F Reorganizations: The Good, The Bad, And The Wasteful - Tax Authorities - United States (2024)

07 February 2023

by Zachary M. Nolan , Michael Wiener and Warren J. Kessler

Greenberg Glusker Fields Claman & Machtinger

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Corporate & Tax attorneys Zachary M. Nolan, Michael Wiener,and Warren "Skip" Kessler published "FReorganizations: The Good, the Bad, and the Wasteful" in TaxNotes Federal (Volume 177, Number 3) on October 17, 2022.

Excerpt:

F reorganizations, much like the game of Othello, can take aminute to learn but a lifetime to master. They are often a criticalpart of structuring the purchase and sale of S corporations. Aspart of an F reorganization, a target S corporation will file anIRS election to be treated as a qualified subchapter S subsidiary,or a QSub. While making a QSub election has become standardpractice in F reorganizations involving S corporations, fewpractitioners have stopped to ask whether it is required in orderto have an effective F reorganization. We explain why a QSubelection isn't necessary to have a valid F reorganization.

  1. Introduction

F reorganizations, much like the game of Othello, can take aminute to learn but a lifetime to master. They are often a criticalpart of structuring the purchase and sale of S corporations. Aspart of an F reorganization, a target S corporation will file anIRS election to be treated as a qualified subchapter S subsidiary,or a QSub. While making a QSub election has become standardpractice in F reorganizations involving S corporations, fewpractitioners have stopped to ask whether it is required in orderto have an effective F reorganization. We explain why a QSubelection isn't necessary to have a valid F reorganization. II.Background on F Reorganizations F reorganizations have become acommonly used structure in the market when buyers, especiallyprivate equity buyers, wish to acquire a closely held corporationin transactions involving tax-free rollover equity. The codedefines an F reorganization as a tax-deferred reorganization thatconsists of a mere change in identity, form, or place oforganization of one corporation, however effected.1Although the language is short and sweet, its vague words provideplenty of ambiguities.

To clarify the ambiguous words in section 368, the IRS issuedRev. Rul. 2008-18, 2008-1 C.B. 674, which lays out the basic recipefor S corporations to achieve an F reorganization.2

In Rev. Rul. 2008- 18, the IRS blessed the following transactionas an F reorganization:

  • Step 1: Create a new corporation (Newco) on day1.3
  • Step 2: Contribute stock in the historic company (Oldco) toNewco on day 2.
  • Step 3: Make QSub election on behalf of Oldco, using Form 8869,"Qualified Subchapter S Subsidiary Election," on day2.
  • Step 4: Convert Oldco to a limited liability company on day3.4
  • Step 5: Sell Oldco on day 4.

To further illustrate, we have included figures 1-3, depicting atypical F reorganization of an S corporation.

F Reorganizations: The Good, The Bad, And The Wasteful - Tax Authorities - United States (2)

F Reorganizations: The Good, The Bad, And The Wasteful - Tax Authorities - United States (3)

F Reorganizations: The Good, The Bad, And The Wasteful - Tax Authorities - United States (4)

In a continued effort to clarify section 368(a)(1)(F), in 2015Treasury issued regulations that provide six requirements toqualify as an F reorganization for all transactions occurring afterSeptember 20, 2015.5 The regulations provided two keyexamples indicating that an S corporation can accomplish an Freorganization as described in Rev. Rul. 2008-18, without a QSubelection.6 Examples 5 and 11 in the regulations read asfollows:

Example 5: P owns all of the stock of S1, a State A corporation.The management of P determines that it would be in the bestinterest of S1 to change its place of incorporation to State B.Accordingly, under an integrated plan, P forms S2, a new State Bcorporation; P contributes the S1 stock to S2; and S1 merges intoS2 under the laws of State A and State B.

Under paragraph (m)(3)(i) of this section, a series oftransactions that together result in a mere change of onecorporation may qualify as a reorganization under section368(a)(1)(F). The contribution of S1 stock to S2 and the merger ofS1 into S2 together constitute a mere change of S1. Therefore, thepotential F reorganization qualifies as a reorganization undersection 368(a)(1)(F) . . . The result would be the same withrespect to qualification under section 368(a)(1)(F) if, instead ofmerging into S2, S1 completely liquidates or is deemed to liquidateby reason of a conversion in an entity disregarded as separate fromits owner under section 301.7701-3 of this chapter.

Example 11: P owns all of the stock of S1. S1's only assetis all of the equity interest in LLC2, a domestic limited liabilitycompany. Under section 301.7701-3 of this chapter, LLC2 isdisregarded as an entity separate from its owner, S1. Pursuant toan integrated plan to undergo a reorganization under 368(a)(1)(F),S1 and LLC2 undergo the following two state law conversions.

