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What Is an “F” Reorganization?

Posted: October 25th, 2022

If you have considered purchasing or selling a business treated as an S corporation, you may have heard about structuring the deal as an “F” reorganization for tax purposes. But what exactly is an “F” reorganization and what are its tax consequences?

An “F” reorganization is a type of qualifying tax-free reorganization for corporations under Section 368(a)(1)(F) of the Internal Revenue Code (IRC) that changes the identity or form of a corporation. To satisfy the requirements of this nonrecognition event, a transaction must meet one of the statutory definitions of a “reorganization” while retaining the same essential ownership structure. Private equity firms often take advantage of the “F” reorganization as a means of acquiring an S corporation without engaging in a lengthy consents process while simultaneously gaining the tax benefits of a deemed asset sale.

Congress created the S corporation (small business corporation) in 1958, which provides one level of income tax, passed through to its owners at the individual level. However, S corporations are subject to several limitations, chief among them a limit on the number of shareholders (who must be natural, living persons), capped at 100. Thus, S corporations continue to be a popular tax election for closely held corporations due to their liability protection and tax benefits. Accordingly, many of the closely held businesses that private equity firms wish to acquire are S corporations.

To effectuate an “F” reorganization under the IRC, the IRS has identified the following steps and timing to comply with the proper use of the IRC’s provisions:

The owners of the original S corporation (OldCo) form another corporation (NewCo) that they will elect to be treated as an S corporation under Section 1362(a) of the IRC. While this election is not required for NewCo since OldCo’s s corporation election will remain in effect, NewCo will need to conduct such election to obtain a new employer identification number (EIN). (Diag. A)
The owners of OldCo then transfer 100% of the issued and outstanding shares in OldCo to NewCo in exchange for 100% of the issued and outstanding shares of NewCo. As a result of this contribution and exchange of shares, the owners will own 100% of the issued and outstanding shares of NewCo while NewCo itself owns 100% of the issued and outstanding shares of OldCo. (Diag. B)
Once the contribution and exchange are completed, the owners of NewCo will form a limited liability company (LLC).
NewCo will cause OldCo to make a “qualified subchapter S subsidiary” (QSub) election within the meaning of the IRC to treat OldCo as a disregarded entity for income tax purposes, without being subject to the typical constraints on an S corporation. This reorganization is then followed by the conversion of the OldCo to an LLC via state law merger or conversion, depending on the state’s applicable statutory provisions. (Diag. C)
After the companies merge or convert, the final structure prior to the sale will have the owners owning 100% of the issued and outstanding shares of NewCo, which in turn owns 100% of the equity interest in the LLC.

Due to this reorganization permitted by Section 368(a)(1)(F) of the IRC, the owners of NewCo can now sell the equity of their LLC instead of the equity of the S corporation, which would have been legally prohibited from selling its interest to another business entity. Since the LLC is treated as a division of its parent S corporation, the sale of an interest in a QSub is treated as a sale of an undivided interest in its assets for federal income tax purposes (corresponding to the amount of stock sold), which provides the buyer with a “step-up” in the basis of the acquired assets equal to the amount paid for the LLC’s equity interest, to be used for depreciation and amortization purposes. However, there are several strategies sellers can take to reduce the potential increased tax liability associated with a deemed asset sale including:

requesting a “gross-up” from the buyer in the purchase price to compensate the seller for any tax exposure they may incur as a result of not being able to instead sell the equity and be subject to capital gains tax.
offering the seller “rollover” equity in the selling company to soften the tax consequences to the seller.

While navigating the complexities of an “F” reorganization may seem daunting, working with an experienced M&A attorney will demystify the process. Please contact us for guidance or with any questions.

This article is for informational purposes only. For tax advice or guidance, please consult your accountant directly.

