In Episode 23 of How Tax Works, Matt Foreman discusses the five W’s of F Reorgs: Who needs one, What they do (and don’t do), When they’re necessary, Where the foot faults lie, and Why you need to be careful when undertaking one.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, “How Tax Works” offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Welcome to the 23rd episode of How Tax Works. I’m Matt Foreman. In this episode I’ll discuss tax free reorganizations under section 368A 1F of the internal Revenue Code, or as we call them, F reorg. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices that we all make.

Matthew Foreman [00:00:44]:
Someone asked me, this is a break in here if I made those words as complex as possible as a slight joke as to how complex taxes. And the answer is not intentionally. Before we get started though, a few administrative things. At new episodes every two weeks, the next episode is going to Talk about divisive reorganizations 368A 1D and section 355. If you have any questions, comments or constructive criticism, you can email me at my FRB email address, which can be found via your favorite search engine. Upcoming speaking engagements and webinars are on the How Tax Works page on the FRB website. It occurs occurred to me that listing them some people listed a month later. So not really helpful.

Matthew Foreman [00:01:23]:
So just, you know, look on the website. It’s easier that way. All right, so now we’re talking about F re orgs. This episode is going to have its own special name which I don’t do very often for a variety of reasons, but this one is going to be called what the F is an F reorg. And I’m calling it that because I will be from time to time I’ll be on calls with client. Well, previously I’m calling clients and we’re talking about it and they’re like, oh, I have an S corp, but they’re only buying 74% and how do we do that? And what do we do? And I’m like, oh, we’ll just do an F reorg. And they always say generally a less vulgar version, but what the F is an F re. Org, right? So the first thing to understand about an F reorg is you need to have an S corporation or a C corporation.

Matthew Foreman [00:02:06]:
People ask me what about a B corporation? Cool. That is not a tax thing. That is the type of entity that it is totally relevant for tax purposes. They’re a C corp or an S corp. Can’t do this with a partnership in a couple. I think the conversation after the next one. So episode 25, if my notes are, if I’m correct in my head, we’re going to talk about partnership divisions which deal with divisive reorganizations. You don’t really need to do an F re Org.

Matthew Foreman [00:02:31]:
A big reason that you need to do a f re Org is because you need an entity that you can roll over and get step up basis. So you do an f reorg because you need a partnership in there somewhere or be able to form a partnership. Right. So there are basically three situations for f reorg. Right. You’ll notice that I will intermittently go between a f reorg and an F reorg. I don’t know what’s right. Don’t worry about what I’m saying.

Matthew Foreman [00:02:55]:
Just worry about the fact you need to do that specific thing under 368A1 cap F. Okay. So the first way to do it, the first situation where every org become commonly done, is if you’re moving from one state to another. People ask me, is that really necessary? And yes, anytime a business does that, anytime a company does that, they do an f reorg. Right? So Twitter, or whatever it’s called these days that did an F reorg from Delaware to Texas for its state of incorporation. There’s a couple ways to do it. You know what happens is sometimes you form a new entity, you merge the two entities with the new entity surviving, and it can take the ein. That’s an f reorg.

Matthew Foreman [00:03:37]:
The other one is you can exchange old stock for stock in the new company, then liquidate the old company. Congratulations, that’s an f Org. And some people just actually form a new entity and then just dissolve the old one. That’s it. Right. So that you can do too. There’s revenue rulings, revenue procedures that will tell you that each one of those is a good f free org. 2 comments.

Matthew Foreman [00:03:59]:
One, each state is going to have its own separate set of rules for how to deal with this, how to deal with mergers, whether you can do a statutory conversion, state to state, things like that. So make sure to check to make sure it’s good from a non tax perspective. I know this podcast is how tax works, but it’s important to note that not everything is tax focused. You just need to make sure the form of the transaction qualifies as a good fior. That’s really, really, really important. I’ll get into why that’s important later. Right. The second one is if you change the type of entity you have, right.

