F Reorganization: What It Means When You Sell Your S Corp

If you own an S corporation and a private equity firm has sent you a letter of intent, one line in it may read something like this: "Prior to closing, Seller will complete an F reorganization." It's usually a single sentence, tucked between the escrow terms and the exclusivity period, and it's easy to read right past it. It sounds like paperwork for the lawyers.

Most of it is paperwork. But an F reorganization also changes how your sale is taxed, and for a contractor or manufacturer whose equipment has been depreciated down to almost nothing, that change can cost real money in the year you sell. Whether the buyer helps cover that cost is something you negotiate before you sign the letter of intent, not after.

One note first. This is an explanation of the mechanics, not tax advice. The right answer for your company depends on facts only your CPA and tax counsel can check: how the company was formed, how its equipment was depreciated, where it does business, and how you plan to hold any equity you roll over. The goal here is to help you recognize what you're being asked for, and which parts of it belong in the negotiation.

What an F Reorganization Is

The name comes straight from the tax code. Section 368(a)(1)(F) of the Internal Revenue Code covers "a mere change in identity, form, or place of organization of one corporation, however effected." Lawyers shorten that to an F reorganization, or an F reorg, after the letter of the subsection. It lets a corporation change its legal shape without the change itself being taxed as a sale.

In a business sale, the F reorg is a setup step. Before closing, your company is rearranged so the operating business sits inside a limited liability company, and that LLC is owned by a new holding company that you own. At closing, the buyer buys the LLC.

Legally, the buyer is acquiring an existing business with its name, contracts, employees, and history intact. For federal income tax purposes, though, an LLC with a single owner is generally disregarded, so buying all of it is treated as buying the assets inside it. That gap between the legal form and the tax treatment is the whole reason the structure exists. To see why buyers care about it, start with the two basic ways a company can be sold.

S Corp Asset Sale vs. Stock Sale

Selling an S corporation comes down to two basic options. In a stock sale, the buyer buys your shares, and the company changes owners with everything in it: equipment, contracts, permits, employees, and its liabilities and history. In an asset sale, the buyer buys the company's equipment, customer relationships, name, and goodwill, and your old corporation keeps whatever the buyer doesn't take.

Sellers have generally preferred stock sales. If you've held your S corporation shares for more than a year, the gain on selling them is generally long-term capital gain, which is taxed at lower rates than ordinary income. Buyers have generally preferred asset purchases, for two reasons:

• The step-up. A buyer of assets records them at the price it paid, which is usually far above their value on the seller's tax books. That higher tax basis lets the buyer depreciate the equipment again and amortize goodwill over 15 years, which lowers its taxes for years after closing. A buyer of stock typically inherits the company's old, low basis instead.
• The history. A buyer of assets can leave problems from before closing with the seller's corporation. A buyer of stock owns them, including any tax the company should have paid in earlier years.

For a C corporation, that tug-of-war usually ends in a stock sale, because an asset sale by a C corporation is taxed twice: once at the corporate level, and again when the proceeds are paid out to the owners. An S corporation is a pass-through entity, so an asset sale is generally taxed once, on the owners' personal returns. The difference between the two kinds of sale is smaller, which makes asset treatment an easier ask for a buyer of an S corporation, and is why F reorganizations come up mostly in S corporation deals.

Smaller is not the same as zero, though. The difference that's left is where your money is, and we'll come back to it.

Why Buyers Ask for an F Reorganization

There's an older way to give a buyer asset treatment while it buys your stock: a 338(h)(10) election, which lets a corporate buyer and an S corporation's shareholders jointly treat a stock purchase as if the assets had been bought. So why do private equity buyers ask for an F reorg instead? There are four main reasons.

• It works with the buyer's structure. A 338(h)(10) election requires the buyer to be a corporation. Private equity firms often buy through LLCs and partnerships, which can't make it. A related election under Section 336(e) can sometimes fill the gap, but it shares the weakness described in the next point.
• It protects the buyer if your S election was broken. An S corporation can lose its status without anyone noticing: a shareholder who wasn't eligible to own S stock, a shareholder agreement that gave some shares different rights to distributions, an election that was filed late or never accepted. If that happened years ago, the company may legally have been a C corporation since, with corporate tax owed on years of income. The 338(h)(10) and 336(e) elections depend on the S election being valid. If it wasn't, the election fails, the buyer loses its step-up, and it may own a company carrying a tax problem. In an F reorg, the buyer's step-up doesn't depend on that history, because it's buying an LLC. The LLC is still the same legal entity as your old company, though, and can remain liable for taxes from before closing, so the purchase agreement typically backs the structure up with tax indemnities from you.
• It makes a tax-deferred rollover simpler. If you're keeping a stake in the business, the structure gives the buyer a clean way to take part of the LLC for cash and accept the rest as your rollover, with tax on the rolled portion generally deferred. More on that below.
• It keeps the operating company intact. In a true asset sale, every contract, lease, license, permit, and bank account has to be transferred or replaced, often with third-party consents. In an F reorg, the operating company is the same legal entity before and after closing, and under the IRS ruling that set out the standard approach, it keeps its own employer identification number, which helps with payroll and banking.

