M&A Monday: The Almighty F-Reorg

In an equity purchase, you must consider the F-Reorg

This M&A Monday is co-drafted and posted with Josh, Partner and Chair of Transactional Tax Group at Albrecht Law because he is the tax genius and expert on F-Reorgs and all things-tax.

Josh told me something yesterday that blew my mind. More and more of our clients are opting to acquire the equity of a target rather than acquiring the assets of a target.

For smaller buyers, this is driven by the SBA 7(a) loan now allowing a buyer to buy less than all of the equity of a seller (Rollover explainer here: HERE). For our independent sponsors and small PE buyers, the benefits of an equity acquisition, include (i) ease of transition, (ii) not having to assign contracts, (iii) retaining licenses, and (iv) not losing preferential pricing. (Deep dive into acquisition structures: HERE)

There are two major downsides: (i) inheriting historical target liabilities, and (2) no "step-up" on the basis of the target (the buyer steps into the seller's depreciation schedule and does not get to depreciate the full purchase price).

For the “step-up” problem, there are tax structuring opportunities that can treat the acquisition of equity in a substantially similar way as an asset purchase.

The best way for a buyer is the F Reorganization (“F-Reorg”). Alternatively, a Section 338(h)(10) or Section 336(e) election can be made (Josh will tell us when the facts and circumstances of each deal makes this election proper). Both of these tax elections and the F-Reorg allow the buyer to purchase equity, but achieve the coveted step-up in tax basis in the target’s assets.

Here is where my mind was blown. I always knew the risk of choosing an Election (not doing an F-reorg) and buying an S-corp is that somewhere along the road the target tripped up the S-corp requirements and the IRS could impute C-corp taxes from the moment the target busted the S-corp. However, Josh informed me that there is also a risk that if a buyer does an election relying on the target being an S-corp and the IRS retroactively says the S-corp was busted (thus, the target was a C-corp), the buyer may not be entitled to the Step-Up either. The risk of not doing an F-reorg is not just past C-corp taxes (bad), but also significantly lower depreciation (even worse). This would be detrimental to a buyer. This greatly tips the scale in favor on an F-reorg in almost all deals where we are acquiring the equity of an S-corp.

I do not need to describe the exact steps of an F-Reorg in this post. I often say, Josh does some magic and suddenly we have a deemed asset purchase, but the EIN remains the same.

The main challenge is the F-Reorg creates more cost and complication for a seller. Often, they ask a buyer to pay for it. The cost tends to be between $10k-$20k, depending on the seller’s tax advisor and there is some incremental cost to the buyer to review the seller’s documentation.

The second challenge is an asset sale (for tax purposes) often has a negative impact on a seller (especially if the seller has taken accelerated depreciation). The seller will then ask the buyer to pay, as an addition to the purchase price, a “gross up” – the difference between the seller’s taxes in a stock purchase vs. an asset purchase. A buyer can head this off by including language in the LOI that the transaction will be treated as a “deemed asset purchase”.

In the middle market, F-Reorgs are exceedingly common. But, in SBA-land, some lenders have a hard time getting them right. They misunderstand the seller entity and it causes challenges. Second, it is critical to complete the F-Reorg at least ten days prior to closing because the bank will not proceed to its closing process until the F-Reorg is complete.

As a buyer, if you are doing an equity purchase, you should strongly consider an F-Reorg. As always, please feel free to reach out to me or Josh if you would like to discuss your transaction.