Matthew Foreman [00:04:31]:
For profit to nonprofit, that’s an f re org State bank to national bank.f re.org LLC taxes a c corp to. To an inc or to a company or to a corp. That’s an F Re. Org regular, you know, Inc to a B corp. I talked about those earlier. That’s an F Re. Org. You can also do cross border F Re orgs.

Matthew Foreman [00:04:51]:
I will tell you something, and I mean this. Don’t, generally don’t do fvorks unless you’re prepared and you know what you’re doing and you have someone who’s done one before and they can walk through it or you’re very confident, very comfortable that you’re doing it right and you’ve done it before. However, if you’re doing a cross border one, I promise you, you do not want to do this unless you’ve really gone through implicates. A lot oftimes section 367 and 367 turns off all the tax free orgs under 368 under a variety of situations. So don’t do one unless you’ve really, really, really, really, really gone to do it. I am only going to talk about domestic. Only us. Us.

Matthew Foreman [00:05:38]:
That’s it. And so it’s really important that if you do cross border one, I could, I could spend a good hour talking through ways that you could mess up an every org and make everything taxable. You, you know actually let’s, let’s do this right now. Let’s do this right now. I’m going to kind of pop ahead a little bit, but people always ask me well what. Why do we need to do an F for York, right? What’s the big deal? And there’s basically the reason is because when you have a C corp or an S Corp you cannot dissolve them or liquidate them without taxable consequences. Section 311B says that any, any asset that’s distributed on which there is gain, okay. You have to recognize the gain as if you sold the asset.

Matthew Foreman [00:06:20]:
Not loss, only gain. One sided. Congress made the rules, right? And so what will happen is people say oh well you know, the assets aren’t worth that much. That’s not a big deal. What about goodwill going concern right there. Their basis is almost certainly zero. Self created intangibles tend to have a basis of zero. And so that’s we recognized realized that’s a problem and that’s what you want to avoid if you do an F rework wrong.

Matthew Foreman [00:06:44]:
Okay, what happens? Congratulations, you have recognized. You now have to recognize income. I’ll use the word suboptimal, I promise you. If you’re thinking to yourself what the F is afriorg. Suboptimal is probably a more polite way to say than what will happen. So this. This is bad. And I know what you’re thinking now.

Matthew Foreman [00:07:01]:
You’re, you’re five, six, seven, whatever. We are minutes into this podcast and you’re telling me, matt, this isn’t why we’re listening. This is not an f. Re. Org. What are you talking about? And yeah, yeah, yeah, I know exactly what you want. But I’m going to make you listen to some music first. We’re going to take first quick break.

Matthew Foreman [00:07:18]:
Okay. And when we come back, we’re going to talk about the fact that you made an S election and now it’s a problem. Be back in a moment. So. So we’re back, right? You made that selection, now it’s a problem. Now you can do an F Re. Org under this context, in a variety. I’m basically going to assume that everything is an S Corp.

Matthew Foreman [00:07:46]:
And the reason I’m assuming that everything is an S corp is because it’s actually a lot easier if a C corp is involved. The trick of this, of the whole thing, the whole idea behind that free Orgs is because you want to keep it an S Corp or a disregarded end. You want that pass through treatment, but you don’t want to actually have a problem where it goes to becoming C Corp. So let’s think about this, right? There’s basically two functions, right? I’m not going to draw this out. We’ve all seen it. If you don’t know what an F. Re. Org looks like, if you Google it, I promise you, you’ll find something that’s two thirds right? Okay.

Matthew Foreman [00:08:20]:
So I’m not going to give you the visual, but I’ll try to paint it with. With my beautiful, beautiful words. All right, so you start off with an S Corp, Okay. The idea is that the ending structure is that there is an S Corp that owns an LLC that’s taxed as a disregarded entity. This is actually more than the S Corp. The f. Re. Org really is.

Matthew Foreman [00:08:39]:
I’ll get to that in a second. So what you do is you form a new. You have. You have what I’m going to call opco, which is an S Corp, and you form a new company. We’ll call it holdco. All right. I’m super creative, but if you’ve ever seen the decks that go through every orgs, this is pretty much what they’re all called until they create names. So you have the S Corp, you have a Holdco.

