes immediately before the potential F reorganization. This requirement is not violated if the resulting corporation holds or has held a de minimis amount of assets to facilitate its organization or maintain its legal existence, and has tax attributes related to holding those assets, or holds the proceeds of borrowings undertaken in connection with the potential F reorganization.
- Liquidation of transferor corporation: The transferor corporation must completely liquidate, for federal income tax purposes, in the potential F reorganization; however, the transferor corporation is not required to dissolve under applicable law and may retain a de minimis amount of assets for the sole purpose of preserving its legal existence.
- Resulting corporation is the only acquiring corporation: No corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the potential F reorganization, if such other corporation would succeed to and take into account the transferor's tax attributes under Sec. 381 as a result of the reorganization.
- Transferor corporation is the only acquired corporation: The resulting corporation may not hold property acquired from a corporation other than the transferor corporation, such that, as a result of the reorganization, it would succeed to and take into account the other corporation's tax attributes under Sec. 381.
The third and fourth requirements are to ensure that: (1) everything that the resulting corporation owns post-F reorganization is from the transferor, with limited exceptions as discussed above; and (2) the transferor will not retain assets and will terminate for tax purposes. The fifth and sixth requirements were added in the final regulations to prevent complexities with respect to a transaction that involves multiple acquisitions of property and tax attributes from multiple transferor corporations, by providing that the resulting corporation must be the one that settles with the tax attributes of the transferor.
For the tax practitioner, there is potentially the concern that an intended F reorganization might be viewed only as transitory — e.g., part of a series of transactions where that part might not be respected on its own; however, Regs. Sec. 1.368-2(m)(3)(ii) provides that transactions preceding or following a potential F reorganization generally will not cause failure of qualification under Sec. 368(a)(1)(F). Prior to the final regulation, the IRS has historically confirmed, via various revenue rulings (e.g., Rev. Ruls. 96-29, 79-250, 69-516, 64-250, and 61-156), that application of the step-transaction doctrine should not cause a failure of an F reorganization consummated as part of a larger transaction. This clarification from the IRS provides comfort for a pre-transaction F reorganization strategy followed by an acquisition, as discussed below.
Pre-transaction F reorganization strategy
As mentioned earlier, the F reorganization strategy has gained popularity within private-equity transactions involving S corporations. The overall transaction plan generally requires the seller(s) of an S corporation target to engage in some pre-transaction restructuring. Generally, those steps are: (1) the shareholder(s) of a target S corporation (Target) form a new corporation (Target Holding) via contributing the shares of Target to Target Holding in exchange for all of Target Holding's shares; and (2) Target elects to be a qualified Subchapter S subsidiary (QSub), which effects a deemed tax-free liquidation of Target into Target Holding (and extends S corporation status to Target Holding per Rev. Ruls. 2008-18 and 64-250).
These are all nontaxable events, treated as an F reorganization under federal income tax law. The transaction steps above are similar to those outlined in Situation 1 of Rev. Rul. 2008-18. The IRS does not specifically conclude in that ruling that the transaction steps qualify as an F reorganization, but it does recognize that they may represent an F reorganization. The IRS also has issued a number of letter rulings (e.g., Letter Rulings 200725012, 200701017, and 200542013) confirming that such a contribution followed by a QSub election is a reorganization within the meaning of Sec. 368(a)(1)(F).
A popular additional step after the F reorganization steps above would be to convert Target, under a state conversion statute, from a corporation to a limited liability company (LLC). The timing of this step is generally at least one day after the steps discussed above. As a wholly owned LLC (just like as a QSub), Target would remain a disregarded entity for federal income tax purposes. The conversion of one disregarded entity (i.e., a QSub) into another disregarded entity (i.e., a single-member LLC (SMLLC) post-LLC conversion) has no federal income tax consequences. The conversion is most often completed when the buyer is a passthrough entity (e.g., an LLC or a partnership), and hence it is preferred not to have Target as a C corporation post-closing. It also protects the buyer's basis step-up if Target inadvertently failed to qualify for S corporation status in the past and/or the QSub election for Target was not properly executed. For instance, assume Target inadvertently failed S corporation status two years before the acquisition. The step of forming Target Holding and converting Target to an SMLLC would still result in an F reorganization (the purported QSub election for Target would be disregarded as a result of the failure to maintain S corporation status) and the buyer's basis step-up would be maintained.
After a pre-transaction restructuring for an S corporation target via an F reorganization, there are multiple options for a buyer to effect the acquisition. Target Holding can contribute some of its Target equity into the buyer's acquisition structure, with the remaining Target equity being acquired by the buyer. This will be treated as a partial rollover and a partial taxable sale of an undivided interest in each of Target's assets for an amount of consideration equal to the cash paid plus the assumption of an associated share of Target's liabilities for federal income tax purposes, in a transaction consistent with Situation 1 of Rev. Rul. 99-5.
Assuming Target's assets are appreciated, the cash paid plus liabilities/debt deemed assumed would generally result in a basis step-up in Target's assets. To the extent the step-up might predominantly be allocable to Target's self-created intangible asset base, perhaps the sellers would be amicable to the transaction structure, inasmuch as they are not harmed by a higher income tax rate (e.g., on depreciation recapture). The remaining Target equity not sold could be rolled over, as discussed above, in exchange for buyer equity that would remain held by Target Holding. That rollover would be expected to be tax-deferred, and Target Holding would retain a carryover basis in the buyer's equity equal to the basis Target Holding had in the property so contributed.
Another popular option is the formation of a partnership via the distribution of an interest in Target (after its conversion into an LLC) to one of the shareholders of Target Holding, or via granting an interest in Target to a key employee, etc. As a result, Target would become a multimember LLC treated as a partnership for federal income tax purposes. After completing that step, Target would make an election under Sec. 754, and the buyer thereafter would acquire an interest in Target. Assuming Target's assets are appreciated, a basis step-up would be achieved under Sec. 743 in connection with the Sec. 754 election.
