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Acquiring the Equity of an Entity Taxed as an S Corporation? Consider an “F Reorg”

In an M&A market that remains exceedingly frothy, many would-be buyers in the middle market are being forced to acquire the equity of a target company (rather than its assets) in order for their bids to be competitive. Depending on the legal and tax classification of the target company, a buyer may or may not be able to achieve a basis step-up (sometimes referred to colloquially as a “tax shield” by those who enjoy a good superhero story) with respect to the target company’s assets in connection with a purchase of the target company’s equity. That basis step-up can prove to be extremely valuable to a potential buyer from an economic perspective.

While the legal and tax classifications of target companies vary (and with them the ability to achieve a basis step-up in an M&A transaction), the middle market in particular contains numerous target companies that are organized as S corporations. An “F reorg” can be an excellent way to achieve various tax and non-tax objectives of both the buyer and the seller in an M&A transaction when the target company is taxed as an S corporation.

Before diving into the specifics (and I promise, we will avoid any tax minutiae here), let’s face it – an “F reorg” does not sound particularly glamorous, and it certainly does not have the panache of other more colorfully named structuring transactions (it is hard to argue that an F reorg sounds as interesting as a “forward triangular merger” or a “reverse Morris trust transaction”). In fact, the F reorg’s name derives from its location in clause (F) of Section 368(a)(1) of the Internal Revenue Code, and few people other than hardcore tax practitioners have much interest in parsing the workings of the Internal Revenue Code. However, despite the lack of a glitzy name, an F reorg is worth paying attention to as a potential option when a buyer is looking to acquire the equity of an S corporation.

Although F reorgs are not necessarily new to the M&A community, their use is becoming more frequent in the middle market (particularly by private equity firms, although by no means exclusively so) given the number of middle market target companies that are organized as S corporations. 

Despite the tax nomenclature, an F reorg is actually quite simple to consummate. First, the equityholders of the S corporation target company form a new corporation (“Newco”). The shareholders then contribute all of the equity of the S corporation target company to Newco in exchange for equity of Newco (so at this point, the S corporation target company is a wholly owned subsidiary of Newco, and the former equityholders of the target company are now the equityholders of Newco). Newco then makes a simple tax filing to treat the target company as a “qualified subchapter S subsidiary,” which is tax jargon for an election to make Newco a permissible owner of the target company (without this election, the target company would have to be taxed as a C corporation, which typically would not be a good result).

Finally, Newco makes a simple filing to convert the target company from a corporation to an LLC. Once the F reorg is complete, the buyer purchases the equity of the target company (which is now a single member LLC that is treated as a “disregarded entity” for federal income tax purposes).

Without getting too far into the weeds regarding federal income tax concepts, the key benefit of an F reorg is that it will allow the buyer to achieve a basis step-up with respect to the target company’s assets, thus allowing the buyer to offset future taxable income of the target company with increased depreciation or amortization deductions. This economic benefit can be quite compelling for a buyer.

Those who have some experience dealing with S corporations may ask why an F reorg is necessary, when a buyer could simply make what is known as a Section 338(h)(10) election and achieve the same basis step-up. While it is true that a Section 338(h)(10) election also allows the buyer to achieve a basis step-up, there are some drawbacks to that approach that are not an issue when an F reorg is used. For example, the basis step-up resulting from a Section 338(h)(10) election is entirely dependent on the validity of the target company’s original election to be taxed as an S corporation – if that original election is not valid for any reason at the time the Section 338(h)(10) election is made, there would be no basis step-up. The use of an F reorg allows the buyer to avoid the risk that the target company has inadvertently “blown” its S election (which is not uncommon in the middle market).

Beyond the certainty of a basis step-up that an F reorg provides, an F reorg can also more easily facilitate a tax-deferred “rollover” investment by the seller (often a key component of an acquisition by a private equity firm or one of its portfolio companies), which is not possible in a transaction involving the alternative approach of making a Section 338(h)(10) election. Additionally, an F reorg allows the buyer to avoid ending up with a C corporation in its organizational structure, which would otherwise be the result if a Section 338(h)(10) election is made.

As is the case with a Section 338(h)(10) election, an F reorg may result in a portion of a seller’s sale proceeds being converted from capital gain to ordinary income. Often, the amount of this adverse tax impact is significantly less than the amount of the benefit accruing to the buyer as a result of the basis step-up – therefore, in many cases the buyer will agree to gross the seller up for this adverse rate differential in exchange for the seller agreeing to undertake the F reorg. While the amount of the tax impact to the seller will depend on the specific assets owned by the target company, this gross-up payment is often a small price to pay for a buyer that will subsequently get the benefit of substantially increased depreciation or amortization deductions.

When considering an acquisition of equity of a target company that is an S corporation, keep the F reorg in mind as a potential structuring tool.  Additionally, note that while this article has focused on traditional S corporations, an F reorg also can be effective in transactions involving an LLC that has elected to be taxed as an S corporation for federal income tax purposes, although slightly different rules and mechanics can apply.  Professionals in Calfee’s M&A and Tax groups stand ready to assist in any negotiations involving, and the implementation of, an F reorg in connection with an M&A transaction. As described above, in many cases the F reorg can prove very useful to a buyer (and a seller looking to maintain an ownership interest in the enterprise) – plus, you’ll be able to impress all of your friends and colleagues at parties and networking events when you start singing the praises of this handy structuring technique.

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