February 26, 2020
Are tax-free reorganizations possible?
Absolutely. Internal Revenue Code Section 368(a)(1) allows for tax-free (or tax-deferred) reorganizations for certain acquisitions, divestitures, bankruptcies, and corporate restructurings. F-type reorganizations, which are a type of corporate restructuring permitted under subparagraph F, allow a single corporation to change their “identity, form, or place of organization” without incurring a tax bill. But F-type reorganizations can do so much more than that.
F-type reorganizations are often used in mergers or acquisitions. During a traditional (and therefore taxable) merger or acquisition, one organization is treated as transferring assets to another. Under an F-type (and therefore nontaxable) reorganization, one organization is treated as transferring assets to itself. To qualify as an F-type reorganization, the asset transfer must be so minimal that the IRS views the transferor and transferee entities as the beginning and ending phases of an organizational restructuring.
In 2015, the IRS released final regulations to help taxpayers understand F-type reorganizations. The document listed six basic requirements to qualify a reorganization under Section 368(a)(1)(F).
The regulations also made F-type reorganizations more appealing by guaranteeing transactions that precede or follow the transfer will be disregarded. Business owners can now freely use F-type reorganizations as part of a larger transaction to help them achieve certain restructuring results.
F-type reorganizations range from simple to complex. A simple reorganization may be changing an entity’s state of incorporation, but a more innovative use for F-type reorganizations can help taxpayers achieve a certain ownership result while avoiding regulatory barriers or transfer taxes.
Consider an S corporation that wants to award a key employee with a profit interest in the business. They cannot do this as an S corporation, but they could if they were a partnership. They can change their ownership from an S corporation to an LLC (taxed as a partnership) by performing a technique known as an LLC drop-down. In this technique, shareholders of the S corporation create an LLC subsidiary, transfer the business’s assets and operations to that subsidiary, and begin operating the business under the LLC. Although this transaction is simple, it is unappealing to most because of the regulatory hurdles they must clear, including re-hiring employees, getting new insurance coverage, and new business licenses. To save the administrative headache, business owners can utilize an F-type reorganization and achieve the same outcome.
In an F-type reorganization, the S corporation shareholders form a new company and make a valid S election. They then exchange their S corporation shares with the shares from the new company, making the original S corporation a subsidiary of the new corporation. The new entity can then make a Q-Sub election for the old S corporation (now its subsidiary) to convert it into an LLC, which can then be taxed as a partnership.
F-type reorganizations are not simple, but the final regulations coupled with older Revenue Rulings make their potential clear. They can help with tax issues for both simple and complex reorganizations and can even play a part in a much larger corporate restructuring. If you have questions about the information outlined above or need assistance with a business tax issue, Wilson Lewis can help. For additional information call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon