Pre-Closing F Reorganizations for S Corporation Targets

Circular 230 / general information notice. This article is general information only. It is not tax, legal, or accounting advice. Reading it does not create an attorney-client relationship. Tax results depend on your facts and on law that can change. Consult your own attorney and CPA before taking any action. This article was not written to be used, and cannot be used, to avoid tax penalties.

When a buyer wants to acquire an S corporation and treat the purchase as an asset deal for federal tax purposes, a pre-closing F reorganization is often the structure on the table. The target can stay in place for contracts and payroll accounts, sellers can roll equity with more flexibility than a plain stock sale sometimes allows, and the buyer can purchase a disregarded entity rather than S corporation stock. The federal mechanics come from Section 368(a)(1)(F) and Rev. Rul. 2008-18, 2008-13 I.R.B. 674. The work is in the sequence. I first worked through these rules as a student at the University of Chicago Law School. The ruling only helps if each step happens in the right order, on the right day, with the right elections on file.

Why buyers ask for a pre-closing F reorganization

A stock purchase of an S corporation does not, by itself, give the buyer a cost basis in the company's assets. Buyers who want that basis step-up usually compare a Section 338(h)(10) election, a Section 336(e) election, or an F reorganization followed by a purchase of a disregarded entity. A Section 338(h)(10) election generally requires a qualified stock purchase of at least 80 percent of the vote and value, plus a valid S corporation (or a target in a selling consolidated group). A Section 336(e) election has its own qualified stock disposition rules and also depends on a valid S election. If the S election is later found invalid, those elections can fail, leaving the buyer with stock basis and carryover asset basis.

An F reorganization followed by conversion of the historic company into a wholly owned limited liability company can change that picture. After the steps in Rev. Rul. 2008-18, the operating company can be a disregarded entity for federal income tax purposes. The buyer then purchases that entity (or its assets) and, if the tax analysis supports it, is treated as buying assets even if a historical S problem would have complicated a 338(h)(10) or 336(e) election. That is one reason passthrough buyers press for a pre-closing F reorganization on S corporation targets.

Sellers may also prefer the structure when part of the consideration is rollover equity. Rolling S corporation stock directly into a partnership raises separate issues. Rolling at a new S corporation holding company, after the historic company becomes a disregarded subsidiary, can be easier to fit into a rollover equity plan. Coordinate that plan with the purchase agreement and the CPA from the letter of intent forward. For the sale process around this work, see what middle-market sellers should expect from LOI to close and our private equity and M&A page.

The Rev. Rul. 2008-18 mechanics

Rev. Rul. 2008-18 addresses a holding-company structure that qualifies as a reorganization under Section 368(a)(1)(F): a mere change in identity, form, or place of organization of one corporation, however effected. In the ruling's basic fact pattern, the shareholders of an existing S corporation (Target) contribute all of their Target stock to a newly formed corporation (Newco) in exchange for all of Newco's stock. Newco timely elects to treat Target as a qualified subchapter S subsidiary (QSub), effective immediately after the contribution. The IRS held that Target's original S election does not terminate. Consistent with Rev. Rul. 64-250, that election continues for Newco. Newco is not required to file a new Form 2553, Election by a Small Business Corporation.

Form 8869, Qualified Subchapter S Subsidiary Election, includes a box to indicate that the QSub election is made as part of an F reorganization described in Rev. Rul. 2008-18. Checking that box tells the IRS that Newco succeeds to Target's S election and that a separate Form 2553 is not being filed for Newco.

The ruling also settles employer identification numbers. Newco must obtain a new EIN. Target retains its historic EIN, even after the QSub election, and must use that EIN whenever the QSub is treated as a separate entity for federal tax purposes, including employment taxes and certain excise taxes, or if the QSub election later terminates. Getting the EINs backwards creates problems for payroll and bank accounts, and it is inconsistent with the ruling.

The QSub election, then the LLC conversion

A QSub is a wholly owned domestic corporation with a valid election under Section 1361(b)(3). For most federal income tax purposes it is disregarded, and its assets, liabilities, and items are treated as those of the parent S corporation. Under Treas. Reg. § 1.1361-3(a), the requested effective date generally cannot be more than two months and 15 days before the filing date, or more than 12 months after it.