Malafi Quoted in Newsday Regarding the Corporate Transparency Act

Posted: October 19th, 2022

By Jamie Herzlich, Newsday

The U.S. Treasury Department has issued a final rule that would create a new database containing personal ownership information that an estimated 32 million small businesses must submit.

The rule’s intended to make it “harder for criminals, organized crime rings, and other illicit actors to hide their identities and launder their money through the financial system,” according to Treasury.

But some experts say the rule, which requires additional guidance, may be burdensome and costly to legitimate small businesses.

“The overall spirit of the rule was something we agreed with, but we also wanted to do it in a way that minimizes the burden of small businesses,” says Will Gardner, a Washington-based director of policy at the U.S. Chamber of Commerce Center for Capital Markets Competitiveness.

In January 2021, Congress passed the Corporate Transparency Act, which aimed to improve anti-money laundering enforcement in the U.S., he says. The legislation directs the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) to create a new federal database requiring certain businesses to report their beneficial owners and the company applicants of the entity, says Gardner, who provides more insight at https://tinyurl.com/yyjw4msa. See https://tinyurl.com/5y5hbmcc for beneficial owner and applicant definitions.

Christine Malafi, senior partner and chair of the corporate department at Campolo, Middleton & McCormick LLP in Ronkonkoma, agrees, noting, “a lot of small businesses do not have their corporate books in order.”

And while “the purpose of the rule is laudable, I’m not sure the people who are intent on laundering money through a front company are going to report that they are involved in the companies,” she says.

Malafi also expressed concern over the security of the information being submitted, which includes the beneficial owner’s name, birthdate, address and a unique identifying number from a document such as a passport or license.

Read full article on Newsday’s website.

The U.S. Treasury’s Call for Transparency: What Small Businesses Need to Know

Posted: October 13th, 2022

By: Christine Malafi, Esq. email

As of January 1, 2024, most U.S. businesses with fewer than 20 employees will have to register with the Financial Crimes Enforcement Network (FinCEN) of the U.S. Treasury Department.[1] Read on for what your business needs to know about this new obligation.

The Corporate Transparency Act

In 2021, the Corporate Transparency Act[2] was enacted as part of the National Defense Authorization Act in an effort to better enforce anti-money laundering laws. The law seeks to make it more difficult for business owners to hide unlawfully obtained assets, hide identities, and launder money through the financial system of the United States. The law is also intended to make corporate ownership more transparent. The law became fully effective on September 29, 2022, when the final regulations were issued.[3]

This federal law requires certain business owners to provide the federal government with specific details on the owners of the business, as well as on other persons who benefit from the business operations. A business that must report is called a “Reporting Company,” which the Act defines as a “corporation, limited liability company, or other similar entity that is created by the filing of a document with a Secretary of State or a similar office under the law of a State or Indian Tribe” (so sole proprietorships or partnerships that are not separate entities do not need to report). However, an entity formed outside the United States which registers to do business in a State is subject to the law.

Who Reports What?

Reporting (at approximately $85 per business) is required of those U.S. corporations, LLCs, or similar entities with 20 or fewer employees. Why is 20 employees the threshold? It is believed that most shell companies being used to hide unlawful assets have few, if any, employees.

The largest exemption from filing is believed to be “large operating companies,” those with more than 20 employees, operating in the U.S. (from a physical business address, not a home office) with over $5 million in sales or gross receipts. Additionally, banks, credit unions, insurance companies, accounting firms, public utilities, governmental authorities, security brokers, and others who report ownership to the government under other laws are exempt from registration under the Act.

Existing, active businesses covered by the Act will have one year to report:

the company name, trade name(s), business address, state of formation, Employer Identification Number (EIN), and
the name, date of birth, residential or business street address, and one unique identification number (i.e., driver’s license, passport, government issued identification) with a copy of the document from which it came, of all “Beneficial Owners,” people who own, substantially control, or create the company (the “company applicant”).

Businesses must make the initial filing, then again every time there is a change in Beneficial Owner status.

