S Corporation Inversion Using an “F” Reorganization

Pub. 4 2022 Issue 2

S Corporation Inversion Using an “F” Reorganization

Published April 28, 2022

This story appears in the
Nebraska CPA Magazine Pub. 4 2022 Issue 2

By Hannah Fischer Frey & Jesse Sitz, Baird Holm LLP

Many new business owners are excited by the flow-through treatment of income and loss as well as the self-employment tax savings that can be available to entities that elect to be taxed under Subchapter S of the Internal Revenue Code of 1986, as amended (the “Code”). Such savings, which stem from the bifurcation of salary versus distributions, can be reason enough to make such an election, from an economic perspective. There are several downsides, however, to making an “S” election that business owners should consider prior to making such an election. Restrictions on the types of owners, classes of stock, and numbers of owners, among other things, can limit a business that wishes to sell or take on investors in the future. This can be particularly problematic to a business that is being acquired by a larger venture. Such acquisition entities, potential investors, or private equity firms are almost always organized as entities. The S corporation rules generally do not allow entities (except for very limited types) to own S corporation stock. Fortunately, there is an IRS-approved method by which an S corporation can reorganize itself to allow for an investment or acquisition of less than all of the stock by an entity. An “F” reorganization effectively allows the entity to admit an entity investor without jeopardizing the S election of the S corporation.¹ This kind of reorganization is commonly referred to as an “S corporation inversion” or “F” reorganization, gaining its name from the Code Section from which it arises—Section 368(a)(1)(F). Lastly, this article provides a summary overview of the steps and rules regarding an “F” reorganization. There are many traps for the unwary. We recommend that careful diligence, documentation of the steps satisfying the requirements summarized below, and coordination between the attorney and accountant all occur prior to undertaking such a reorganization.

A. Steps for “F” Reorganization

For purposes of this explanation, we will use the following terms:

Operating Entity – This refers to the original entity, which is taxed as an S corporation.
NewCo – This is the new entity, which will become the holding company of the Operating Entity.
QSub – This refers to a “qualified subchapter ‘S’ subsidiary” as defined in Section 1361 of the Code.

The starting point may look like the following:

First, the owners of Operating Entity organize a new entity (“NewCo”) as a state business entity that meets the requirements for qualification as a small business corporation. NewCo should not be capitalized, other than a nominal amount that may be required by state law for formation or incorporation.²

Second, the same owners contribute all of their equity in the Operating Entity to NewCo in exchange for ownership interests in NewCo.

Third, immediately following the contribution, NewCo causes the Operating Entity to elect to be taxed as a qualified subchapter S subsidiary (“QSub”). This is an important step, the complexity of which is frequently overlooked.

After the above steps are completed, NewCo should cause the Operating Entity to convert from a state-law corporation to a state-law limited liability company.³

Following such conversion, an entity investor could then purchase equity interests of the Operating Entity without disqualifying the S election of NewCo. Upon such a purchase, the Operating Entity, of course, would no longer be an eligible QSub.

Because the limited liability company is a disregarded entity for income tax purposes, the purchase would be treated as an acquisition of assets of the limited liability company by the Buyer. Following the purchase, the limited liability company would be characterized as a partnership under the “check-the-box” rules. For example, if the Buyer acquires 70% of the interests of the Operating Entity, NewCo will recognize gain or loss as if NewCo had sold 70% of the assets of the Operating Entity to the Buyer.

B. Documentation

These steps must be memorialized in a written Plan of Reorganization, which would also specify the business purpose of the reorganization. Each party must file a required statement with their respective return under the Treasury Regulations for the tax year, which requires a report of the names and EINs of all parties to the reorganization; the date of the reorganization; and the aggregate fair market value of the assets, stock, or securities of the Operating Entity transferred in the reorganization.