Timing relative to any later conversion is the point that trips people up. A QSub election can be made only for an entity that is a corporation when the election is made. If Target converts to a limited liability company under state law first, and Form 8869 is filed afterward, the election can be ineffective because Target is no longer a corporation. The IRS has granted Section 1362(f) relief in at least one private letter ruling with that fact pattern, but a private letter ruling is not precedent you can rely on for your deal. File the QSub election, effective immediately after the stock contribution, while Target is still a corporation. Convert Target to an LLC only after that election is in place, typically on a later day.

Once Target is a valid QSub, a state-law conversion (or merger) into a wholly owned LLC is generally a change from one disregarded entity into another and often has no additional federal income tax effect. After the conversion, Target can remain disregarded as a single-member LLC owned by Newco, which is usually the form the buyer wants to purchase. Confirm the conversion statute, the filing, and the effective time with Texas or other applicable counsel before anyone assumes the federal tax narrative is finished.

The Texas conversion step

For a Texas corporation, the conversion into an LLC runs under Chapter 10 of the Texas Business Organizations Code. The board and shareholders approve a plan of conversion that meets § 10.103, and the converting entity files a certificate of conversion with the Secretary of State under § 10.154, with the LLC's certificate of formation. Under § 10.106, the converted entity is treated as the same entity continuing, and its property, liabilities, and pending proceedings continue without a transfer. That continuity is the state-law reason contracts and permits often survive the conversion, although the contract language still controls whether a consent is needed. If Target is a Delaware corporation, the parallel statute is 8 Del. C. § 266, and the LLC is formed under 6 Del. C. § 18-214.

How the step-up and the rollover usually sit on top

The F reorganization itself is intended to be a nonrecognition reorganization if the requirements are met. It does not, standing alone, create a cost basis step-up in Target's assets. The step-up, if available, comes from the later purchase: the buyer acquires the disregarded LLC or its assets, and the transaction is modeled as an asset purchase for federal income tax purposes. Purchase-price allocation and depreciation or amortization belong in that later step, worked through with the CPA.

The size of the step-up is what makes the work worth doing. Assume the buyer pays $30,000,000 for the LLC, the target's inside basis in its assets is $3,000,000, and, for simplicity, the entire $27,000,000 of excess is allocated to goodwill and other Section 197 intangibles amortized over 15 years. That produces $1,800,000 of annual deductions. For a buyer taxed as a partnership whose owners are at a 37% rate, the deductions are worth about $666,000 a year in federal tax, or about $9,990,000 over 15 years before discounting. Allocation to equipment eligible for 100% bonus depreciation under the OBBBA would accelerate part of that into year one.

The seller's side of the ledger also moves. Because the buyer is treated as buying assets, the S corporation recognizes gain asset by asset, and the gain flows through to the shareholders. Depreciation recapture on equipment is ordinary income, and if the company was a C corporation that converted to S status within the five-year recognition period, Section 1374 imposes a corporate-level built-in gains tax at 21% on the built-in gain recognized. That is the context for a gross-up negotiation, discussed in what middle-market sellers should expect from LOI to close.

Rollover is a later-step problem. If sellers will receive equity in the buyer's holding company, decide whether that rollover happens at Newco, at a partnership above or below Newco, or as a contribution of Newco stock. Each path has different Section 351, Section 721, and disguised-sale issues. An F reorganization only sets the entity the parties will use. It does not answer the rollover question by itself.

Traps: a busted S election, state tax, and the EIN and contracts

First, test the historic S election anyway. Ineligible shareholders, a second class of stock, late or missing elections, and disproportionate distributions are the usual issues. The F reorganization plus LLC conversion can still help a buyer, because the purchased entity may be disregarded even if a 338(h)(10) or 336(e) election would have failed. Sellers still cannot ignore a busted S election. Historic tax years, shareholder-level reporting, and possible relief under Section 1362 need a real review. If the S election was never valid, some of the "S election continues for Newco" statements in Rev. Rul. 2008-18 may not describe what occurred.