Following the steps discussed in the "Pre-Transaction F Reorganization Strategy" section above, the effect of the QSub election treats Target as a disregarded entity for federal income tax purposes. The timing of the QSub election is important. Target Holding elects to treat its subsidiary as a QSub by filing a Form 8869, Qualified Subchapter S Subsidiary Election. The effective date of the QSub election generally cannot be more than: (1) 12 months after the date the election is filed; or (2) two months and 15 days before the date the election is filed. The Form 8869 should be filed by Target Holding with an effective date simultaneous with the date of the contribution of Target shares to Target Holding in exchange for Target Holding shares. Since Target Holding was formed specifically via the contribution of the Target shares, that contribution date would also be the legal formation date of Target Holding.
As part of the transaction's tax due diligence process and purchase document review, the buyer would generally request a copy of the executed Form 8869 to confirm the proper timing of the election. If Target Holding was formed in advance of the contribution, there would be a natural time gap between its formation and the contribution and effective date of the QSub election — in such an instance, it would be appropriate to query whether Target Holding had C corporation status for the period from its formation to the contribution date.
In Letter Ruling 201724013, the IRS granted relief under Sec. 1362(f) for an inadvertently invalid QSub election. The facts in the letter ruling were: (1) X was organized under the laws of State on date 1 and made an election to be a Subchapter S corporation effective on date 1; (2) Sub was organized under the laws of State on date 2 and made an election to be a Subchapter S corporation effective on date 3; (3) on date 4, X was part of a reorganization under Sec. 368(a)(1)(F) whereby Sub's shareholders contributed all of their stock in Sub to X, thereby causing Sub to become a wholly owned subsidiary of X; (4) Sub then converted to an LLC under State law on date 5 and by default was treated as a disregarded entity for federal income tax purposes; and (5) X made an election to treat Sub as a QSub effective on date 4.
X's election to treat Sub as a QSub was considered ineffective due to Sub's failure to meet all of the requirements of Sec. 1361(b)(3)(B) at the time the election was made. This failure occurred after Sub's conversion from a corporation to an LLC, which is a disregarded entity for federal income tax purposes. The general timeline for a QSub election appeared to have been met, as the requested effective date was not more than two months and 15 days before the date the election was filed; however, the issue was the actual timing of the filing of the election, which occurred when it had already converted to an LLC under State law. The IRS concluded that the ineffective QSub election was inadvertent and granted relief under Sec. 1362(f) for the Sub to be treated as a QSub effective on date 4.
Rev. Rul. 2008-18 refers to Rev. Rul. 64-250, which provided that a merger qualifying as an F reorganization of an S corporation into a new corporation that also met the S corporation requirements did not terminate the S election. Therefore, under the facts in Letter Ruling 201724013, an election of S corporation status on Form 2553, Election by a Small Business Corporation, is not required for Target Holding, inasmuch as Target's original and existing S corporation election/status continues in effect for Target Holding. A new federal EIN is generally required for Target Holding, while Target retains its existing federal EIN.
The IRS redesigned Form 8869 in December 2008 and added a question to confirm whether the QSub election was being made in connection with a Sec. 368(a)(1)(F) reorganization described in Rev. Rul. 2008-18 (in which a subsidiary (Target) was an S corporation immediately before the election, and a newly formed holding company (Target Holding) will be the subsidiary's parent). The purpose of this revision is presumably to alert the IRS that there will be no separate S corporation election for Target Holding, since Target's S corporation status continues in effect for Target Holding after it becomes the parent of Target. The IRS makes clear in the instructions to line 14 of Form 8869 (as revised December 2017) that a Form 2553 is not required to be filed by Target Holding as the parent.
Pursuant to the F reorganization, Target Holding will file a full-year, uninterrupted return, inasmuch as the F reorganization does not break Target's tax year and Target Holding is deemed a continuation of Target. That full-year federal income tax return is filed in the name and federal EIN of Target Holding. Target's federal income tax return for its immediately prior year would be its last — it would not file any further returns in its name and federal EIN (and, interestingly, that prior return likely would not be marked as final). An F reorganization statement explaining the transaction steps would be included in Target Holding's return, along with Target Holding's Form SS-4, Application for Employer Identification Number, to explain the manner of filing and to support the new federal EIN. Target's QSub election should be included in that return as well.
Costs and benefits
Pre-transaction restructurings for S corporation targets via an F reorganization provide various potential benefits to sellers and buyers. For sellers, this strategy allows shareholder(s): (1) to defer gain recognition with respect to rollover equity; (2) to obtain the tax benefit of transaction costs; and (3) to defer gain recognition with respect to deferred payments. For buyers, the strategy allows them: (1) to obtain a step-up in the tax basis of Target's assets for the purchase portion of the transaction; (2) to avoid the dependency on S corporation status for a valid Sec. 338(h)(10) election; and (3) to avoid a need for cumbersome legal considerations common in an asset purchase, while at the same time preserving continued use of Target's federal EIN post-closing in the buyer's structure.
That said, pre-transaction restructurings for S corporation targets via an F reorganization might not necessarily eliminate the need for tax due diligence and/or alleviate any potential tax exposures with respect to Target, inasmuch as the buyer is in fact buying the historic Target legal entity. However, tax advisers have debated whether the fundamental deemed continuation in an F reorganization for federal income tax purposes means that Target Holding would remain liable for any/all historic federal income tax exposures, while Target would not. Even if that is the case, that consideration would seem not to extend to Target's potential historic non—income tax exposures.
Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or firstname.lastname@example.org.
Contributors are members of or associated with Crowe LLP.