F Reorgs Redux

In episode 27 of How Tax Works, Matt Foreman discusses what to do when you’ve made a S election and might have some remorse, need to restructure, or need to sell part of the business.

How Tax Works, hosted by Falcon Rappaport & Berkman LLP 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.

Follow us on Bluesky:
@howtaxworks.bsky.social

This podcast may be considered attorney advertising. This podcast is not presented for purposes of legal advice or for providing a legal opinion. Before any of the presenting attorneys can provide legal advice to any person or entity, and before an attorney-client relationship is formed, that attorney must have a signed fee agreement with a client setting forth the firm’s scope of representation and the fees that will be charged. 

This Podcast is Hosted by:
Falcon Rappaport & Berkman LLP
1185 Avenue of the Americas, Suite 1415
New York, NY 10036
(212) 203 -3255
info@frblaw.com

Transcript

Matthew Foreman [00:00:00]:
Welcome to the 27th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss what you do after you made an S election and now you regret your decision, which is somewhat predictable in my view. 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 decisions that we all make before we get started.

Matthew Foreman [00:00:43]:
A few Administrative Things episodes every two weeks. Next episode I'm not sure what I'm going to talk about next, but most likely family offices structuring and how they operate. I also been meaning to do a 2:80e episode, you know, cannabis and stuff like that for a while. I haven't haven't done it for a variety of reasons. Thought the law was going to change, but JK lol. Not going to happen anytime soon it seems like. So I think that's, that's something that I'll probably end up doing at some point. Probably.

Matthew Foreman [00:01:11]:
Probably going to be a good discussion of 471C and all the other bad ideas that come across. Anyway, if you have any questions, comments, constructive criticism, you can email me at my FRB email address and then, you know, you can find that via your favorite search engine. Upcoming Webinars Speaking game prints are on the How Tax Works landing page on the F4B website. And now F3ORGS part two. Before we start, we're in year two. This is the first one of year two. I hope, I hope you've enjoyed it. I hope you learned something.

Matthew Foreman [00:01:38]:
I've definitely, I'll say I enjoy doing it because I, I do like talking about tax, which I I have been told comes through when I talk about tax. You know, I do this for free. You know, I know this is marketing and blah blah blah. But. But I just want to make one pitch. You know, I do a lot of I volunteer with a nonprofit 501c3 called Savvy Ladies. You can look up the mission and all that stuff online. SavvyLadies.org and what it does is it gives, you know, financial helps women get financial literacy, which is the problem.

Matthew Foreman [00:02:07]:
I mean generally speaking, anyone who works in the tax or legal field or accounting or finance or really whatever knows that generally speaking, most people and this is not an American problem. This is, this is problem generally really are not terribly financially literate but what happens a lot of times is, you know, a lot of times BP men, you know, historically have had the financial knowledge control, all that stuff, and the women kind of go along. It becomes a problem if there's a divorce, if there's a widowhood, et cetera. So what they try to do is they seek to help women get financial knowledge. I, I help, I volunteer, what's called a helpline volunteer. And where I volunteer is that as anyone who knows and has ever dealt with issues, when there's financial problems, tax problems often follow where you're not keeping records properly, you don't have money to pay, things like that, you often have tax problems. Right? So I help people with that. I volunteer.

Matthew Foreman [00:02:54]:
It's a big part of the firm's pro boto initiative. I'm just going to ask you that if you feel like I've helped you and I haven't charged a whole lot of money for it. If you want to donate, you know, feel free. If you don't want to donate, that's, that's cool too. I'm just glad that you're, you're hopefully enjoying this and listening, so wanting to make that pitch. Probably won't ever make that pitch again or won't for a while, but now that we're in year two, I'm going to kind of go for it. So let's talk about F reorg or what to do after you made an election and now you, you know, regret your, your decision. So when I recorded episode 23, what, you know, what, what the F is an F reorg, I kept it tight.

Matthew Foreman [00:03:28]:
I didn't want to discuss why you do an F reorg other than as part of a sale. But the truth is there are so many reasons F reorg has come in a lot. There are internal ones, there's internal restructurings, There's a variety of things, which is what I'm going to talk about in this episode. And you basically can't dissolve the S Corp because of section 311B because it would trigger a gain, trigger the recognition of gain. 311B or 357C, if my recollection is correct, which is what happens. You have a lot of, lot of debt. So I really wanted to kind of go through and do a second one, but I didn't want to do it right away because I didn't want to make it F reorgs. F reorgs.

