If you own an S corporation and you are getting ready to sell it, there is a good chance your buyer's lawyer or accountant is going to ask for something called an F-reorganization. Most sellers have never heard the term. It is worth understanding before you agree to it.
I have set up this structure many times for clients selling S corporations, usually at the buyer's request. It is not a red flag. It is a routine piece of deal structuring that solves a real problem for both sides.
1. It lets a stock deal act like an asset deal for tax purposes
Buyers generally prefer to buy assets rather than stock, because assets get a stepped-up tax basis that the buyer can depreciate going forward. Sellers, on the other hand, often prefer a stock sale because it is simpler and can qualify for more favorable tax treatment.
An F-reorganization, named for the type of tax-free reorganization described in Section 368 of the tax code, is a way to give the buyer the tax benefits of an asset purchase while the transaction is still legally structured as a sale of an entity. Everybody gets closer to what they wanted.
2. How the mechanics generally work
Before closing, the S corporation owner forms a new holding company and the target company converts into a limited liability company that is treated as disregarded for tax purposes, sitting under that new holding company. The S corporation election effectively continues through the new holding company.
The buyer then acquires the LLC interests, or the buyer may also form its own acquisition vehicle. From a tax standpoint, the purchase is treated as an asset purchase, giving the buyer a stepped-up basis in the underlying assets.
3. Why buyers push for this structure
A stepped-up basis means bigger depreciation and amortization deductions after closing. Over time that can be worth real money to a buyer, which is why buyers and their advisors ask for it even when the seller was expecting a straightforward stock sale.
Buyers also like that liabilities of the old corporate entity can be left behind more cleanly than in a typical stock purchase, since the operating business continues in a new entity form.
4. What sellers should watch for
The reorganization has to happen in the right order and be documented correctly to qualify for tax-free treatment under the reorganization rules. Get the sequencing wrong and you can create an unintended taxable event before the sale even closes.
Sellers should also confirm the S corporation eligibility requirements are met throughout the process, since a slip in S corporation status can have consequences well beyond the pending sale.
5. It is a negotiation point, not just paperwork
Because the F-reorganization primarily benefits the buyer, it is reasonable for a seller to expect something in return, whether that is a purchase price adjustment or the buyer covering the additional legal and accounting costs of the restructuring.
I encourage sellers to treat a request for an F-reorganization as an opening for negotiation, not simply a box to check.
If your buyer or their advisors have raised an F-reorganization, or you want to understand your options before you are deep into a letter of intent, reach out through blgattorney.com or call my Oklahoma City office. It helps to know what you are agreeing to before it is the only option on the table.