Companies seeking to minimize taxes in the exhilarating world of M & A frequently accomplish it through an F-Type Reorganization—also called an F- Reorganization. The “F” comes from Internal Revenue Code Section 368 (a) (1)(F), with subparagraph F allowing a single corporation to change its identity, form, or place of organization without incurring a tax bill.
One of the keys to success, according to the IRS code, is to have your company’s business structure properly defined. By understanding this part of the IRS Code, you will have a better chance to accomplish your merger, acquisition, or sale—tax-free. Because of the complexity and the potential upside, the task should not be attempted without professional guidance.
What is an F-Reorganization?
F-Reorganizations can be used for companies wishing to buy all or a portion of another company. The F-reorganization can happen when an organization is preparing for a merger and acquisition or a partial sale of the company’s assets, or partial purchase of another company’s assets. It can also work for the purchase of a partial interest in a single member LLC, which is also treated as an asset purchase.
A primary purpose of the IRS Regulations is to preclude divisive transactions or acquisitions from occurring during the reorganization process. The transaction (sale, purchase, merger, or investment) works best if only one continuing corporation is included.
Who does them?
F-Reorganizations let buyers in M&A transactions acquire assets that can be depreciated or amortized rather than buying stock, which can not. The purchase of assets rather than stock, may also be preferred as the buyer may not want to buy stock which could subject them to the prior liabilities of a company. It allows a buyer to obtain the corporation’s assets without relying on it to keep its S corporation status. They also make rollover transactions more efficient while letting investors invest in the company’s future growth.
When?
The time to do an F-Type Reorganization is typically immediately prior to a sale transaction closing. Is there a good time to ask your CPA for their guidance? The answer is before you try it by yourself. Even forgetting to send one of the myriads of IRS Forms by Certified Mail can deny you the tax-free advantages of this type of reorganization. Typically this type of transaction is part of the overall plan for a merger or sale.
How?
Many advisors recommend creating an interim corporation to serve as a “holding” company for what will become the new entity. The F-Reorganization entails a three-step process that suggests:
- Individual shareholders who hold an interest in the “Beginning” Company create a new company that will become the “End” Company.
- The shareholders transfer their shares from the Beginning Company into the new corporation in return for all the End Company’s outstanding and issued shares.
The Beginning Company becomes a subchapter S subsidiary of the End Company, which is owned after the transaction by the Beginning Company’s original shareholders.
- The Beginning Company is reorganized in its state of organization as a Limited Liability Company (LLC). Once converted into a single member LLC, the Beginning Company is disregarded by the IRS, so all activity of both companies is reported on the tax return for the End Company.
Once the Beginning Company converts into an LLC fully owned by the End Company, it is considered a single member LLC. Therefore, a sale of a partial or full ownership interest in the LLC will be treated as an asset sale by the End Company.
Suffice it to say that the associated tax issues are especially tricky when using F-Reorganizations with S Corporations. The details can trip up even the most vigilant M & A participants, including correctly assigning EINs, handling S subsidiary elections, and filing income taxes. Each of these can be enacted using IRS Forms requiring explanations and caveats to protect against an unfriendly ruling by the IRS.
Why?
Several reasons can precipitate an F-Reorganization.
- Companies seek mergers and acquisitions hoping that the new entity will offer an enhanced, more efficient operational structure, improved productivity, and reduced costs. One of the main benefits of the F-reorganization is that by consolidating your assets and liabilities into a single entity, the company can simplify its financial reporting and reduce administrative costs.
- A combined organization may be eligible for tax benefits previously unavailable to the two or more entities making up the new one.
- A robust, informed M & A strategy can maximize a company’s value while enhancing cash flow and planning for the best entity selection to achieve your company’s mission and vision for internal and external stakeholders.
When It Doesn’t Work
The M & A team must be careful because IRS rules about a company’s structure before and after are very strict. The idea of a restructuring could be sound, but if its execution is done incorrectly (outside of IRS regulations), the results could keep the goal of a tax-free reorganization from being achieved.
How Much?
How much does it cost to reorganize? How much can it save in taxes if you do? How much does it “cost” shareholders? What benefits accrue to the investors from an F-Reorganization? These are all good questions that M&A tax consultants can answer.
It’s important to note that the F-Reorganization can be complex and time-consuming, with potential legal and regulatory obstacles to overcome. Additionally, blending the cultures and operations of merging companies can present its own set of challenges.
Conclusion
Overall, the F-Reorganization can be a powerful tool for enhancing competitiveness and achieving long-term success. Before making any decisions, carefully evaluating the potential benefits and drawbacks is crucial. Is restructuring the right choice for your organization? Is the timing right? Can you “afford” it? Can you afford not to do it?
LSL CPAs tax professionals can answer your questions. Please don’t hesitate to contact us.
