DealLawyers.com Blog

‘S-Corp’ is a popular entity classification among small business owners for good reason, but with the benefits come specific requirements and harsh penalties for noncompliance — and buyers may not want to inherit issues from prior ownership. So, this Torys alert says:

Because of the potential downsides of failing to be a “good” S-Corp, prior to closing an acquisition, it has become popular practice to reorganize the target in a pre-closing reorganization to protect the buyer from any mistakes the target’s owners may have made from a tax perspective. These acquisitions are likely familiar to the skilled dealmaker, as these transactions are growing in popularity. Just as familiar, if not more, is that when a deal like this comes across the desk and the tax folks have been looped in, the first question is usually something along the lines of, “Have the parties considered a pre‑closing F‑reorganization?” Which immediately begs the question: “What is an F‑reorganization, and why are the tax folks always asking about this?”

To which the memo answers:

A pre‑closing F‑Reorg allows buyers to effectively achieve the same result as a 338(h)(10) election while also reducing the risk to the buyer that the target’s S‑Corp status was inadvertently terminated or never effective in the first place [. . .] The purpose of an F-Reorg is to allow a corporation to reincorporate, change its name, or move its place of organization without triggering gain or loss recognition. In the end, the resulting corporation is considered the same as the original corporation, which allows it to maintain the tax attributes of the old corporation and possibly carry back NOLs or net capital losses.

It goes on to describe the roughly five steps to an F-reorganization, which, while seemingly simple, has some regulatory requirements and traps for the unwary, including the following (shortened from the memo):

– Stock of Newco can initially be issued only to existing owners of Oldco stock.
– Identity of stock ownership must remain the same.
– Newco cannot hold any property or have any tax attributes before the potential F-Reorg.
– Oldco must liquidate completely for tax purpose (but not for corporate purposes).
– Newco must be the only acquiring corporation.
– Oldco must be the only acquired corporation.
– Timing is key.

Timing, the memo says, is one of the most common mistakes. Specifically:

Newco must be formed before the acquisition—ideally at least two days prior. After Oldco transfers its equity to Newco, the QSub election for Newco should be filed no later than one day before the acquisition. If the parties also intend for the QSub to elect to be treated as an LLC, that election likewise must be completed one day prior to closing.

– Meredith Ervine