Second, do not treat federal nonrecognition as a state tax answer. Some states follow federal QSub and reorganization treatment. Some do not, or they follow it only in part. Texas has no personal income tax, but it does impose a franchise (margin) tax, and many targets have nexus elsewhere. Model the contribution, the QSub election, and the LLC conversion for state income and franchise tax before the steps are locked. That is CPA work on the company's actual footprint.

Third, plan the EIN, payroll, banking, licenses, and contracts as an operating workstream, not as a cleanup item after signing. Newco needs a new EIN. Target keeps its EIN. Payroll accounts often stay with Target's EIN, which is one practical reason parties like this structure. Contracts, loans, insurance, permits, and licenses may still treat the contribution, the QSub election, or the LLC conversion as an assignment, a change of control, or a change in legal form that requires consent or notice. A commercial lease with a tight change-of-control clause is a recurring example. Read the material contracts before the conversion documents are filed.

Fourth, preserve eligibility along the way. Newco must qualify as a small business corporation when it is to be an S corporation. Adding an ineligible rollover partner or a prohibited second class of stock at the wrong moment can undo the plan. If the buyer is a partnership, the usual design is that Newco is the S corporation seller vehicle and the partnership buys the disregarded LLC from Newco.

Purchase agreement language

The purchase agreement should make the reorganization a covenant and a closing deliverable, and should allocate the risk of a busted S election. A typical covenant:

"Prior to the Closing, Seller Parent and the Company will complete the Pre-Closing Reorganization in accordance with the steps and sequence set forth on Exhibit C, and Seller Parent will deliver to Buyer (a) a copy of the Form 8869 filed with respect to the Company, effective as of the date of the contribution described in Step 2, together with evidence of its timely filing, and (b) the certificate of conversion filed with the Texas Secretary of State. Seller Parent will not revoke its election to be treated as an S corporation, and will not take any action that would cause that election to terminate, before the Closing."

What each piece does:

1. Exhibit C fixes the order of steps. The sequence is the whole point of Rev. Rul. 2008-18, so it belongs in the contract, not in an email chain.

2. Proof of the Form 8869 filing and the conversion certificate become closing deliverables, so the buyer does not close on a promise.

3. The no-revocation sentence protects the S status of Newco through closing.

A separate tax indemnity usually covers pre-closing taxes of the company, including any tax resulting from the invalidity of the S election for periods before closing. Because the buyer is acquiring a disregarded LLC that carries the target's historic liabilities, an invalid S election can leave corporate-level tax exposure inside the entity the buyer bought. Buyers often ask that this indemnity survive until 60 days after the applicable statute of limitations and sit outside the general cap and basket. Sellers push back on the survival period and on representations and warranties insurance coverage carve-outs for known S election issues. Where it lands depends heavily on diligence: a clean election history supports market terms, while a known gap, such as a missing shareholder consent, usually leads to a special indemnity or escrow sized to the exposure.

A step-by-step process I use with the CPA

1. Diligence the S election, shareholders, capitalization, and second-class-of-stock risk, and get the CPA's written view.

2. Confirm that an F reorganization is the right path compared with a 338(h)(10) or 336(e) election, including rollover and buyer form.

3. Form Newco, issue equity only to eligible shareholders in a single class, and obtain Newco's EIN. Do not reuse Target's EIN.

4. Shareholders contribute all Target stock to Newco in exchange for all Newco equity, documented as part of a plan of reorganization under Section 368(a)(1)(F).

5. File Form 8869 effective immediately after the contribution, check the Rev. Rul. 2008-18 box, and keep proof of filing. Do not file a new Form 2553 for Newco unless counsel and the CPA conclude the ruling does not apply.

6. Only after the QSub election is in place, convert Target to an LLC under the applicable state statute, typically on a later date.

7. Inventory contracts, leases, loans, permits, insurance, and payroll accounts for consent, notice, and EIN mapping.

8. Model state tax, then close the purchase of the disregarded LLC or its assets, with allocation and rollover documents that match the tax plan.

9. Calendar post-closing filings and any employment-tax setup that still uses Target's historic EIN.

How I can help

I advise on the corporate, contract, and transaction documents that have to match the tax plan, and I work with the CPA rather than replacing that relationship.

Want to run your scenario by me? info@robertsandwillie.com or (469) 910-4017. Sending a message does not create an attorney-client relationship.

Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.