F Reorganizations in M&A: What S-Corps Need to Know About this Winning Tax Strategy

S corporations involved in mergers, acquisitions, or other significant business transactions often face complex tax and structural considerations. One planning approach commonly used in these situations is an F reorganization, which allows a business to change its legal structure without triggering unintended tax consequences or disrupting ongoing operations.

F reorganizations can support a range of strategic objectives, including simplifying transaction structures, facilitating business sales, and accommodating changes in tax domicile. Understanding what an F reorganization is, how it works, the requirements involved, and the potential benefits can help businesses evaluate whether this approach aligns with their broader transaction planning strategy.

What is an F reorganization?

A business restructuring qualifies as an F reorganization when there has been “a mere change in identity, form, or place of organization.” If the transaction qualifies, the IRS treats the newly formed entity as the same taxpayer that existed before the restructuring — even though its legal form or structure changed.

But… how is it a mere change in identify if an entirely new entity is created?

Even though the legal paperwork changes, nothing meaningful about the business changes — at least to the IRS. The same shareholders own the company before and after the restructuring; the assets transfer from the old entity to the new one; and the operations continue as they had before. The business simply picks up and moves into a new wrapper.

How do F reorganizations work?

Here’s the simplest way an existing S corporation can restructure under the F reorganization rules. Let’s assume the owners of Business A (an S corp) want to form Business B (also an S corp).

1. The owners of Business A form a new holding company — Business B.
2. The owners transfer their stock in Business A to Business B in exchange for Business B’s stock.
3. The owners file a QSub election for Business A so that it is treated as a disregarded subsidiary of Business B for tax purposes.

When all is said and done, the owners hold stock in Business B, which owns Business A — now a disregarded entity for tax purposes. Before the restructuring, Business A was the filing entity, but after the restructuring, Business B becomes the filing entity. Business B will report all of Business A’s income and activities that occurred prior to the reorganization, which means that no short-period returns are required — continuity is preserved.

Why are F reorganizations so useful?

To understand the benefits of an F reorganization, let’s first consider the alternative. If an S corporation restructures their business but fails to qualify for F reorg treatment, all the following could occur:

• Gain recognition: The IRS may treat the restructuring as a taxable sale of stock, resulting in capital gain recognition for owners.
• Loss of continuity: In typical restructuring that creates a brand-new legal entity, business contracts, licenses, permits, insurance policies, and other operational agreements won’t automatically transfer to the new owners. This can be especially problematic in highly regulated or contract-driven industries like construction, healthcare, or government contractors.
• Loss of tax attributes and elections: A new entity may need to obtain a new EIN, make a new S election, and re-elect accounting methods.

As you can see, business restructurings can hurt businesses in more ways than one. If, instead, the restructuring qualifies as an F reorg, the business and its shareholders can avoid nearly all these negative tax and legal consequences.

What are the requirements of an F reorganization?

Even though F reorganizations have been commonly used for tax-free reorganizations since the 1950s[1], the IRS issued final regulations in 2015 that outline how reorganizations can qualify for this special treatment. Treasury Regulations Sec. 1.368-2(m) outlines six requirements:

1. Stock must be exchanged for stock: All stock of the new corporation must be distributed in exchange for stock of the old corporation. If other assets are distributed to the shareholders, it likely won’t qualify.
2. Same owners and ownership percentages: Shareholders’ ownership percentages must remain substantially identical in the new entity as in the original. If new investors are introduced, it likely won’t qualify.
3. The new corporation can’t have any assets: The new entity cannot have significant assets before the reorganization occurs — which is why most transactions simply create a new holding company rather than merge with an existing entity.
4. Complete tax liquidation of the old entity: The original corporation must transfer all its assets to the new corporation and fully liquidate for federal tax purposes.
5. (And 6.) Only one corporation at a time: There must be a single operating entity both before and after the restructuring. If more than one entity is formed into a single entity, or if a single entity is split into two, it likely won’t qualify.

Consider F Reorganizations for your Next M&A

F reorganizations can be a valuable tool in M&A planning and other strategic transactions, but they require careful timing and coordination to be effective. Because the tax and legal implications can vary based on ownership structure, transaction goals, and future plans, early planning is crucial. If you’re considering a sale, merger, or restructuring, contact your CRI advisor to discuss whether an F reorganization may support your objectives and how it could fit into your broader transaction strategy.