When selling an S corporation, an increasingly common transaction structure is the so-called “F” reorg QSub drop. Its popularity is tied to the fact that it can provide each party in the transaction a desired tax benefit.
What tax benefit does a buyer want when acquiring a company? A step-up in asset basis. Increased asset basis reduces tax over time by creating depreciation/amortization deductions.
What tax benefit do the owners of target want? To defer tax.
Let’s say buyer is an entity taxed as a partnership and offers $10,000,000 to purchase target S corp. The transaction consideration is $7.5M in cash and $2.5M in buyer equity. So, 75% of the assets are being purchased for cash, and 25% of the assets are being purchased for equity. An “F” reorg QSub drop allows buyer to take the portion of the assets purchased for cash with a $7.5M basis and the assets purchased with equity with a carry-over basis (often nominal). The owners of target recognize gain on the assets sold for cash and defer gain on the assets exchanged for equity. It’s a nice way to split the baby.
This same result could be accomplished by an S corp simply dropping assets into a single member LLC and then selling the LLC to buyer for cash and buyer equity. But the “F” reorg QSub drop has two additional advantages: buyer receives the target entity with its original employer identification number (EIN), and the operating business continues in the original entity so contracts do not have to be re-executed with suppliers, etc.
So, without further ado, here are the required steps…
Step 1: The owners of the target S corporation (“Target”) form a holding corporation (“Holdco”) and contribute their equity in Target to Holdco in exchange for Holdco equity. If desired, a protective S election can be made on IRS Form 2553.
Step 2: Holdco elects to treat Target as a qualified subchapter S subsidiary (“QSub”) by filing IRS Form 8869 and checking “Yes” in Box 14 of such form. At this point, Holdco is owned by the original owners in the same proportion as they used to own Target, and Target is owned 100% by Holdco and is disregarded for tax purposes.
The contribution and QSub election are treated as an “F” reorganization transaction described in Revenue Ruling 2008-18. Holdco is a continuation of Target for federal income tax purposes. Holdco obtains a new EIN and Target retains its EIN.
Step 3: If Target is a corporation, it converts into a limited liability company that will be disregarded for tax purposes. If Target was instead a limited liability company that had elected S corp status, it makes a check-the-box election on Form 8832.[1] Neither the conversion[2] nor election causes tax.
It is very important that Step 3 does not occur until the QSub election in Step 2 has been filed (i.e., mailed) and is effective.
Sometimes following completion of Steps 1-3 Holdco distributes an equity interest (typically 1%) in Target to the owners for the purposes of converting Target into a partnership for income tax purposes. This is avoid anti-churning concerns under 197(f) but should only be necessary if Target has assets acquired prior to August, 1993.
Step 4: Buyer acquires all of the equity interest of Target in exchange for cash and rollover equity. The transaction is treated as a part sale, part contribution of the assets of Target.
If the rollover equity is equity in a partnership, the gain will be deferred by tax code Section 721, but springs back to life upon a later sale of the Target interest by Buyer, under tax code Section 704(c) principles.
If the rollover equity is C corp equity, the rollover deferral will only be available if tax code Section 351 is available, and may be limited by 351(b).
As an alternative to Buyer providing rollover equity, Buyer could directly acquire less than 100% of the equity of Target, meaning that Holdco could simply retain some Target equity.
In each case, the deferral of the gain on the rollover or retained equity, is dependent upon Holdco continuing to hold such equity. Said another way, if Holdco distributes out that equity to the owners, that will trigger gain on the built-in appreciation.
Mike Baker frequently advises with respect to S corp “F” reorg QSub drop down transactions. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] A check-the-box election can only be made if the LLC’s S election was made effective as of the LLC’s formation, or, if not, if such election was made more than 5 years ago. If Target is an LLC and this election is not possible, a new LLC will have to be formed and target can be merged into that LLC. However, if that is required, it may in fact be simpler from the beginning to just form a new LLC and do an asset drop, which means the buyer will not get the EIN of the original operating company and that contracts may need to be revised to be contracts with respect to the new LLC.
[2] See Treas. Reg. 1.1361-5(b)(3) Ex. 2.