F-reorganizations in acquisition transactions: Key benefits and critical compliance steps

Businesses frequently prefer to organize as limited liability companies (LLCs) because of the flexibility in tax treatment and management structure these entities provide. Many businesses also choose to be taxed as pass-through entities (partnerships or S corporations) because of the single level of tax on the company's income. The choice between treatment as a partnership or S corporation involves many factors, but when a limited liability company chooses to be treated as an S corporation, the flexibility afforded by the LLC can become a trap for the unwary without proper documentation to comply with the strict pro rata economic sharing requirements for S corporation owners.

When it comes time to sell the company, this lack of flexibility leads some S corporation owners to have buyer’s remorse because of the rigid requirement that S corporation owners share in profits, losses and distributions. The restrictions on who can own S corporation – only US individuals, estates and certain trusts – significantly limit the pool of potential buyers for the equity of an S corporation, meaning that most buyers will want to acquire the assets of the S corporation to achieve a better go-forward tax result through a step-up in the basis of the purchased assets.

In these situations, an “F reorganization” can be an effective tool to loosen the S corporation structure while providing a buyer with more favorable tax treatment without actually transferring assets, contracts, or employees. 

When the target is a service business, the difference between asset sale and stock sale tax treatment may not differ materially to the seller, so the ability to provide a go-forward tax shield to a buyer may result in receiving a better price for the business.

What is an F-reorganization?

F-reorganizations get their name from Section 368(a)(1)(F) of the Internal Revenue Code (IRC), which permits an entity taxed as a corporation to rearrange its legal structure on a tax-free basis so long as it consists of “a mere change in identity, form, or place of organization of one corporation.” The simplest form of F-reorganization involves a reincorporation of the corporation in a state different from its original state of formation.  However, in recent years F-reorganizations have frequently been utilized to restructure an S corporation target business in a way that allows an equity acquisition for corporate law purposes to be treated as an asset sale for federal income tax purposes.

Revenue Ruling 2008-18 provides the practical roadmap for an entity taxed as an S corporation (whether an LLC or a state law corporation) to implement a pre-closing F-reorganization to facilitate a deemed asset sale.  First, the owners of the entity (Target) create a new holding company (Holdco) with the exact same ownership as Target and contribute their equity interest in Target to Holdco. Then, effective on the conversion date, Holdco elects to treat Target as a “qualified subchapter S subsidiary” (QSub) under IRC 1361(b)(3)(B)(ii) by filing IRS Form 8869 and checking box 14 on the form to notify the IRS that the election relates to an F-reorganization. The QSub election causes “all assets, liabilities, and items of income, deduction, and credit of [Target to] be treated as assets, liabilities, and such items (as the case may be) of [Holdco]” under IRC 1361(b)(3)(A)(ii) and, when box 14 is checked, for Holdco to succeed to the Target’s S election. 

Because the sale of a QSub terminates its QSub status under IRC 1361(b)(3)(C)(i), most transactions involve a further pre-closing step to turn the QSub into an “entity disregarded as separate from its owner” under Treasury Regulation Sections 301.7701-2(c)(2)(i) and 301.7701-3(b)(1)(ii) (a “DRE”), which status is preserved when Target becomes owned by the buyer. If Target is an LLC, then it files IRS Form 8832 to elect DRE treatment.  If Target is a state law corporation, then it converts to an LLC either under a state law conversion statute or by merging into a newly created LLC owned by Holdco.  The equity of the resulting DRE LLC can then be sold to the buyer for cash, rollover equity or a combination of the two, which is treated for income tax purposes as a sale by Holdco of all of the assets and liabilities of the DRE LLC or, if rollover equity is include, as a part taxable sale / part tax-free exchange for rollover equity (assuming the transaction otherwise qualifies under IRC 721 or 351).

Advantages for structuring a deal using an F-reorganization:

This pre-closing restructuring provides value to the parties in three principal ways. First, it preserves the target’s employer identification number (EIN), which may reduce operational disruption, particularly in businesses with government contracts that are usually tied to the EIN. Second, contracts, licenses, permits, title to assets, and employment relationships remain in the same legal entity, which can reduce the need for novating or assigning contracts, retitling real estate and other assets, and rehiring employees in the buyer entity. Finally, the buyer obtains a step-up in tax basis in the assets of the acquired target entity in situations where an IRC 338(h)(10) or 336(e) election may be unavailable and, even if such an election is available, without the potential concerns related to Target’s historic S-election qualification.

Buyer-side benefits

Buyers are often focused on the tax asymmetry between a stock deal and an asset deal. In a straightforward S corporation stock acquisition, the buyer inherits Target’s historic inside basis in its assets. By contrast, the acquisition of a DRE LLC Target following an F-reorganization allows the buyer a fair-market-value basis step-up in the underlying purchased assets, thereby increasing future depreciation and amortization deductions.  With the permanent extension of 100% bonus depreciation in 2026, this basis step-up can be extremely valuable when the target business involves substantial hard assets to operate.  Even with limited hard assets, a buyer still receives the benefit of depreciating acquired goodwill and intangible assets that can be written off over 15 years under IRC 197. While IRC 338(h)(10) allows a corporate buyer to join with the seller to treat the purchase of the stock of an S corporation as asset sales on an elective basis, the election is only available if the target is actually taxed as a corporation, so a non-corporate buyer (such as a private equity fund taxed as a partnership) cannot avail itself of this election. Both a 338(h)(10) election and a 336(e) election only allow deemed asset sale treatment in a transaction in which at least 80% of the stock of Target is acquired, so if the seller is retaining more than 20% of the Target equity (as opposed to receiving rollover equity), these elections would not be available.  In these situations, a pre-closing F-reorganization facilitates similar “deemed asset sale” treatment for any buyer.