Matthew Foreman [00:08:59]:
A lot of Times the Holdco, they actually format it. Delaware. It just creates a neutrality. You don’t have to register in a state, it’s not really doing business past the point, etc. Etc. So you form it. What you do is you contribute the S corp to the, to the, the OPCO to the hold code section 351 tax free. You exchange the stock.

Matthew Foreman [00:09:18]:
Congratulations. Right, that’s it. You finish the f. Re. Org mostly. Okay, now that contribution is done under again as I said taxpayer section 351. Technically you don’t need to make an S election for Holdco. I will tell you that.

Matthew Foreman [00:09:35]:
I largely do as a belt suspenders kind of move. And then the whole, the subco, the subsidiary, the opco, you make a Q sub election tax. Technically a Q sub does not make a Q sub election, the Holdco does. So you make that. I will talk about some timing things in a moment, but I think that’s really important. The next step is you need to get that S corp, that Q sub to become an LLC. Why? Because you really can’t sell 75% of, of an S corp. Most of the buyers are not going to be individuals.

Matthew Foreman [00:10:09]:
And plus if you, if you have a Q sub, it must be wholly owned by another S corp. So all you’re going to get is a C corp underneath. Not really helpful. So depending upon the state, right. You either form a new llc, new opco and you merge it with the historic opco. The new co takes the ein. Great. And then at the end of it you have a Holdco which is an S corp owning a disregarded entity.

Matthew Foreman [00:10:34]:
Option two is a statutory conversion. A lot of states allow that. Delaware, top of my head. I think Georgia does too. Most states do. New York, New Jersey, don’t. I know that. In particular, I’m licensed to practice law in both of those states.

Matthew Foreman [00:10:49]:
So I’m quite familiar with the quirks in this regard. Right. So we have the. You have a statutory conversion. There is a third option. If you have an LLC taxed as an S corp, you can at that moment then check the box, file a third election, make that entity into disregarded entity. I always have wondered, well, isn’t that a third election? And the answer is technically not. You have the initial election, assuming the first election is more than five years go.

Matthew Foreman [00:11:17]:
I’ll get into that in a little bit. The five years is pretty important, but I’m going to get into that later. And what happens is you have the S corp election, the S election at the top, and then the, the Q sub Election is made by the S Corp. So some people say. I don’t know if it’s true. Oh, you can just check this, you can just check the box disregard and you’re fine. IRS seems okay with it. Seen it a lot happens a lot.

Matthew Foreman [00:11:39]:
IRS doesn’t really question. That’s great, that’s fine. So I think we’re okay there. So you have it. If you want to go belt suspenders, I would still consider merging and then the resulting entity, you know, file a disregarded entity as an initial election. I don’t know if it matters, but some people want to do it. I do. It depends on, you know, the client’s risk tolerance, the purchaser’s risk tolerance, et cetera, et cetera.

Matthew Foreman [00:12:03]:
The order of elections is really, really important. Right. The initial selection for the holdco that, that has to be done first. I. You then can do a Q sub election, you know, post contribution. Great. You can do both of those on the same day. If you’re going to do another election elect to be taxes disregarded entity or the merger with the new llc, I like to wait a day or two.

Matthew Foreman [00:12:26]:
People think that’s a little much. It’s not necessary. Probably. Right. But I think it’s really important to know that on some level there is some concern if that’s the right word for, you know, if you’re doing it right. Belt and suspenders. And I tell everyone to send in every single election separately and people say why? And the answer is because. Let’s say you get an envelope and you work really for anyone.

Matthew Foreman [00:12:54]:
I do. Us too. Right. You take all the documents out, you kind of look at them. Oh boy. What order do I put them in? Well, they’re all the same. They all just feed them through the machine. Right.

