What Is the F Reorganization, and Why Is It So Popular?
This year has seen an uptick in F reorganizations. Let’s explore the advantages and disadvantages for buyers and sellers.
![Three business executives walk side by side outside the front entrance to a skyscraper.](https://cdn.mos.cms.futurecdn.net/99tvsfxG5soRWDXrJDdjFJ-415-80.jpg)
Recent S corporation sales have increasingly used an F reorganization structure this year. This article focuses on:
- The definition of an F reorganization
- The effect of the reorganization on both the buyer and the seller
- Why F reorganizations are so popular
What is an F reorganization?
An F reorganization is defined in Internal Revenue Code Section 368(a)(1)(F) as a mere change of identity, form or place of organization of one corporation. In particular, this involves a tax-free reorganization of the target company (seller), which is typically an S corporation.
An S corporation is a corporation which is a pass-through entity, meaning that the corporation itself does not pay tax. With certain limitations, the income is passed through to the shareholders, who pay tax as individuals, avoiding the dreaded “double tax.” A C corporation pays tax at the corporate level. When the C corporation distributes income to its shareholders as dividends, the income is taxed as a gain for the shareholders as individuals, the “double tax.”
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
S corporations can have a maximum of 100 shareholders. Those shareholders can only be individuals, single-member LLCs or certain types of trusts. The individuals must be U.S citizens or U.S. residents.
Seller’s advantages
The primary advantage of the F reorganization for the seller is that the buyer in an F reorganization has more flexibility than using an IRC Section 338(h)(10) election or an IRC Section 336(e) election. This includes the ability for the buyer to use a greater mix of cash and buyer rollover stock in the purchase price. The 338(h)(10) election is to treat certain stock purchases as asset purchases. The 336(e) election is for a corporation to treat the sale or exchange as a sale of all the subsidiary’s underlying assets.
For tax purposes, a stock sale is better for a seller, while an asset purchase is better for the buyer. This is typically because the buyer in an asset purchase can allocate part of the purchase price to depreciable assets, providing a post-closing tax benefit. On the other hand, such an allocation may trigger depreciation recapture for the seller, which is considered ordinary income. The tax rates for ordinary income are higher than the tax rate for a capital gain on the sale of stock. With an F reorganization, the seller can have the transaction taxed as a stock sale while the Buyer may be able to treat the sale as an asset purchase for tax purposes.
The seller avoids transfer tax and the need for legal consent by creating a 100%-owned subsidiary that owns assets of the target.
Seller’s disadvantages
- The cost and risk of implementing the F reorganization is typically on the seller.
- The F reorganization creates additional complexity, the risk of which may not be discovered until months after the completion of the sale.
Buyer’s advantages
- The buyer gets asset purchase tax treatment while utilizing a stock or equity purchase structure. In other words, the buyer receives a step-up in the basis of the target’s assets equal to the amount paid for the seller’s LLC interest.
- The buyer no longer needs to terminate the target’s S corporation election at closing and reduces the buyer’s risk regarding the target’s existing S corporation election.
- The buyer may retain some target attributes post-closing, such as the operating history and creditworthiness.
Buyer’s disadvantages
- The buyer’s liability for the seller’s debts post-closing may be higher than in an asset sale. That can be mitigated in part by seller warranties and indemnities.
- The tax filings (largely prepared and filed by the seller’s counsel or team) are not approved and returned by the IRS until well after the actual closing. This can create unknown risks.
One other reason that the F reorganization is so popular may be that the restriction on S corporation shareholders is limited primarily to individuals, with very few exceptions. Many of the F reorganization/sales that we’ve handled involved investment groups. These investment groups are often formed as or include LLCs or other entities that will not qualify as subchapter S shareholders. The F reorganization may help solve the problem.
Related Content
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Founder of The Goralka Law Firm, John M. Goralka assists business owners, real estate owners and successful families to achieve their enlightened dreams by better protecting their assets, minimizing income and estate tax and resolving messes and transitions to preserve, protect and enhance their legacy. John is one of few California attorneys certified as a Specialist by the State Bar of California Board of Legal Specialization in both Taxation and Estate Planning, Trust and Probate.
-
Eight Key Steps to Take When Investing in the Stock Market
The stock market can be a confusing place for beginners, but it doesn't have to be.
By Kiplinger Advisor Collective Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Talkin' 'Bout My Generational Wealth: Baby Boomers
With retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
By Alvina Lo Published
-
How to Avoid a Big Hassle if Your Financed Car Gets Wrecked
How an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
By H. Dennis Beaver, Esq. Published
-
Estate Planning Strategies to Consider as Election Nears
Are big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
By David Handler, J.D. Published
-
How to Get Your Money's Worth From Your Financial Adviser
A good financial adviser will focus on how your financial planning and investment strategy align with your lifestyle and aspirations.
By Pam Krueger Published
-
Think of Prenups and Postnups as Financial Planning Tools
These contracts provide a clear framework for asset management and protection and are especially useful if you get married later in life.
By Andrew Hatherley, CDFA®, CRPC® Published
-
Congratulations on Your Raise: Three Things to Do With It
We're not saying you shouldn't spend it on a new car, but there are some considerations to guard against lifestyle creep and to help ensure a comfy retirement.
By Andrew Rosen, CFP®, CEP Published
-
Check Off These Four Financial Tasks to Finish 2024 Strong
The new year is a popular time to set financial goals, but now is the ideal time to check how you're doing. Four tweaks could make a big difference.
By Daniel Razvi, Esquire Published