Matthew Foreman [00:04:03]:
F reorgs. Because then I would just be talking about F this and F that, which, which, you know, Would be fun and funny to do but probably not the best decision anyway. So let's, let's talk about reason number one. You're granting equity to employees. So you can grant equity in a. You know, to an S corp to employees. Right. Assuming they meet the requirements, eligible shareholder, et cetera.

Matthew Foreman [00:04:24]:
Not an issue at all. But maybe you want to do lesser voting, non pro rata waterfall, things like that. You really can't do it right. Because it's single class requirement. You can do non voting which they may or may not like. I don't. I don't know, it doesn't really matter to me. Or you could do a variety of other reasons, other things but that's it.

Matthew Foreman [00:04:43]:
Right. The economic rights are the same so it's going to be taxable upon grant. So a lot of the biggest one is done is you do an F re Org, you drop the LLC down and the LLC regards when you grant a profits interest. There's an article I wrote in The Tax Advisor, AICPA's main tax publication. I co authored it with Michelle Cable where I talk about how profit interests are structured. So I basically ignore the F reorg but a lot of that what happens is after the F re org the LLC boom that's in a regards. So you might have some. That revenue ruling 95 or 96 concerns there.

Matthew Foreman [00:05:15]:
But I think that's really important. You know the. The historic owner still owns their ownership interest through an S corp. We'll call them Scott Scott, the S corp owner, Poor Scott has an S corp. So you're going to just basically create a new class LLC granted to employees profit interest. It can be full equity. Maybe they're someone who's not going to be, you know, they're going to own it. They're going to own it and put it into like certain trusts or they're going to hold it through an LLC which then they'll, you know, they'll transfer some of it to a spouse, what have you.

Matthew Foreman [00:05:43]:
So things like that. So that's really it. You know the first one is granting equity. It's just so much, so much, so much easier if you have a partnership. I always say LLC because you're almost always going to want to have an llc but really partnerships what you're going for. Reason number two, you're going to take on investors. A lot of times, you know you'll become a C corp with professional investors. Why? You know they just.

Matthew Foreman [00:06:03]:
They want Delaware C. It's what they know. Not right, not wrong. It's. It's what they know. But you know, a lot of times professional investors invest through funds, whether it's an LLC themselves or family LPs, you know, coming in through a company, through an LP, through a fund structure or, or something else. They invest through trust, et cetera, family partnerships, things like that. So they're going to come in and they don't, they don't want to invest in S Corps.

Matthew Foreman [00:06:26]:
It's just too easy to blow it. And I tell this story about, oh, they're just going to invest through a single member llc. And I'll tell this story. I had a client who had an investor in a number of S Corps that existed and the owner died. And they didn't know this, right? Pay attention. And it said, for reasons I don't understand, they didn't seem to actually issue it to the individual owner. They issued to llc. Llc.

Matthew Foreman [00:06:49]:
Ein they find out a couple years later, hey, we dissolved the llc. The owners are now these three people and they're like, well, how does that work out? And they said, well, you know, so and so Scott, right, Scott died. Gotta keep using Scott, the S Corp owner, even though he owned the single member llc. I guess Scott, the SM LLC owner, whatever, he died. It went to the three daughters, right? Perfectly fine. Except now that LLC that was single member is no longer single member. You have a partnership that owns an S corp. Congratulations, you have a partnership that owns a C Corp.

Matthew Foreman [00:07:18]:
And so what happened is that situation blew the S election for like 15s corps. He was a very minority owner. What he would do is, I forget the. I feel like there were auto repair shops and things like that. He just, he knew a lot of them. It was a lot of stuff, gas stations, I think, things like that. He knew a lot of stuff. He owned like 3% of a lot of them.

Matthew Foreman [00:07:42]:
They needed cash, he'd invest, you know, he'd be willing to do it, et cetera. And so what ended up happening is he just successfully blew the S elections for a whole lot of people, created a huge problem all because that he used an S single member LLC and they didn't know it. Clearly problematic. Created a whole host of issues, et cetera. They had to refile as a C corp for a couple years and then that's, that's where you kind of sit down. Not. Not great, right? So what, what people do is when they want to take on investors, just again, you're an f. Re.

Matthew Foreman [00:08:13]:
Org. Drop the LLC down and they invest into the llc. Now you don't have that issue. People say, oh, I Don't you know, I can't do, I don't do this little payroll tax thing. And I'm like, I'm really sorry. You might get a better PTE out of it because you don't have to do salary for yourself and you don't have the audit risk. I really think people underestimate the. I know I say this a lot.