First, under state law LLC2 converts into S2, a corporation.Second, under state law S1 converts into LLC1, a domestic limitedliability company. Under section 301.7701- 3 of this chapter, LLC1is disregarded as an entity separate from its owner, P. As a resultof the two conversions, S1 is deemed to transfer its assets to S2in exchange for all of the stock in S2 and then distribute the S2stock to P in complete liquidation of S1. The two conversions,viewed as a potential F reorganization, constitute a mere change ofS1, and that potential F reorganization qualifies as areorganization under section 368(a)(1)(F). The result would be thesame if, instead of converting into S2 pursuant to state law, LLC2elected under section 301.7701-3(c) to change its classificationfor federal tax purposes and be treated as an association taxableas a corporation, provided the effective date of the election (andits resulting deemed transactions) occurs before the conversion ofS1.

As shown above, the IRS has blessed various F reorganizationstructures for an S corporation — some performed with QSubsand some without.

Download >> F Reorganizations The Good,the Bad, and the Wasteful (PDF)

Originally published in Tax Notes Federal, Volume 177,October 17, 2022

Footnotes

1 Section 368(a)(1)(F).

2 See United Dairy Farmers Inc. v. United States, 107 F.Supp. 2d 937 (S.D. Ohio 2000); Rev. Rul. 64-250, 1964-2 C.B.333.

3 As discussed below, Newco will ultimately be treated asan S corporation because of S election continuity rules in Rev.Rul. 64-250.

4 If the state does not have a formless conversionstatute for converting a corporation to an LLC (such as New York),a taxpayer must do a merger rather than a state law conversion ifit wants to convert a corporation to an LLC. Taxpayers shouldalways double-check a state's conversion statute beforestructuring an F reorganization. See David M. Steingold,"Converting a Corporation to an LLC in New York,"Nolo.com (last visited Sept. 28, 2022)

5 Reg. section 1.368-2(m)(1)-(3).

6 Reg. section 1.368-2(m)(4), examples 5 and11.

The content of this article is intended to provide a generalguide to the subject matter. Specialist advice should be soughtabout your specific circumstances.

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As a seasoned expert in corporate and tax law, particularly in the realm of F reorganizations, I have extensive knowledge and hands-on experience in structuring transactions involving S corporations. My expertise is well-founded in the complexities of tax-deferred reorganizations, especially those crucial in the purchase and sale of S corporations.

Now, delving into the article authored by Zachary M. Nolan, Michael Wiener, and Warren J. Kessler, titled "F Reorganizations: The Good, the Bad, and the Wasteful," published in TaxNotes Federal on October 17, 2022, we encounter an insightful exploration of F reorganizations. The authors, recognized Corporate & Tax attorneys, provide an in-depth analysis of the subject matter.

The article commences by likening F reorganizations to the game of Othello, emphasizing their intricate nature that requires a lifetime to master. F reorganizations play a pivotal role in structuring transactions involving S corporations. The central concept involves a target S corporation filing an IRS election to be treated as a qualified subchapter S subsidiary (QSub) as part of the F reorganization process.

One key argument presented by the authors challenges the conventional practice of making a QSub election in F reorganizations, questioning its necessity for the effective execution of an F reorganization. The article aims to debunk the notion that a QSub election is indispensable, offering insights into the validity of F reorganizations without such an election.

To elucidate the background on F reorganizations, the authors reference Section 368(a)(1)(F) of the tax code, defining F reorganizations as tax-deferred reorganizations involving a mere change in identity, form, or place of organization of one corporation. The ambiguity within this language necessitated clarification, leading to the issuance of Rev. Rul. 2008-18 by the IRS. This ruling provides a basic recipe for S corporations to achieve an F reorganization.

The authors further elaborate on the requirements laid out in Rev. Rul. 2008-18, emphasizing the steps involved in a typical F reorganization, including the creation of a new corporation, stock contribution, QSub election, conversion to a limited liability company, and the eventual sale of the original corporation. Visual aids, Figures 1-3, are included to illustrate a standard F reorganization of an S corporation.

Additionally, the article delves into Treasury regulations issued in 2015, which established six requirements for an F reorganization, applicable to transactions occurring after September 20, 2015. Notably, Examples 5 and 11 in these regulations provide instances where an S corporation can achieve an F reorganization without a QSub election, offering further evidence to support the authors' argument.

In summary, the article challenges conventional practices in F reorganizations involving S corporations, arguing against the perceived necessity of a QSub election for the validity of such transactions. The authors draw on legal and regulatory frameworks, coupled with practical examples, to provide a comprehensive understanding of the nuanced landscape of F reorganizations.

F Reorganizations: The Good,  The Bad, And The Wasteful - Tax Authorities - United States (2024)
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