Matthew Foreman [00:13:02]:
Let AI figure it out. It doesn’t. However, the IRS absolutely reviews its mail in chronological order. So if you send one in on day one, send one in on day two and one on day four, congratulations. They will be done in correct order. And that’s belt that suspenders. That’s. That’s rope around it, a little bit of glue.

Matthew Foreman [00:13:24]:
It’s a little much, but it’s important to do right. So people always ask. All right, well, this isn’t that hard, Matt F reorg’s are not that challenging. How can I, how can I mess this up? Wrong order. You miss an election, you don’t fill something outright. You do the wrong effective date. Five years. Okay, so the five year one is a really interesting one in S Corps.

Matthew Foreman [00:13:43]:
Right. So. Or already election so you are not allowed to make a second election within five years of the first election unless the first election is at formation. I have seen people form entities on December 27, then make an election as of January 1. Congratulations. That’s not an. That’s not an immediate election. Some people say it is.

Matthew Foreman [00:14:03]:
I don’t think it is. So if you’ve already made one, you can’t make a second one within five years. So you have issues. Right? And that’s something you want to watch out for. And I want to talk about eins for a second. If you go to the IRS website or you read the irm, it’ll talk about when you need a new ein. First off, I’m of the opinion that Congress needs to make EINs more portable than they are. I think they need to make it so it’s obvious when you’re doing certain things, you don’t do it.

Matthew Foreman [00:14:31]:
EIN rules are outdated, outmoded, and unnecessary. I think that it needs to be simplified and something that Congress can do. They don’t. I don’t know why tax lawyers do quite well because of, say, incoherent at times and inconsistent. Einstein. They just. The way they read is as if they have not been updated since they were, you know, since LLC became a thing. Because they talk about sole proprietorships and partnerships, and then they talk about llc.

Matthew Foreman [00:15:00]:
And if you’ve heard me talk about LLC before, losses are neither or both. Right? Or one. So you need to really, really update that. I think that’s problematic, and it creates a lot of issues for people don’t know what to do. And I think if the IRS were to come out with a revenue procedure that walked through how to do this when you need it, different situations, I think that would be one of the most welcome revenue procedures in a long time, because I think it would make things a lot simpler. I’m also of the opinion that they should have one form total to make elections, not three. And I think they should have one form where you could do an entire f reorg on one form. I think that would make it a lot easier, both for practitioners, also for clients.

Matthew Foreman [00:15:43]:
Make them happier, and it’d be easier for the irs. Right? Think about things like that. If we’re gonna, you know, make changes in the name of efficiency, this is an efficiency that would help. And people say, you know that. So that’s. I think that’s helpful. That would be helpful if they were to do it. But people always say, matt, there’s more to the f rework.

Matthew Foreman [00:16:00]:
What are you Talking about there’s that next step and there is, there is a next step, but I’m gonna make you again listen to some music. So I’ll be back in a moment. Foreign. So let’s talk about the rest, right? I’m going to put in quotation marks, right? The rest of the F reorg, really the rest of the F reorg is revenue ruling 99.6 or 99.5 or both or one of the others. And it depends on the order. So that, that’s pretty important, right? So a Q sub is technically a disregarded entity. One of the important things about F reorgs that really I think people don’t think about and you know, how they function is that what happens is the OPCO just disregards. It gets ignored.

Matthew Foreman [00:16:51]:
One of the things that’s really nice is a revenue procedure. And I’m not going to tell you what the revenue procedure is because I don’t remember. Off top of my head, I can say 2008, 18, but I actually don’t think that’s right. And what it says is that even though the, the Holdco, right, in our, in my example only existed, you know, mid year as of August or whenever it’s formed, you actually file a return as if it existed the whole year and owned the entire business the whole year. So that actually really simplifies things, that cuts out one return. So since the Q sub is just a disregarded entity and well, so is a single member LLC that’s, you know, either no election or has elected to be taxed as a disregarded entity. So the premise is, is that you can go from the Q sub to the disregarded entity without tax, right? Because you still have the S Corp at the top. Which is the idea, which is how it works.