C. Qualification as an “F” Reorganization

The Treasury Regulations provide the following general requirements for an “F” reorganization under Section 368(a)(1)(F):

All of the stock⁴ of NewCo must be distributed in exchange for equity interests of the Operating Entity.
The same persons must own all of the equity interests of the Operating Entity immediately prior to the reorganization and of NewCo immediately after the reorganization, in identical proportions.
NewCo may not hold any property or have any tax attributes prior to the reorganization.
The Operating Entity must completely liquidate for federal income tax purposes in the reorganization but it is not required to dissolve under state law. This could include a deemed liquidation under the Section 7701 Regulations.
Immediately after the reorganization, no entity other than NewCo may hold property that was held by the Operating Entity immediately before the reorganization, if the other entity would succeed to the tax attributes.
Immediately after the reorganization, NewCo may not hold property acquired from anyone other than the Operating Entity, if NewCo would succeed to the tax attributes.

Unlike other tax-free reorganizations under Section 368, an “F” reorganization is exempt from the judicially created “continuity of business enterprise” and “continuity of interest” requirements. An “F” reorganization is not, however, exempt from the business purpose requirement. A summary of what constitutes a valid “business purpose” for purposes of Section 368 is beyond the scope of this article. With that said, business owners and practitioners would be well-advised to identify a business purpose in the Plan of Reorganization as part of their due diligence.

D. Carryover of the S Election

Guidance from the IRS provides that the above steps result in the original S election carrying over to NewCo. Accordingly, NewCo need not make a separate “S” election nor file a Form 2553. For such carryover to occur, the parent must cause the subsidiary to make the QSub election. Note that a QSub election must be made for the Operating Entity effective immediately following the transaction to allow for such carryover.⁵

E. Carryover of EIN

IRS guidance provides that, if carried out properly, the Operating Entity will retain its original EIN. This allows the Operating Entity to utilize the same business registrations and other aspects associated with its unique EIN. NewCo must apply for a new EIN.

F. Tax Results

If structured properly, the follow tax results apply:

No gain or loss is recognized on the transaction by the Operating Entity.
No gain or loss is recognized by the owners of the Operating Entity (at least until a subsequent sale of the equity of the Operating Entity). The owners’ basis in the equity interests of NewCo will be the same as the basis they had in their equity interests of the Operating Entity. The holding period for the equity interests of NewCo will include the holding period of the Operating Entity equity interests.
No gain or loss is recognized by NewCo on its receipt of assets in exchange for its equity interests (until a subsequent event such as a sale). NewCo succeeds to all tax attributes of the Operating Entity under Section 381(c).

Again, there are many traps for the unwary, but an “F” reorganization can be a useful tool for restructuring an entity taxed as an “S” corporation prior to certain investments or acquisitions. Practitioners should follow the above steps and assure compliance with all aspects of Section 368(a)(1)(F) as well as the various forms required to be filed with the IRS.

Hannah Fischer Frey and Jesse Sitz are partners at Baird Holm LLP, focusing their law practices in the areas of federal and state income tax law and business succession planning. Fischer Frey and Sitz work closely with other tax practitioners and preparers to document and structure deals for their clients in a tax-efficient manner.

For more information, contact them at hfrey@bairdholm.com and jsitz@bairdholm.com, respectively.

¹This article refers to “S corporations” generally to refer to limited liabilities companies or corporations that have made an “S” election under Section 1361 of the Code. Under the check-the-box rules, a multi-member limited liability company can elect taxation other than its default partnership status.

²For purposes of this article, the term “corporations” when used in the phrase “S corporations” is intended to reflect the tax status of the entity, not the entity’s state law entity form.

³If the Operating Entity is already a limited liability company, this step may be skipped. Note, however, that complexities apply relating to a limited liability company making a QSub election. Special attention should be given to the election forms required for such an election.

⁴For purposes of this article, the term “stock” when used in the phrase “S corporation stock” is intended to refer generally to ownership interests of an entity taxed as an “S” corporation.

⁵With that said, there are nuances related to the tax election forms to be filed during the reorganizations that would apply to limited liability companies, but not state-law corporations. Care should be taken to ensure that the proper forms are filed with the Internal Revenue Service.