Tax - F Reorganization - Deferring Tax Obligations of Target Company's Equity Holders

Under F reorganization (IRC 368(a)(1)(F)), the equity holders of Target first transfer all of their equity interest to a newly formed corporation, Newco. This first step can be accomplished either by a direct transfer in exchange for Newco Stock, or by Newco setting up a new subsidiary that merges with and into Target, with Target equity holders receiving Newco stock in the merger.

Next, Target converts into a Target LLC wholly owned by Newco. These two steps constitute the so-called F reorganization. For tax purposes, after these two steps, Newco is considered to be a continuation of the same corporation as Target, and the assets owned by the Target LLC are treated as being owned by Newco.

Then, Newco sells all of the Target LLC (think of this like an asset holding vehicle) ownership interests to Buyer. Newco's sale of the Target LLC ownership interests to Buyer is treated as a sale of the assets of the Target LLC to Buyer (step up basis for Buyer).

Advantages of this F reorganization includes:

• No physical transfer of assets to Buyer
• No deemed liquidation of Target unlike in other instances where a physical transfer of assets are avoided; that is, Newco may stay alive with the cash proceeds of the sale of the Target LLC ownership interests, thus avoiding tax on the proceeds of the sale from the seller equity holders' perspective
• Newco is able to retain those assets not sold to Buyer without any tax on such assets because during the period in which Target is an LLC wholly owned by Newco, Target LLC is treated as part of Newco and therefore can distribute assets to Newco without tax consequences. Newco then can sell the interests in Target LLC and is treated as selling the assets held by Target LLC.

Ex. Sole member (Seller) of an IA LLC (S corp) plans to sell all of his membership interests therein to Buyer. Seller sets up a DE corp (S corp) as the Newco to retain the sale proceeds therein (not a liquidation, no taxable event). Since S corp IA LLC (Opco) may not have a corporate member-owner, Seller converts IA LLC to IA corporation and Newco immediately elects to treat IA corporation as a qualified S corp (Q-sub) as defined under IRC 1361(b)(3). Seller transfer all of his shares in IA corporation (Q-sub) to Newco (1st step of F reorg). IA corporation converts to a DE LLC (2nd step of F reorg), which terminates the Q-sub election. 

If a Q-Sub election terminates, the former Q-Sub (IA corporation) is treated as a new corporation (DE LLC) acquiring all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation (to be held by the S corporation parent). (26 C.F.R. 1.1361-5 - Termination of QSub election).

Newco then sells all of its membership interests in the DE LLC to Buyer.