Matthew Foreman [00:08:31]:
I really think people underestimate the audit risk issues with S corpse and ease to do it. There was a presentation by Tony Nitti. I suspect a number of my listeners know who he is. He's a, he's a principal at eye. Great guy, Brilliant, absolutely brilliant. And what he did was he said in a, in a presentation at the ABA Tax, when he says there is no, there are no S Corps. There are only S Corps that don't know they've blown their S election yet. And that's a fatuous statement.

Matthew Foreman [00:09:00]:
It's, it's not true. But at the same time, it's absolutely, categorically true. There's the number that have blown it and don't know it or have done little ticky, tacky things that blow it and just aren't aware because they didn't know. That's problematic. So just too easy to do. Anyway. All right, we're moving on, right? Estate planning, we're talking about some estate planning. So only certain trusts can hold S Corps.

Matthew Foreman [00:09:19]:
So if you have an llc, it's easier to put it in trust, right, so you can move it over. So furthermore, if you die under section 1014, what happens with an S Corp is you get a basis increase, step up basis in the S Corp stock itself. But if you have a single member LLC or disregarded entity that holds it, right, you get a basis increase in the underlying assets. If you have a multi member LLC that's taxed as a partnership, you get an increased basis in the LLC interest and you make an election through 754 to adjust the basis and the underlying assets that are held by that partner, right, that member of the llc. So if you have an S Corp, you sort of have this problem. You have to step up in a capital asset, the S Corp shares. So what happens is when you sell the underlying asset, right, there's gonna be some ordinary income capital gains, but then you have a capital loss that you'll sort of get from selling it. So what happens is you always have leakage, you have this capital loss that's always, always held within an estate.

Matthew Foreman [00:10:11]:
So the capital loss disappears. Can't pass it out, and then you have ordinary income, some of which gets leaked up to the beneficiaries or the estate pays it. Great. Not. Not really all that helpful. So there's leakage. So the partnership resolves that by having full fair market value basis in the underlying assets themselves. Single member LLC which disregards or a multi member LLC which is a partnership.

Matthew Foreman [00:10:32]:
Great. So you do an f re Org then you do a profits interest again so all the growth goes into the profits interest holder side which is not held through an S corp. So that that helps it mitigate, doesn't ameliorate. Or you do a freeze partnership. This is another episode I'll talk about freeze partnerships. You're kind of somewhere between this kind of weird debt interest bearing account kind of thing that does it. They're pretty neat. We do a budget the firm so definitely talk about.

Matthew Foreman [00:10:57]:
Or you contribute cash into an LLC and use it in the business. So let's say you need to put more money into an S corp. What some people do, what I've done is you do an f Re Org, drop the LLC down and then individually you put the money into the LLC itself so that you know, mitigates the growth going forward and allows you to go directly. LLC gets a step up in basis in the underlying assets, etc. Etc. So that's really helpful. That's an estate planning benefit. That's something you can do.

Matthew Foreman [00:11:20]:
The contributing cash, not as much but you know that's what you're going to do. It's definitely better for estate planning purposes. S corps are tough and it's kind of what it is. And you only have 8 months, 18 months anyway in trust. That's not a non qualifying trust. Large estates, maybe they're moved, maybe they're not. So it's hard. You can't really use trust.

Matthew Foreman [00:11:37]:
So it's a problem. All right, let's get some music in and we're going to talk about anti churning. All right, we're back with some more effort orgs part part 2 so I tried to get the anti churning stuff into episode 23 but it was kind of running a little longer than I wanted to be if I had it in it. So I took it out. Anti churning is a legacy tax thing that exists that a lot of people probably don't know exists that you. I run into maybe like once a year. As I said, I do a lot of f reorgs. I probably do one f org in the context of a sale a month, maybe two pencil time of year.

Matthew Foreman [00:12:20]:
Right in the summer I might do One in three months in November I might be doing one one a week. Right? Just, just the normal thing of oh, we got to get this. Anyway, so anti churning pre1993 if you sold intangibles to related parties and then amort then you would amortize them, right? And the answer is well, no. So here's the problem, right? They weren't 15 year assets. They used to be able to set up a useful life of intangibles. The owner would. So they would be like oh well the useful life of goodwill is two years which actually might be true in a lot of businesses. But now it's, it's, it's locked in under 197 at 15 and so Congress said okay, well instead of actually setting, you know, goodwill at the right term or people would have bad years and then they would sell goodwill to them, to other ones to generate some income and then the other one would re amortize it later.

Matthew Foreman [00:13:11]:
So it's basically pushing off the loss. Congress said you can't amortize if you acquired the business after August 10, 1993 or July 25, 1991 with the election and any of the following. So you acquire basically after August 1093 or 91 with the election and 1, the tax or related person held or used intangible or interest in the intangible during the transition period. Transition period is 91 to 93, those two dates I mentioned. Two, the taxpayer acquired the intangible from a person who held the intangible during the transition period as part of a transaction that the user of the intangible does not change. So like you sold intangible that the person who uses the intangible is the client base, right? Goodwill. That's who's using it. Three, the taxpayer grants the right to use the intangible to any person or related person who held or used it during the transition period.

Matthew Foreman [00:14:03]:
So like a sale leaseback is common or four and point four is just the transition period again, 7-25-91, 8-10-93. Basically that's the period when they first proposed the law to when it became enacted. Congress used to prospectively pass tax laws crazy to think about and give more than like two weeks to implement them. So what a time to be alive, huh? The 80s and the 90s. The related parties very broad. 707, 267. So again, you know, it's not so much a big deal today because intangibles over a 15 year amortization period. But I think it's really important to note that this is something that's really done.

Matthew Foreman [00:14:41]:
So what you have to do is you have to deal with this with an f re. Org. So what you do is, is basically you've done an f reorg. You have the S Corp. Holds a single member LLC. It disregards you form LLC 2. You contribute 1% of the historic company to LLC 2. Okay, so you have S Corp.

Matthew Foreman [00:14:59]:
Holds LLC to hold historic CO. Right? Historic CO being an LLC. So you probably can't call it code because you can't call LLC is co. But whatever you distribute LLC to to the owners to the shareholders of the Escort, right? The distribution is a taxable distribution. 311B. You're intentionally triggering it, okay? It's as if you're distributing the assets that are in LLC to which is the equity and the historic LLC entity. And you get a stepped up basis in the underlying assets in it. Because the moment that that LLC 2 regards, right.

Matthew Foreman [00:15:31]:
999 5, 996 transaction that's going to have a fair market value basis both in LLC2 and LLC2's assets. And when LLC2 regards, assuming that there's more than one owner of the S Corp. Before or otherwise, LLC2 actually remains a disregarded entity and has a fair market value basis, right? Then the historic LLC regards because the S Corp is one owner and LLC two is the owner or an individual. And so that's really important. And there are different people. There's a case. Moline Properties, I always want to call it Mobile Properties. Not right.

Matthew Foreman [00:16:03]:
Mobile City in Alabama or Mobile is the thing that, you know, a small child uses whatever Moline Properties. Basically a corporation is always a separate taxpayer and a separate person for tax purposes. Even though C Corps consolidate S Corps may be A, it may be a Q sub, it's still considered separate under this one. Unless the key sub Q sub C or not. So then what you do is you sell the historic LLC or you roll it over, whatever, and the sale proceeds, the cash that's going to get a step up in basis, it mitigates around the issue because the way that Congress thought about this is okay, if you do the bad thing that I talked about, right, you can't do it, you can't amortize it. What you do is you just don't get a step up in the basis in the intangible assets. So I think that that's really important to talk about and to think about. Right? Congress's way to do this is we're just going to Kick you in the teeth pretty hard.

Matthew Foreman [00:16:50]:
Call it a day. The way to get around that is an F reorg and an extra entity. Not that hard to do. I think this is one that Congress is like, well, there's no way to do this. Can't get around this unless you're willing to trigger a tax. And it's like a 1% tax when we're about to sell it anyway. Not a big deal. Also, LLCs didn't exist.

Matthew Foreman [00:17:07]:
91, 93 did, but not really, so it was less of an issue. So it was always one of those ones that I've always kind of wondered what Congress was thinking. Totally on this. I think this is one where later in the 90s when they moved the amortization period for goodwill and all intangibles to 15 years, I think they actually solved the problem in the next one. Not the first one, but they left in the first thing. That's kind of a headache to deal with. Creates everywhere. Look, it's extra billables for lawyers, extra billables for accountants.

Matthew Foreman [00:17:33]:
Great, wonderful. But that's not really helpful for the client. I think this is one they need to remove. They actually want to change something. But I saw the recent tax bill and not a whole lot of these stuff is in there, so that's kind of problematic. Anyway, let's take a few minute break. Or a few moment break. We're not breaking for minutes.

Matthew Foreman [00:17:49]:
We're going to talk about halfway, what I call a halfway D reorg and liquidating one shareholder when the other one sticks around. All right, we're back. We're bringing it home. Episode 27 How Tax Work so I call this the halfway Derek. Org. Right. If you do a D reorg. Talked about that a couple episodes ago.

Matthew Foreman [00:18:14]:
And then sell one of the businesses, right, One of the two entities, you actually blow the D reorg for both. Unless you wait, you know, 2, 3, 4, 5, 17, 52 years, right. So what I tell clients to do is do an F reorg, right? And then just sell, you know, what you do is you do F reorg. Both entities are in the lower tier entity. Distribute one of the entities from the lower tier, the Q sub, up to the main entity or. Or after you've already made a disregard and you distribute it up, whatever, then sell the historic code like the Q sub or the LLC below that only contains one entity that's taxable, you still have it. I call it a halfway D reorg. Not really.

Matthew Foreman [00:18:50]:
It's an F that you don't totally, you know, deal with. But it's a good way to do it because what happens is the only taxable portion of it is from the sale portion. However much you sell makes it much easier. I do one of these like once a year probably where there's two businesses and like, oh, but they only want to sell one. They're not sure what to do. I'm like, friend, I have a deck for you. So walk them through that. Super, super happy clients because they come to you with a problem and you tell them that you don't really have to do all that much.

Matthew Foreman [00:19:16]:
Pretty simple, pretty straightforward. Keep the ein, you can sell either one, et cetera, et cetera. So that's really helpful. The next one I've actually done a number of times with the halfway D reorg where one shareholder wants out, the other one other one wants to stick around, right? So you do an f reorg, have the llc, you sell it, there's an earn out, right, whatever. So what you do is the cash goes equally to both. It's an S corp, has to be pro rata, can't have multiple classes, et cetera, et cetera, right? So the cash goes easily to both. Then what you do is you use the earn out or you, you create a new note with it and you use that to buy. The biggest exception to 311B, okay, plain and simple, is that if you use a note to buy out one of the shareholders in a complete liquidating distribution, okay, then basically their characteristics, basis, all that stuff, the S corp stock gets transferred into the note that's distributed to them and that's it.

Matthew Foreman [00:20:13]:
There's no 311B. You work your way around it. So that's actually a really, I think a really nice way to do it. Not the most elegant sometimes in an earn out, this is what you have to do. A company might have a very large debt that it has to service. So you could have a significant problem if it doesn't have cash flow, et cetera, et cetera. But they're no longer involved and that's a way to get them out. You know, sometimes you have like six shareholders and one wants out.

Matthew Foreman [00:20:37]:
This is a way to do it. Sometimes it's 50, 51 just wants to leave, right? That's what you do and that's, that's the way to do it. You know, I, I, I think that these two often work together. There's two businesses effectively, one ran one, one ran the other. One person just wants to retire, right? Two, the halfway de reorgan, they sell one, they use the Note to liquidate one of the two shareholders, and they move along. It really is a nice kind of elegant way to do it. I don't know if elegant is the right word, but it's. It's a very direct way to do it.

Matthew Foreman [00:21:06]:
People say, oh, what if we did this? What do that? Lean into it. Go directly at it. This is a problem. This is what we're resolving. Have a nice day. And I think that that's really important to note. You know, a lot of times with f reorgs and things like that, you know, I. Some people try to do.

Matthew Foreman [00:21:21]:
What if we do this? What if we. That I always say, look, lean into the problem. This is the problem. This is what we need to work on, get this done. And I think that's really important to do, and that's important to think about. Sometimes the most direct way to do it. You know, I mentioned it. I think of the partnership dissolution, right.

Matthew Foreman [00:21:35]:
To divide. When you're dividing a partnership, I'm struggling with words here at the end, but when you do that, you know, sometimes there's a district, there's a disguise sale. And I always say that disguise sales are not necessarily bad things. You just have to know when you're expecting. Expecting it. And that's what happens a lot. A lot of these people are like, well, if I'm leaving, I expect to pay taxes. And if you can tell them, look, I.

Matthew Foreman [00:21:54]:
You're going to pay taxes, but I'm going to defer your tax until you actually get the money from it, they're going to be really happy. They're going to be really, really happy with you. Because people don't. People who are antithetical to taxes generally. I appreciate that, but generally speaking, what I find is most people don't mind taxes that much. They hate taxes when they're not getting a whole bunch of cash along with it. And if you can tell them, look, I'm going to delay your taxes to get cash. And that.

Matthew Foreman [00:22:19]:
That's it. Okay, that's cool. That's fine. I've accepted it. I'm ending my involvement in this business. So that's really fine. All right, that's it. Time for some music.

Matthew Foreman [00:22:29]:
27th episode of How Tax Works. Hope you learned something back in two weeks. Two weeks with the 28th episode. Probably going to talk about family offices. Might talk about cannabis. My talk about family offices, investing cannabis. Cannabis, which they generally don't seem to do, but, you know, here we are. And now for the best song of all time.