Beneficial Owners

A Beneficial Owner is any person who, directly or indirectly, owns or controls 25% or more of the entity, or who exercises substantial control over the entity. Substantial control is defined to include any person who serves as a senior officer, has authority to appoint or remove senior officers or members of the board of directors, or who provides direction or makes decisions about a company’s “important matters.” The ownership or control that triggers reporting obligations may exist in not only corporate or business governance documents, but also through separate contracts, arrangements, relationships, or understandings.

However, Beneficial Owners are not minor children (assuming the child’s parents/guardians are reported), an individual acting solely on behalf of another person (an agent, nominee, custodian, etc.), a non-owner employee of the entity, creditors, or individuals with inheritance interests only.

Penalties

Any changes in Beneficial Owner statuses must be reported within 30 days of the change.

Penalties for willful non-reporting are both civil ($500 per day) and criminal (up to two years in prison and/or a $10,000 fine). The Reporting Companies are required to comply with this reporting law, not the Beneficial Owners themselves. These are most definitely safe harbors, which permit the sidestepping of liability for failure to report.

Safeguarding of Information

The U.S. Treasury Department is tasked to create a database to house the personal information of what is believed to be over thirty million businesses throughout the country.

The database will be accessed only by law enforcement, banks, and the government. FinCEN is responsible for safeguarding the financial system of the United States from illegal activity, including not only money laundering, but also fraud, corruption, and financing of terrorist activities. Ironically, a law intended to combat fraud may lead to potential concerns about safeguarding the sensitive information collected.

For further guidance, compliance information, and updates, please contact us.

[1] According to the New York State Department of Labor figures, in 2021 90% of all businesses on Long Island had between one and 19 employees.

[2] For full text of Act, see https://www.congress.gov/116/bills/hr2513/BILLS-116hr2513rfs.pdf.

[3] See https://bostontaxinstitute.com/wp-content/uploads/2022/09/boston-tax-institute-public-inspector-regs.pdf and generally https://www.fincen.gov/beneficial-ownership-information-reporting-rule-fact-sheet.

6 CMM Attorneys Recognized as 2022 Super Lawyers® and 3 Named Rising Stars

Posted: September 29th, 2022

Campolo, Middleton & McCormick, LLP is proud to announce that nine attorneys at the firm, in multiple practice areas, have been named to the 2022 Super Lawyers® list, three of them as a Rising Star. The CMM attorneys recognized this year, in practice areas including Business and Corporate, Personal Injury, Real Estate, Business Litigation, Mergers & Acquisitions, Construction Litigation, Employment Litigation, and Appeals, are:

The rigorous Super Lawyers selection process is based on peer evaluations, independent research, and professional achievement in legal practice. The Rising Stars recognition denotes superior professional achievement by attorneys who have been in practice for under 10 years or are under age 40. No more than 2.5 percent of lawyers in New York State are named to the Rising Stars list.

Learn more about CMM’s outstanding legal professionals here.

CMM Closes Sale of Nassau Insurance Company to Major US Agency

Posted: September 26th, 2022

CMM’s latest M&A deal highlights the tremendous appeal of Long Island businesses to nationwide companies looking to grow through acquisitions. CMM recently closed the multimillion-dollar stock sale of a Nassau County-based property and casualty insurance agency to a large insurance company with operations across the country. The national carrier saw the potential to expand its portfolio of cybersecurity, workers’ compensation, and other insurance products with the acquisition of this successful Long Island business.

CMM Senior Partner Christine Malafi led the deal with critical support from Zachary Mike and paralegal Cailey McByrne. The team handled all aspects of the deal, including leasing issues pertaining to the client’s property where the office is located.

For guidance on the purchase or sale of a business, please contact us.

CMM Secures Dismissal of Malicious Prosecution Claim Against Suffolk County Town

Posted: September 14th, 2022

Think municipal law is limited to zoning disputes? You’ll be intrigued by CMM’s latest municipal law success story involving an animal shelter, an arrest for trespass, and an accusation of malicious prosecution.

CMM’s client, a Suffolk County Town, had previously suspended the plaintiff (the supervisor of the Town animal shelter) based upon concerns about her performance. Pending a hearing on the matter, the Town barred her from returning to Town property. Days later, she appeared at the shelter, and Town employees reported the incident. The plaintiff was subsequently arrested for trespassing (charges that were later dropped).

The plaintiff sued the Town in 2017, alleging First Amendment (freedom of assembly) and Fourth Amendment (abuse of process) claims, as well as malicious prosecution. Almost immediately, CMM secured the dismissal of all claims except malicious prosecution, which the Court allowed to proceed through discovery. The plaintiff claimed that the Town (through certain employees and investigators) “initiated” criminal proceedings against her by urging her prosecution and providing false information to the D.A.’s office. After discovery concluded, with these claims debunked, CMM’s Scott Middleton and Richard DeMaio moved for summary judgment (essentially, asking the Court to find that there are no facts in dispute and to rule in our favor).

In a recent decision, the Court granted that motion and dismissed the case. The Court found that the plaintiff failed to establish that the Town employees initiated criminal proceedings; rather, all they did was report a perceived trespass. The Court also found that regardless of whether there was a crime, the Town employees were entitled to qualified immunity.

This outcome was a major win for the Town, finally putting this case to rest after more than five years. Visit our Municipal Liability page to learn more about other successful cases.

CMM Closes Complex F-Reorganization M&A Deal for Longstanding Family Business

Posted: September 13th, 2022

Selling a business you’ve spent decades building is never easy, but having the right legal team in place makes a stressful time much easier to navigate.

CMM’s M&A team recently represented a client who had devoted nearly 40 years to its business of selling building cleaning supplies and sanitation products. To close the multimillion-dollar stock deal, we guided our client through a complex F-reorganization under the Internal Revenue Code. For companies in New York, this process, in short, involves forming additional companies and merging the existing corporation into a newly created LLC prior to closing.

Vincent J. Costa led the CMM team, which also included Zachary Mike and paralegal Cailey McByrne. Vinny and Zach skillfully managed the client’s concerns and deftly handled the major NYC firm representing the buyer. Cailey kept the deal on track and made all necessary filings with the Department of State, all while keeping the dozens of versions of transaction documents well organized and the open issues in the forefront. Our client was very happy with the outcome of the sale to the buyer, a specialized distributor with operations throughout the United States.

CMM has the experience to handle the most complex M&A transactions. Contact us today.

Legal Brief: Inflation, M&A Deals & More

Posted: September 13th, 2022

Christine Malafi, Senior Partner, Featured in LIBN Who’s Who 2022 Women in Professional Services

Posted: August 30th, 2022

Christine Malafi is a senior partner at Campolo, Middleton & McCormick, LLP (CMM), where she also chairs the corporate department at CMM.

Malafi has led CMM’s legal team in closing countless M&A deals worth billions of dollars. She has vast experience advising on both buy-side and sell-side M&A transactions in a variety of industries, including technology, manufacturing, education, healthcare, and professional service sectors.

She is particularly adept at working closely and strategically with clients’ other professional advisors, including accountants, bankers, and M&A advisors, as well as forging those critical relationships for clients based on the deep network of relationships she has cultivated over years in the business.

Malafi’s practice also includes advising clients on business divorce matters and a wide variety of both routine and complex corporate transactions. She serves in a general counsel role for many of the
firm’s corporate clients. Clients also turn to her for guidance on employment issues including payment of wages, overtime, paid and unpaid leave, hiring, and termination; drafting customized policies, procedures, handbooks, and training programs, including sexual harassment prevention; and conducting internal investigations in connection with discrimination, harassment, compensation and overtime.

Read the full Who’s Who spotlight here.