The acquisition of American corporations continues to increase. S corporations. S corporations is a popular entity structure choice for closely held and operating businesses and, more importantly, are often the targets in acquisition transactions.
Eligibility to make a S election is limited to a “small business corporation,” defined in Section 1361(b) of the Internal Revenue Code as a domestic corporation which is not an “ineligible corporation” and which has (1) no more than 100 shareholders; (2) only shareholders who are individuals, estates, and certain types of trusts and tax-exempt organizations; (3) no nonresident alien shareholders; and (4) not more than one class of stock. The 100-shareholder limit disqualifies publicly traded corporations from S status, and the one-class-of-stock rule shuts the door to corporations with complex capital structures. But there is no requirement that a S corporation must be small when measured by income or value as a going concern, and some very large enterprises operate as S corporations. When a small business corporation chooses to become an S corporation for federal income tax purposes, it must file an election with the Internal Revenue Service (“IRS”) using Form 2553, Election by a Small Business Corporation.
An Overview of Type F ReorganizationsThere are many ways to acquire an S corporation. This article will discuss the acquisition of corporations through a Type F reorganization under Internal Revenue Code Section 368(a)(1)(F) with a focus on S corporations. Section 368 defines a set of tax-free reorganizations that serve as exceptions to the general rule that gain or loss must be recognized upon the sale or exchange of property. This includes a “mere change in identity, form, or place of organization of one corporation, however effected.” (“Type F reorganization”).
The rules applicable to corporate reorganizations as well as other provisions recognize the unique characteristics of reorganizations qualifying under Section 368(a)(1)(F). In contrast to other types of reorganizations, which can involve two or more operating corporations, a reorganization of a corporation under Section 368(a)(1)(F) is treated for most purposes of the Internal Revenue Code as if there had been no change in the corporation and, thus, as if the reorganized corporation is the same entity as the corporation that was in existence prior to the reorganization. See IRC Section 381(b); Treas. Reg. Section 1.381(b)-1(a)(2).
In Rev. Rul. 69-516, 1969-2 C.B. 56, the IRS treated as two separate transactions a reorganization under Section 368(a)(1)(F) and a reorganization under Section 368(a)(1)(C) undertaken as part of the same plan. Specifically, a corporation changed its place of organization by merging into a corporation formed under the laws of another state and immediately thereafter, it transferred substantially all of its assets in exchange for stock of an unrelated corporation. The ruling holds that the change in place of organization qualifies as a reorganization under Section 368(a)(1)(F).
Treasury Regulation 1.368-2(m) sets forth six requirements for a reorganization to qualify as a Type F reorganization. A potential Type F reorganization must satisfy the following six requirements:
1. Immediately after the Type F reorganization, all of the resulting corporation must have been distributed (or deemed to have been distributed) in exchange for stock of the transferor corporation. The regulations will disregard a de minimis amount of resulting Corporation shareholders, if necessary to facilitate the organization of the resulting Corporation. The regulations do not expressly define “de minimis” but an example in the regulations suggests that the issuance of 1% of the shares of the resulting corporation to another shareholder would be acceptable.
2. The same person or persons must own all of the stock of the transferor corporation and the resulting corporation at the beginning and end of the potential Type F reorganization, in identical proportions. Exchanges of stock in the transferor corporation for stock in the resulting corporation with equivalent value, but different terms, will not disqualify the Type F reorganization.
3. The resulting corporation cannot hold property or possess any tax attributes immediately before the Type F reorganization. There is an exception to this rule that allows 1) a de minimis amount of assets to facilitate its reorganization and maintain its legal existence; 2) tax attributes related to holding those assets, and 3) holding the proceeds of borrowing in connection with the reorganization. Based on this rule, when performing an F reorganization, businesses should create a new entity to ensure that there is no history of unwanted assets or tax attributes.
4. As part of the Type F reorganization, the transferor corporation must completely liquidate for federal income tax purposes (but not necessarily for state law purposes). This can be one of the attractive features of an F reorganization because the assets can continue to be held by the transferor corporation (with no transfer of title).
5. Immediately after the Type F reorganization, no corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the Type F reorganization, if such corporation would succeed to tax attributes of the transferor corporation that are listed in Internal Revenue Code Section 381(c).
6. Immediately after the Type F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would succeed to the tax attributes of the other corporation that are listed in Section 381(c) of the4 Internal Revenue Code.
The fifth and sixth requirements were added to eliminate uncertainty when a Type F reorganization overlapped with other nonrecognition provisions.
Type F Reorganization Transactions and the Defining the Concept of the “Bubble”The step transaction doctrine is a judicial doctrine that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. The doctrine is often used in combination with other doctrines, such as substance over form. The doctrine is often applied to prevent tax abuse.
Traditionally, the IRS has not applied the step transaction doctrine to disqualify a transaction from Type F reorganizations that involve a combination with another company or the issuance of shares to new shareholders. See Rev. Rul. 96-29, 1996-1 C.B. Thus, the regulations provide that the step transaction doctrine will only apply to Type F reorganizations in a very specific way; the “bubble” is in fact well protected. This means related events that preclude or follow a potential Type F reorganization will not cause a reorganization to fail to qualify as a Type F reorganization. See Treas. Reg. Section 1.368-2(m)(3)(ii). Example 13 in the regulations discuss a Type F reorganization in a “bubble” concept and how the step transaction doctrine may apply to disqualify a Type F reorganization.
In Example 13, X owns all of the stock of T, and P acquires all the stock in exchange for $50 cash and P voting stock worth $50. Immediately thereafter and as part of the same plan, P forms S as a wholly-owned subsidiary and T is merged into S. Although the merger of T into S would appear to qualify as a Type F reorganization in a “bubble,” the step transaction doctrine applies in Example 13 to treat the transaction as a statutory merger of T into S in exchange for cash and P’s voting stock and P’s momentary ownership of T stock is disregarded. Example 13 further states that since the transaction as recast it qualifies as an asset reorganization of a type that trumps Type F reorganization treatment under the overlap rule and as a result, the transaction does not qualify as a Type F reorganization.
A Type F Reorganization Transaction Structure
The structure of an F Reorganization can take many shapes. A list of examples is set out in Treasury Regulation Section 1.368-2(m)(4). Many of these structures involve mergers among related entities and/or the reincorporation of a business in a new state.
Example 6 of the Regulations illustrates this in a merger among related entities and the reincorporation of a business in a new state. In Example 6, P owns all of the stock of S1, a State A corporation, and wants to change S1’s place of incorporation to State B by merging S1 into a newly-created State B corporation, S2. Immediately after the merger, P sells all of its stock in S2 to an unrelated party. The Regulations provide that the subsequent sale is disregarded whether the merger of S1 into S2 qualifies as a Type F reorganization.
One way of completing an F reorganization is through the creation of a new corporation, which initially becomes the parent holding company of a new entity that will operate the existing business. The parent holding company then sells part or all of its interest in the new entity. PLR 201611015 demonstrates the structuring of such a Type F reorganization.
The ruling describes a transaction in which (1) Oldco forms Holdco A, (2) Holdco A forms Merger Sub, (3) Merger Sub merges into Oldco, with Oldco surviving, (4) Oldco shareholders receive Holdco A stock, (5) Oldco converts into a limited liability company (“LLC”) treated as a disregarded entity, (6) LLC distributes stock of a subsidiary to Holdco A, (7) Holdco A forms Holdco B and contributes all its interests in LLC to Holdco B, and (8) Holdco A forms Holdco B and contributes all its interests in LLC to Holdco B, and (9) LLC re-converts into a state law corporation. Oldco is reincorporated and is, at the end of the transaction, a corporation for U.S. federal income tax purposes. The IRS concluded that the reincorporation did not preclude the potential Type F reorganization from qualifying as such.
EIN Number Considerations
In Revenue Ruling 73-526, the IRS stated that the resulting corporation of an F reorganization should generally use the employer identification number (“EIN”) of the transferor corporation, and in circ*mstances in which the transferor corporation. A more complex fact pattern may arise where the transferor corporation remains in legal existence as a disregarded entity of the resulting corporation and continues to engage in transactions where an EIN may be required. For example, Revenue Ruling 200-18 addressed a Type F reorganization of a S corporation where the transferor corporation became a qualified subchapter S subsidiary (“QSub”) of the resulting corporation. The IRS held that the resulting corporation needed to obtain a new EIN and that the QSub would continue to use its historic EIN for employment and excise tax purposes.Revenue Ruling 2008-18 is based on Treasury Regulation Section 301.6109-1(h) and (i), which provides that an entity that becomes disregarded from its owner or elects to be treated as a QSub is generally required to use its parent’s EIN for all tax purposes, except as otherwise provided. However, these entities appear to “retain” their old EIN and may be required to use its own EIN even though the entity is otherwise disregarded.