Matthew Foreman [00:17:42]:
IRS has confirmed it works great, right? So there’s basically two orders at this point, right. Everyone’s always saying, Matt, this is where it really hits the rubber, hits the road. You know, they’re buying 85%, my client’s holding on to 15. How do I do that? And there’s two different orders, okay? Some of them they buy first and then there’s a contribution. And so you have the Opco, which is an LLC, it’s bought by another LLC, 85% of it. And then the, the S Corp, which is the owner, you know, historic owner of that, of the, of the opco, contributes the rest. The other one’s the opposite, right? The Holdco, the s Corp contributes 15% of the OPCO and then sells the rest. And People say well does it actually matter what the order purchase versus contribution or contribution versus purchase and the answer is yes.

Matthew Foreman [00:18:38]:
No. Maybe. Okay, you sort of have to think this through. If you were to contribute and then buy an entity that you own, right? Some percentage of whatever it is is now buying another entity, does that get a step up in basis? 754 says yes. And because you own part of the buying entity, shouldn’t you share in that step up in basis? Some people say yes, some people say no. I say let’s talk. Depends what sign I’m on. The converse the purchase versus purchase and then the contribution.

Matthew Foreman [00:19:13]:
Then there’s a. There’s no need to make a 754election because when you purchase, okay, when you, when you purchase it 995 you are purchasing the assets themselves and you therefore get a step up in basis. When the llc the OPCO regards into a partnership and then the contribution then it redis regards but the top coat then regards. So it’s a matter of allocating where the basis is. Who has basis, who gets a depreciation, right? Any. Anyone who’s ever been in a purchase like this that has the f re org that has this whole thing that basis is really important. The people who are buying it, they really want that depreciation because they’re like I bought it, I want to get that depreciation. I want to get a great return on investment.

Matthew Foreman [00:19:59]:
And being able to deduct it really helps. So it’s really important to think through what is the structure, what is it? There are other ways to do this. I have seen it where if it’s a C corp that’s involved the purchaser, there’s a partnership sitting on top. The C corp buys it the partnership, you contribute into the partnership at the top and then the partnership pushes it down under 351. I’ve seen people, if you’re dealing with the anti churning rules, take that partnership and just push it out. So before you actually have the purchase or contribution they take the S Corp. They intentionally trigger 311B tactful transaction so that the lower tier entity is now a partnership to get around anti churning rules that have existed at a time before intangible all had 15 year useful life. So there’s, there’s flavors, there’s a lot of wiggles within this.

Matthew Foreman [00:20:52]:
People do this, people want to do that, etc. I think that’s really important to think about and make sure you’re getting this right and make sure it’s tax free. This is an area where the buyer and the seller are going to be extremely collaborative. So that’s really important. Make sure you talk to it. Then you know there’s another, another reason to do it. Right. My favorite is, is do an f re Org so that there’s an LLC below and then grant profits interests in the entities.

Matthew Foreman [00:21:19]:
Profits interest I talked about in episode seven of How Tax Works. And there’s also an article in Tax Advisor I co authored with Michelle Cable, an associate at frb where I talk about profits interests. And that’s the idea, right? It allows you to grant equity on a tax efficient basis to employees of the company. And I think that’s another really important, really good option for doing an f reorg. So you don’t actually use it to sell, you use it to grant equity. I always ask at that point, why do you. Why did you make the S election if this was an option? It’s the number one reason I suggest to people that they don’t make the selection is granting equity to employees. Another big one is if you’re going to have investors, they really can’t use S corpse.

Matthew Foreman [00:22:02]:
But that’s neither here nor there. So let’s, let’s wrap this bad boy up right? Easy. Everyone’s right. Easy to mess up. You still have an S corp at the top. The Holdco remains an S Corp. So you didn’t totally get out of the S Corp, but you can kind of get out of it. Especially if you do a profits interest or a freeze partnership can help do it.

Matthew Foreman [00:22:20]:
All right. Next time. Next time. Next time it will be the 24th episode you hope you enjoyed this one. This was 23 and we’re going to talk about divisive reorganizations. And now, now, now for the best song of.