Intact doesn't mean nothing needs attention. Some contracts, licenses, and surety relationships treat a conversion or a change of control as a trigger for notice or consent. Your counsel will go through them. The list is generally shorter than an asset sale's, but for a contractor it can still include your surety, your lender, and key licenses.

How an F Reorganization Works, Step by Step

The steps vary by state and by deal, and your counsel will run them. A common sequence, modeled on the approach the IRS described in Revenue Ruling 2008-18, looks like this:

1. Form a new holding company. You and any other shareholders form a new corporation, often called NewCo.
2. Contribute your shares. The shareholders contribute all of their stock in the operating company to NewCo. You now own NewCo, and NewCo owns the operating company.
3. Make the QSub election. NewCo elects to treat the operating company as a qualified subchapter S subsidiary, or QSub, on IRS Form 8869. The contribution and the election together are what qualify as the F reorganization. The company's S election doesn't end. It carries over to NewCo, which gets its own new employer identification number.
4. Convert the operating company to an LLC. Under state law, the operating company converts into a limited liability company, or merges into one. Because it's wholly owned by NewCo, the LLC is disregarded for federal income tax purposes.
5. Close. NewCo sells the LLC to the buyer, or sells part of it for cash and contributes the rest to the buyer's holding entity as your rollover.

A few practical consequences follow. The seller of record is NewCo, so the sale proceeds land there, and the gain flows through to you on NewCo's return, the same way the company's income does today. If you roll over equity, NewCo will typically hold it, which means NewCo stays in existence, with its own filings, until that equity is sold. And because the steps are usually completed shortly before closing, ask your counsel when to start them. Restructuring your company for a deal that ends up not closing costs time and fees for nothing.

What It Can Cost You: Recapture on Equipment You've Written Off

Here's the part the one-line mention in a letter of intent leaves out. Because the buyer is treated as buying assets, you're treated as selling them. The gain on each asset is taxed according to its own character, and some of those characters are less favorable than the long-term capital gain you'd generally see on a straight stock sale.

If your company owns a lot of heavily depreciated equipment, the biggest of those is likely depreciation recapture. When equipment sells for more than its tax basis, the gain up to the depreciation you've already taken is generally taxed as ordinary income under Section 1245, not as capital gain. Plenty of owners have spent years writing off trucks, pavers, loaders, cranes, and machine tools through bonus depreciation or Section 179 expensing. Those deductions lowered your taxes when you bought the equipment. In an asset-style sale, much of that deduction can come back as ordinary income in the year you sell.

A hypothetical makes it concrete. The numbers are round, with no units on purpose. Say a buyer pays 100 for your company, and 20 of that price is allocated to equipment whose tax basis has been depreciated close to zero. In a straight stock sale, you'd generally report the whole gain as capital gain. In an F reorganization, roughly 20 of it can be ordinary income instead. If, for illustration, your ordinary rate runs 15 points above your capital gains rate, that one difference costs you about 3, or 3 percent of the price. Real figures depend on your rates, your basis, and the allocation, but the shape holds: the more equipment you've written off, the more the structure can cost you.

Recapture isn't the only difference. Depending on your company, a few others can apply:

• Built-in gains tax. If your company became an S corporation within the past five years after operating as a C corporation, or picked up a C corporation's assets in a tax-free deal during that time, Section 1374 can impose a corporate-level tax on built-in gain recognized in an asset-style sale. That tax reduces the gain that flows through to you, but the combined bill is still higher.
• Receivables, inventory, and contract balances. Depending on your accounting method, some of what the buyer pays for can produce ordinary income rather than capital gain.
• State taxes. Gain on a stock sale is generally taxed where you live. Gain on an asset sale can be apportioned to the states where the company does business. For a contractor working across several states, that can change the bill in either direction.

None of this makes an F reorganization a bad deal for you. It means the structure moves value from your side of the table to the buyer's, and it's reasonable to ask for some of it back.

The Tax Gross-Up and the Purchase Price Allocation

Remember why the buyer wants the structure: the step-up gives it years of deductions it wouldn't get from a stock purchase. Depending on the company, those deductions can be worth more to the buyer than the extra tax the structure costs you. When that's the case, there's room in the deal for both sides, and the two usual ways to use it are a gross-up and an agreement on the allocation.

