Many practitioners are familiar with the benefit of using disregarded entities (DREs) or Single Member Limited Liability Companies (SMLLCs) in structuring merger and acquisition transactions. However, advisors should also consider the advantages of using F reorganizations to solve certain issues that can be encountered when forming a SMLLC.
What is an F Reorganization?
An F reorganization, tax-free under IRC Section 368(a)(1)(F), is typically defined as a mere change in identity, form or place of organization. An F reorganization is very useful when the Target selling corporation has a business or tax reason to implement a disregarded entity, but there are impediments to forming a SMLLC.
Businesses encounter various issues when forming a DRE, including:
- Obtaining legal consent
- Incurring transfer taxes
- Incurring an additional tax burden on IRC Section 338(h)(10) sales
- Regulatory hurdles such as deemed change in control in Healthcare transactions
The usual manner to implement a DRE is commonly called a “drop-down,” where the Target transfers assets and liabilities into a SMLLC. The F reorganization can effectively achieve the same result as a drop-down while avoiding some of the negative consequences listed above.
Structuring Mergers & Acquisitions with F Reorganization
A common example of using an F reorganization would involve a transaction where the seller is an S-Corporation. Assume further that the selling S-Corporation and Buyer are considering an IRC Section 338(h)(10) election, IRC Section 336(e) election or a drop-down, but are faced with the rigidity of elections and obtaining potentially hundreds of legal consents. The F reorganization allow for more flexibility and the structure is typically accomplished by the following steps:
- The S-Corporation shareholders form a new Holding Company and make a valid S-election.
- The shareholders contribute shares of the selling S-Corporation to the new Holding Company.
- The Holding Company makes a Q-Sub election for the S-Corporation subsidiary and makes an election to convert to an LLC.
Thus, you now have the desired result of an S-Corporation which owns 100 percent of an LLC without triggering any of the negative consequences of a drop-down.
Seller Benefits of F Reorganization
The F reorganization structure places the seller in a position where they can have flexibility to do the following:
- Avoid obtaining legal consent or incurring transfer taxes via a drop down
- Structure the sale of the LLC interests thus avoiding the rigidity of an IRC Section 338(h)(10) election or an IRC Section 336(e) election, including the requirements on greater than or equal to 80% sale, taxing the entire gain and meeting the qualified stock purchase requirements.
- Deferral of gain recognition with respect to rollover equity
Buyer Benefits of F Reorganization
The F reorganization structure places the buyer in a position where they have flexibility to do the following:
- Achieve a step-up in the basis of the Target’s assets equal to the portion paid for Seller’s LLC interest.
- Retain the Federal Employer Identification (FEIN) number of the Target.
- Remove the risk associated with the validity of the Seller’s S-Corporation election that could otherwise potentially taint a step-up in the basis of Target’s assets under an IRC Section 338(h)(10) election or an IRC Section 336(e) election. Note: While the F reorganization structure protects the buyer’s basis step-up, many practitioners believe that the F reorganization structure does not reduce the risk of historic C Corporation income tax liabilities if Target did not historically have a valid S-election.
Caution for Target Entities in Existence Prior to 1993
Under Section 197(f), an intangible asset acquired by a taxpayer cannot be amortized if the taxpayer or a related person held or used the intangible during the period between July 25, 1991 and August 10, 1993. This section of the code is commonly referred to as the Anti-Churning Rules and can prevent the taxpayer from amortizing the step-up in the basis of the assets if the seller receiving rollover equity is related to the taxpayer. In general, under IRC Section 197(f), a seller is considered related to the post-transaction entity if it owns more than 20 percent of the entity. The related party and attribution rules should be closely analyzed as they can pose certain traps for the unwary.
However, flexibility to convert the SMLLC to a partnership prior to the sale can help the buyer capture the full benefit of the step-up in tax basis as the anti-churning rules typically do not apply to an increase in the basis of partnership property under IRC Section 743(b). In general, an increase in the basis of partnership property under IRC Section 743(b) is achieved when a new or existing partner acquires a partnership interest from an existing partner and an IRC Section 754 election is in place.
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If your company is weighing the advantages of using a F reorganization in a merger and acquisition transaction, Bennett Thrasher’s M&A practice is here to help. We can help you weight the benefits and costs of an F reorganization versus other strategies. Because of our experience in guiding companies through this process, we are confident we can find a solution that works for you.