Updated. Originally posted May 1, 2021.
When selling an S corporation, an increasingly common structure is the so-called “F” reorg QSub drop. This structure has gained popularity because it offers valuable tax advantages for both the buyer and the seller.
Tax Objectives
- Buyer’s goal: Obtain a step-up in asset basis, which increases depreciation and amortization deductions, reducing taxes over time.
- Seller’s goal: Defer recognition of taxable gain on the sale.
Let’s use an example.
Suppose a buyer (an entity taxed as a partnership) offers $10 million to purchase an S corporation (“Target”). The purchase price consists of $7.5 million in cash and $2.5 million in buyer equity—in other words, 75% of the value in cash and 25% in equity.
An “F” reorg QSub drop allows this transaction to achieve both parties’ goals:
- The buyer receives a $7.5 million stepped-up basis for the portion purchased with cash.
- The buyer takes a carryover basis (often nominal) for the portion purchased with equity.
- The Target shareholders recognize gain only on the cash portion and defer gain on the equity portion.
In short, it’s a way to “split the baby”—providing partial gain deferral and a partial step-up in basis.
Why Use an F Reorg with a QSub Drop Instead of a Simple LLC Sale?
The same economic result could be achieved by dropping assets into a single-member LLC and selling interests in that LLC. However, the “F” reorg QSub structure offers two key advantages:
- Continuity of EIN: The buyer receives the target entity with its original employer identification number, simplifying payroll, reporting, and other administrative processes.
- Contract continuity: Because the business continues in the same legal entity, existing contracts don’t need to be re-executed with suppliers, customers, or employees.
Step-by-Step Process
Step 1: Formation of Holdco
The Target shareholders form a new corporation (“Holdco”) and contribute all their Target shares in exchange for Holdco stock. If desired, Holdco can file a protective S election on IRS Form 2553.
Step 2: QSub Election
Holdco elects to treat Target as a Qualified Subchapter S Subsidiary (QSub) by filing IRS Form 8869 and checking “Yes” in Box 14.
After this step:
- Holdco owns 100% of Target.
- Target is disregarded for tax purposes.
- The transaction qualifies as an “F” reorganization under Revenue Ruling 2008-18, meaning Holdco is a continuation of Target for tax purposes.
EIN note: Holdco receives a new EIN, while Target retains its original EIN.
Step 3: Conversion of Target
If Target is a corporation, it is converted into a limited liability company (LLC) that will be disregarded for tax purposes.
If Target is already an LLC that previously elected S corporation status, it makes a check-the-box election on Form 8832 instead.[1]
Neither the conversion[2] nor election causes tax.
⚠️ Timing matters: Step 3 should not occur until the QSub election in Step 2 has been filed and is effective with the IRS. In this case the mailbox rule does not apply, the Form 8869 needs to have actually been received by the IRS.
Occasionally, Holdco may distribute a small (e.g., 1%) equity interest in Target to its shareholders, converting Target into a partnership for tax purposes. This can help avoid anti-churning issues under §197(f) but is typically only necessary if Target holds pre-August 1993 assets.
Step 4: Sale to Buyer
The buyer acquires all of Target’s equity interests in exchange for cash and rollover equity. The transaction is treated as a part sale / part contribution of Target’s assets.
- If the rollover equity is partnership equity: Gain is deferred under §721, but later recognized under §704(c) when that equity is sold.
- If the rollover equity is C corporation stock: Deferral may be available under §351, though subject to limitations under §351(b).
Alternatively, the buyer could acquire less than 100% of Target’s equity—leaving Holdco with a retained interest, which also supports gain deferral.
However, note that any distribution of the retained or rollover equity by Holdco to its owners will trigger gain recognition on the built-in appreciation.
Conclusion
The S corp “F” reorg QSub drop can be a powerful and flexible transaction structure, offering:
- A step-up in basis for the buyer,
- Gain deferral for the seller, and
- Administrative simplicity through continuity of the entity and contracts.
However, executing these steps requires careful attention to timing and elections. Professional tax and legal advice is essential before implementation.
About the Author
Mike Baker frequently advises clients on S corporation “F” reorg QSub drop transactions. He has extensive experience in tax law, employee benefits, and executive compensation planning. For more information, contact mike@mbakertaxlaw.com.
[1] A check-the-box election can only be made if the LLC’s S election was effective upon formation or, if later, was made more than five years ago. If not, a new LLC may need to be formed, and Target merged into it. In that case, the buyer might not inherit Target’s EIN, and contracts may need to be updated.
[2] See Treas. Reg. § 1.1361-5(b)(3), Example 2.