S-Corporation owners who want to sell their business should first look into whether an F Reorganization makes good tax and business sense for them.
In today’s post, I’ll lay out the basics of F Reorganizations and explain how the process applies to taxes.
What is an F Reorganization?
An F Reorganization is typically a tax-free way for an S-Corporation to change the “identity, form, or place of organization” of their corporation without going through a lengthy consent (paperwork) process.
Why would a company undergo an F Reorganization?
S-Corporations often choose to go through an F Reorganization prior to selling–sometimes many years prior–because it can make their business more attractive to buyers.
Aside from buying and selling, F Reorganizations can also be used to change certain characteristics of a company such as the company’s name or organizational structure. Additionally, an F Reorganization can allow a company to reincorporate in a different state.
What are the steps for an F Reorganization?
Step 1: The S-Corporation forms a new company that becomes the “home” for both their new and original company. To make the process easier to follow, I’ll refer to the original company in this example as Company A and I’ll refer to the new company as Company B. Keep in mind that Company B must elect to be taxed as an S-Corporation. You can think of this step as building a brand new home for the business.
Step 2: Company A transfers all of its assets, liabilities, and shares to Company B. If the S-Corporation has more than one owner, the ownership percentages in Company B are typically the same as they are in Company A. This step is like moving all of Company A’s stuff into the new home.
Step 3: At this stage, Company A becomes an S-Corporation subsidiary of Company B by filing a Form 8869 to make a qualified subchapter S subsidiary election. Basically, this step means that both companies are now living under the same roof.
Step 4: If Company A was a corporation at the state level, then Company A completes the necessary steps in that state to become an LLC rather than a corporation.
Step 5: Company A waits at least one day after completing step 4 (if applicable) and then files Form 8832 to be treated as a disregarded entity. Company A is now officially a subsidiary of Company B.
Step 6: The owners of Company A own Company B, which is taxed as an S-Corporation, just like their original business. Additionally, Company A is a subsidiary of Company B. If another company purchases Company B, the purchase money will flow through to the owners.
What are the advantages and disadvantages for the seller when undergoing an F Reorganization?
The biggest advantages and reasons why a seller would want to undergo an F Reorganization are that the legal consent process (lots of paperwork) is avoided and that they can avoid transfer taxes that are typically applied to the sale of a business.
One disadvantage to the seller in this situation is that there may be increased costs to hire the needed professionals to complete the F Reorganization. It’s also a fairly complex process that takes expertise.
What are the advantages and disadvantages for the buyer of a company that’s undergone an F Reorganization?
As is the case with the seller, one of the biggest benefits for the buyer in this situation is that the legal consent process is avoided.
Additionally, the buyer is able to acquire the business at a stepped-up basis, which means that the business has an increase in value when it goes through the F Reorganization. This stepped-up basis is what generally leads to the buyer paying less in taxes after the purchase since there is an increase in depreciation on the assets.
Another advantage is that buyers who want to maintain the company’s name, history, credit or other desirable characteristics are able to do so if the company has undergone an F Reorganization.
As for disadvantages, buyers may have concerns about how long it will take the IRS to complete the necessary paperwork after the sale is complete. And it is possible that the risks of purchasing a company that’s gone through this type of reorganization are higher than purchasing a company through a typical business sale transaction.
The big takeaway and biggest reason to go through an F Reorganizations is that if done correctly, the reorganization should make your company more marketable by helping you and the seller avoid a big tax bill. However, it’s important to contact a Certified Public Accountant who is knowledgeable in the process so they can make sure each step is completed successfully.