While partnership vehicles (particularly multi-member LLCs) are ordinarily the flow-through entity of choice, many businesses – especially long-standing closely-held businesses and healthcare businesses – opt for S corporations status. S corporations can present tax efficiency challenges, particularly on the exit of a business. Purchasers rarely desire to acquire an historic corporation (which may end up as a C corporation), but rather prefer to acquire assets to receive a step-up in basis for depreciation purposes. The nature of the business activity may also motivate a desire to retain the historic Employer Identification Number (“EIN”). Offering rollover equity in a tax-efficient manner to S corporation shareholders can present further challenges.
Enter the F reorganization. The U.S. federal income tax law permits tax deferred treatment for certain types of mergers or restructuring. Section 368(a)(1)(F) of the Internal Revenue Code of 1986, as amended, is one such provision which affords tax deferred treatment a mere change of identity, form, or place of organization of one corporation, however effectuated. In the context of an S corporation, the F reorganization (colloquially referred to as an “F Drop”!) can offer a planning tool. A typical F Drop involves the following steps: (1) the shareholders of an existing S corporation (which we will refer to as “Target”) contribute all their Target shares to a newly formed S corporation holding company (“NewCo”); (2) effective as of the same day as the contribution to NewCo, NewCo makes an election to treat Target as a qualified subchapter S corporation (a “QSub”); and (3) Target/QSub converts to a single member LLC via applicable state law.
What are the consequences?
First, under Rev. Rul. 2008-18, Target retains its EIN. Thus, the F Drop allows Purchaser to retain Target’s EIN (e.g., which is often important because vendor contracts or purchase orders are tied to the Target’s EIN).
Second, if properly structured, the purchaser can be treated as acquiring assets (or receive a basis step-up in its pro rata share of the Target assets) and the historic Target shareholders can receive tax-free rollover equity interests. Since Target is a single member LLC and treated as a disregarded entity for U.S. federal income tax purposes, the purchaser can either acquire a portion of the membership interests or NewCo can contribute Target to a newly-formed LLC in exchange for cash and rollover equity.
There are several different variations of F Drops in addition to the typical structure outlined above. With any F Drop, the order of the steps and the timing of elections is of paramount importance with respect to whether a tax-efficient result can be achieved. There are several traps for the unwary.