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.
- 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.
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 circ*mstances.
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