The Type F Reorganization and the Tax Planning for Buyers of S Corporations
Now that we have discussed the mechanics of a Type F reorganization, we will need to discuss why to use a Type F reorganization in the acquisition of an S corporation. When a buyer of a S corporation would like to maximize the depreciation and amortization deductions available to it post acquisition, a Type F reorganization may be an effective tool. In addition, restructuring an S corporation through a Type F reorganization can facilitate the buyer’s ability to obtain a step-up basis in the S corporation’s assets.
Even though sellers of S corporations do not have to worry about two layers of tax, a buyer typically prefers to dispose of their businesses as a whole and pay capital gains on the sale of the stock. From the buyer’s perspective, purchasing stock can have several important advantages. It avoids complications involved with transferring trade names, contracts, licenses, and permits and allows for continuation of the seller’s EIN.
The principal problem buyers face in stock sale is the inability to obtain a fair market value tax basis for the assets inside the corporation for depreciation purposes. One solution is for the buyer to make a Section 338(h)(10) election. This allows a buyer of stock in an S corporation to treat the transaction as an acquisition of 100% of the assets of the seller for tax purposes. A Section 336(e) election is similar to a Section 336(h)(10) election. However, to make a Section 338(h)(1) election, the buyer must be a corporation. Therefore, individuals, partnerships, and other non-corporate entities that otherwise cannot benefit from a Section 338(h)(1) election may be able to qualify for a Section 336(e) election, but there are important limitations with respect to these elections.
In a 338(h)(10) election, the buyer must acquire at least 80% of the total combined voting power of all classes of the seller’s stock entitled to vote and at least 80% of the total value of the stock. A similar requirement must be satisfied for a Section 336(e) election. Another concern for the buyer is the validity of the seller’s S corporation election. To make a Section 338(h)(10) election, the seller must be a corporation that is a subsidiary in a consolidated group, a corporation that is a subsidiary eligible to file a consolidated return but chooses not to, or an S corporation. To make a Section 336(e) election, the seller must be a domestic corporation that makes a “qualified stock disposition” of stock of another corporation. If a transaction qualifies under both code sections, the Section 338(h)(1)) takes place. Thus, if Section 338(h)(10) is controlling but the seller’s S corporation status has knowingly or unknowingly terminated, the Section 338(h)(10) election will be effective and the buyer will be ineffective and the buyer will not obtain a fair market value basis in the seller’s assets.
Both Section 338 and Section 336 elections have limitations that do not exist under a Type F reorganization. Thus, a Type F reorganization can become a critical part of effectively structuring a transaction because it permits the buyer to obtain a step-up in tax basis.
The steps of a Type F reorganization of a S corporation are discussed in Situation 1 of Rev. Rul. 2008-18. According to Situation 1 of Rev. Rul. 200-18, a Type F plan involving the reorganization of an S corporation should include the following:
1. The creation of a new corporation on day one. Under this first prong, the buyer should be treated as an S corporation as a result of the S corporation election continuity rules of Rev. Rul. 64-250.
2. There is a contribution of stock in the historic company owned by the seller to the new company on day two.
3. A Qualified Subchapter S Subsidiary (“QSub”) election is made on behalf of the seller by filing Form 8869 on day two.
4. The seller is converted to an LLC on day three.
5. There is a sale of the LLC to the buyer on day four.
While this transaction looks simple, there is a potential trap in step. The trap arises from the general rules governing a QSub election. Traditionally, an S corporation can make a QSub election for its subsidiary at any time during the year, with the effective date being no earlier than two months and 15 days before the date of filing and no later than 12 months after the date of filing. However, at the time the election is made, the subsidiary must be a corporation. Some may argue that the guidance provided in Rev. Rul. 2008-18 because the QSub election is not made on the same day as the LLC conversion. As a result, there exists some controversy over whether a QSub election should be necessary in the first place.
ConclusionA Type F reorganization represents an opportunity to simplify the sale of an S corporation for income tax purposes. For buyers, a Type F reorganization offers an opportunity to obtain a step-up basis in the corporation’s assets.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