Seller-side benefits

From the seller’s point of view, this structure makes it easier to rollover equity and continue participating economically in the business after closing, using a straightforward transfer of ownership interests in Target. While rollover equity can also be received in exchange for contribution of a fractional interest in all assets and liabilities of Target, an F‑reorganization simplifies the overall process from a corporate perspective, and permits Target to retain its EIN, which can be critical in certain industries. As a result, sellers have the opportunity to provide the buyer with a valuable step-up in tax basis while potentially avoiding certain operational and regulatory steps that could delay or block a transaction from occurring.

Key considerations to ensure the F-reorganization is completed properly

Tax diligence

At the outset of any transaction involving a pre-closing F reorganization, tax diligence should focus on validating Target’s S election.  A defective S election can prevent the seller from achieving the intended tax outcome of the F-reorganization and sale and presents potential tax exposure to the buyer. 

Diligence should focus on both IRS filings and governing documents. Typical Form 2553 issues include missing shareholder signatures, missing spousal consents in community-property states, ownership by ineligible shareholders, and violations of the one-class-of-stock requirement due to non-conforming governing provisions in the organizational document. When Target is an LLC, review of the terms of the LLC’s operating agreement is critical.  Since many LLC’s are taxed as partnerships, businesses frequently adopt off-the-shelf partnership-style agreements that contain non-identical governing provisions that inadvertently create a second class of stock and invalidate or terminate the LLC’s S election.

So long as only one of these issues exists, sellers can avail themselves of automatic relief to cure the defects. Revenue Procedure 2004-35 allows relief for missing community property spouse signatures.  Revenue Procedure 2013-30 allows relief for late-filed elections for the corporation or by certain otherwise ineligible trust shareholders to become qualified shareholders.  Finally, Revenue Procedure 2022-19 allows for correction of non-identical governing provisions that otherwise would invalidate or terminate an S election.

However, all of these automatic relief provisions require that the taxpayer follow certain steps, which may involve additional filings with the IRS, that can take time to complete and submit, which can extend the timeline for closing the F-reorganization and, ultimately, the sale transaction. In addition, relief may require the entity and the shareholders to certify that they have always filed tax returns consistent with the treatment of the entity as an S corporation.  When there have been changes in ownership between the date of the S election and the date of the sale transaction, obtaining these statements can be challenging and time-consuming.

Another potential foot fault in an F-reorganization can occur when an LLC that was initially filed as a partnership subsequently elects S corporation status. If the S election was made within 60 months of the completion of the F reorganization, then additional steps are required to allow for the LLC to elect on IRS Form 8832 to become a disregarded entity.  When an LLC files a valid election to be an S corporation, and the entity is not already classified as a corporation, the LLC is treated as “having made election to be classified as an association taxable as a corporation (as of the effective date of the election under section 1362(a)(1))” pursuant to Treasury Regulation Section 301.7701-3(c)(1)(v)(C). However, under Treasury Regulation Section 301.7701-3(c)(1)(iv), an eligible entity that elects to change from its default status (other than concurrently with the date of its formation) cannot reelect within 60 months.  Thus, if an LLC taxed as a partnership files IRS Form 2553, then it cannot file IRS Form 8832 at the conclusion of an F-reorganization to become a DRE. 

To address this problem, the Target LLC can be converted under state law to a corporation before commencing the F-reorganization, which has no impact on the S corporation status of Target. Then, once Target is a QSub under Holdco, Target can be transformed under state-law (through conversion or merger) into an LLC, which would be treated as a DRE by default.  Without these additional steps, the filing of an IRS Form 8832 after an F-reorganization involving an LLC S corporation would result in Target becoming a C corporation upon its acquisition by buyer under Treasury Regulation Sections 1.1361-5(a)(1)(iii) and 1.1361-5(b)(i).

Transaction sequencing

Like any good recipe, the steps outlined in Revenue Ruling 2008-18 need to be completed in the proper order or the results can leave a bad taste. The structure works because Target first becomes a QSub of HoldCo, resulting in a deemed tax-free liquidation under IRC 332 into Holdco for tax purposes, by filing IRS Form 8869 and checking box 14.  Only after completing that filing should the parties implement a state-law transformation (by conversion or merger) of a corporate Target to an LLC.  The IRS has taken the position that flipping the steps invalidates the QSub election.  In IRS private letter ruling 201724013, the subsidiary converted from a corporation to an LLC and then filed a QSub election, which the IRS found to be invalid because the subsidiary was not a “domestic corporation” at the time the election was filed, as required by IRC 1361(b)(3)(B). Although the IRS granted relief under IRC 1362(f) based on the taxpayer’s representation that the error was inadvertent, the taxpayer still had to incur the cost and delay of obtaining a private letter ruling to achieve a result that could have simply been achieved by waiting a day to convert the LLC until after the QSub election was filed.

Conclusion

F-reorganizations are one of the most useful structuring tools for acquisitions of businesses historically operated as S corporations. When implemented correctly, an F-reorganization permits a transaction structured as the sale of equity to produce tax consequences like an asset acquisition, which can create meaningful value for buyers through basis step-up and for sellers through rollover flexibility and smoother operational continuity.  Successful implementation of a pre-closing F reorganization requires due diligence of the target entity’s compliance with all S corporation requirements and, in many cases, cleaning up compliance defects pre-closing. In addition, careful sequencing of the F-reorganization steps provided in the Revenue Ruling 2008-18 “cookbook” over a number of days requires planning and attention from all parties involved in the transaction.

While the multi-step process in an F-reorganization may seem technically complex, the tax and operational benefits of a completed pre-closing F-reorganization are well worth the effort for both buyers and sellers.