The gross-up. A tax gross-up is an increase in the price meant to leave you, after taxes, about where a straight stock sale would have. In the hypothetical above, it would be roughly 3, plus enough to cover the tax on the gross-up itself, which at capital gains rates can add a quarter or more. Some buyers agree to a full gross-up, some split the cost, and some say the step-up is already reflected in their offer. Which answer you get depends on how many buyers want the company and on when you ask. Asked for at the letter of intent stage, while any other bidders are still in the picture, a gross-up is a price term. Asked for after you've signed exclusivity, it's a favor.

The allocation. In an asset-style deal, buyer and seller divide the price among classes of assets, and both report that purchase price allocation to the IRS on Form 8594. The split drives your tax. More of the price on equipment means more recapture for you and faster deductions for the buyer. More on goodwill means more capital gain for you and slower deductions for the buyer. Your interests point in opposite directions, so agree on the method early, ideally in the letter of intent and at least well before the purchase agreement is final, and have your CPA model the result. Equipment appraisals tend to anchor that conversation, so it's worth knowing what yours would say.

One smaller item: ask who pays for the reorganization itself. The legal and accounting work to set it up costs real money, and it's done mainly for the buyer's benefit, so it's reasonable to ask the buyer to cover it.

Where Your Rollover Fits

If you're selling to private equity, you may be asked to keep a stake in the business, usually called rollover equity. The F reorg is part of how that stake gets set up.

In a typical version, NewCo sells most of the LLC to the buyer's holding entity for cash and contributes the rest in exchange for equity in that holding entity. When the holding entity is taxed as a partnership and the contribution is structured under Section 721, tax on the rolled portion is generally deferred until that equity is sold, usually at the buyer's own exit. Structured wrong, you can owe tax on value you received in equity rather than cash.

Two things to watch. First, because the rolled portion generally isn't taxed at closing, the recapture math above applies mainly to the cash portion. The deferred gain doesn't disappear. It generally travels with the rolled equity, the recapture part can still come back as ordinary income when that equity is sold, and some events inside the buyer's company can trigger it sooner, so your CPA should model both pieces together. Second, the terms attached to rolled equity, such as its class, vesting, and repurchase rights, matter as much as its tax treatment. Our rollover equity guide covers those terms, and selling to private equity walks through how a rollover can pay off, or lose value, at the next sale.

Questions to Settle Before You Sign the Letter of Intent

An F reorganization is a reasonable request. The mistake is treating it as boilerplate. Before you sign a letter of intent that includes one, get answers to these:

• Has your CPA modeled the difference? Ask for your after-tax proceeds under a straight stock sale and under the F reorganization, using your actual depreciation schedules. That difference is the starting point for a gross-up.
• Who covers the extra tax? A full gross-up, a split, or nothing, decided before exclusivity, while any other bidders are still involved.
• How will the price be allocated? Agree on the method, or at least the principles, before exclusivity.
• Who pays to set it up? The work is done for the buyer's benefit.
• Is your S election clean? Buyers will check in diligence. Have your CPA and counsel review the company's S history first, so a defect turns up on your schedule rather than theirs. If the election isn't valid, the asset-style sale can be taxed at the corporate level as well as on your return, so a defect costs you, not just the buyer. Some defects can be corrected through IRS relief procedures, and that takes time. It's the same logic as commissioning a quality of earnings report before going to market.
• What needs notice or consent? Customer contracts, equipment financing, real estate leases, contractor licenses, DOT registrations, and your surety can each have a notice or consent requirement that a conversion or change of control triggers. Your counsel will build the list. Your surety and your lender should hear about it from you, early.
• When do the steps happen? Close to closing, once the deal is on solid ground.
• How will any rollover be held? Through NewCo, in which class of equity, and on what terms.

Most of these get settled before anyone drafts the purchase agreement, and most of them depend on having more than one buyer at the table when you ask. That part is our job. We run a sale process designed to draw competing interest, compare each offer's structure (the gross-up, the allocation, and the rollover) using your CPA's tax analysis, and negotiate the economic terms alongside your deal counsel. For an equipment-heavy contractor, the process looks a lot like the one we describe in selling a paving company.

If a letter of intent with an F reorganization in it is already on your desk, or you expect one soon, talk with our team before you sign it. Or start with a directional look at what your business might be worth.

Sources

• 26 U.S.C. § 368, Definitions relating to corporate reorganizations. Cornell Legal Information Institute.
• 26 U.S.C. § 338, Certain stock purchases treated as asset acquisitions. Cornell Legal Information Institute.
• 26 U.S.C. § 1245, Gain from dispositions of certain depreciable property. Cornell Legal Information Institute.
• Revenue Ruling 2008-18, S corporation reorganization with a QSub election. Internal Revenue Service.
• Form 8594, Asset Acquisition Statement Under Section 1060. Internal Revenue Service.