F Reorganization
A tax-free reorganization under IRC Section 368(a)(1)(F) that restructures an S-corporation into a new holding company — often used to give buyers a stepped-up tax basis while preserving stock-sale treatment for the seller.
Full Definition
F reorgs are the elegant solution to a common tension in S-corp transactions: the seller wants stock-sale capital-gains treatment, the buyer wants asset-sale step-up for depreciation and amortization. A 338(h)(10) election forces the seller to recognize gain as if it were an asset sale. An F reorg — properly structured — lets both sides get what they want.
How it actually works: The mechanics: (1) The S-corp owner forms a new holding company (NewCo) and contributes all S-corp stock to NewCo in exchange for NewCo stock; (2) The existing S-corp (now a subsidiary of NewCo) elects to be treated as a qualified subchapter S subsidiary (QSub) — a disregarded entity for tax purposes; (3) The S-corp converts to an LLC (either by direct conversion or merger); (4) The buyer purchases either the LLC interests or the NewCo stock. Because the LLC is a disregarded entity for tax purposes, its sale is treated as an asset sale — giving the buyer a full stepped-up basis. But because the seller is selling membership interests/stock, they get capital-gains treatment on the entire gain.
The F reorg itself is tax-free under Section 368. The subsequent sale is taxed, but at the favorable rate. No 338(h)(10) gross-up needed. The buyer gets the full step-up benefit, typically 15–20% of purchase price in present-value tax savings. The seller gets full capital-gains treatment.
This structure has become standard for PE acquisitions of S-corps. Both sides win.
Seller vs. Buyer Perspective
If you're an S-corp seller facing a buyer who wants asset-sale tax benefits, ask your tax advisor about an F reorg before defaulting to 338(h)(10). The F reorg structure generally produces better net proceeds for you — no ordinary-income reclassification of depreciation recapture or inventory, clean capital gains treatment on the entire sale. The complexity is higher (formation of NewCo, QSub election, timing of steps) but standard M&A tax counsel handles this regularly. For deals above $10M where buyer wants step-up, F reorg is usually the better answer. Costs: additional $15–35K of tax and legal fees for the reorganization mechanics. Typically worth it if gross-up alternative would cost $100K+.
F reorgs give you everything a 338(h)(10) gives — full tax basis step-up, goodwill amortization over 15 years, depreciation on equipment at stepped-up basis — without requiring a gross-up payment to the seller. The structure does require specific execution: the reorganization steps must be completed before the closing, not contemporaneously, and documentation matters for IRS purposes. Use experienced tax counsel. Don't try to do F reorgs with a buyer's general counsel alone — the execution details matter. The economic benefit vs. a stock sale without step-up is typically $500K-$3M+ in present-value tax savings on a mid-sized deal.
Real-World Example
An S-corp industrial services company is being acquired by a PE firm for $35M. The owner has been running the S-corp for 25 years with $2M tax basis in stock. Total gain: $33M. Options compared: (1) Plain stock sale — seller pays long-term capital gains on $33M (federal 20% + 3.8% NIIT + state 6% = ~30% total = $9.9M tax). Buyer gets no step-up; deducts purchase price only upon eventual exit. Net to seller: $25.1M. (2) 338(h)(10) election — seller recognizes as if asset sale; approximately $6M of gain reclassified as ordinary income (depreciation recapture). Additional tax cost vs. stock sale: ~$600K. Buyer agrees to $600K gross-up. Net to seller: $25.1M (same, post-gross-up). Buyer gets step-up benefit worth ~$5.8M PV, net of the $600K gross-up: $5.2M net benefit to buyer. (3) F reorg — seller forms NewCo, contributes S-corp stock, S-corp converts to LLC. Buyer purchases LLC membership interests. Tax treatment for seller: entire $33M as long-term capital gain (no ordinary income reclassification). Tax treatment for buyer: full asset step-up (same benefit as 338(h)(10)). No gross-up required. Net to seller: $25.1M. Net to buyer: $5.8M step-up benefit, full value captured. F reorg costs both sides ~$25K more in legal fees but generates $600K of combined additional value. Both sides choose F reorg.
Why It Matters & Common Pitfalls
- !Step sequence matters. The reorganization steps must occur in a specific sequence; incorrect sequencing can disqualify the structure and cause unexpected tax consequences.
- !Timing requirements. The F reorg is typically completed days or weeks before the actual sale closes — not the same day.
- !Documentation. IRS scrutiny of F reorgs has increased. Proper documentation of business purpose, reorganization plan, and consistent treatment is important.
- !State tax considerations. State treatment of F reorgs varies. Some states may impose transfer taxes or real estate transfer taxes on the conversion steps.
- !Only works for S-corps. C-corps can't use F reorg to achieve the same effect — they need different planning.
- !Still requires buyer agreement. The buyer must agree to the LLC structure (or stock purchase of NewCo with appropriate elections). Most PE buyers are familiar and comfortable with F reorgs.
- !Employment-related issues. Employees of the S-corp technically become employees of the LLC during the reorg. Plan continuity requires attention.
Frequently Asked Questions
What is an F reorganization in M&A?↓
How does an F reorganization differ from a 338(h)(10) election?↓
Who pays for an F reorganization?↓
Related Terms
Stock Sale
A transaction in which the buyer purchases the stock (or equity interests) of the target company, acquiring the entity itself along with all its assets and liabilities — contrast with an asset sale.
Asset Sale
A transaction in which the buyer purchases specific assets and assumes specific liabilities of a business, while the seller retains the legal entity — contrast with a stock sale, where the entity itself changes hands.
Capital Gains (Short vs Long Term)
The tax treatment of gain from selling a capital asset (like a business). Long-term capital gains (asset held >1 year) are taxed at preferential federal rates (typically 20%); short-term gains and ordinary income can be taxed at up to 37%.
Purchase Price Allocation
The allocation of total purchase price across asset categories (inventory, equipment, real estate, goodwill, etc.) for tax purposes under IRC Section 1060 — affecting seller's tax treatment and buyer's future depreciation deductions.
Get Weekly M&A Insights
Valuation data, deal analysis, and plain-English M&A education — every week.
The LegacyVector Newsletter
Join 5,000+ business owners, investors, and buyers who get weekly M&A market data and deal insights.
- Weekly valuation multiples by industry
- SBA lending rates & deal financing data
- Market trends & acquisition opportunities
No spam. Unsubscribe anytime. Free forever.
Disclaimer: The information provided on this page is for educational and informational purposes only. It should not be considered financial, legal, or investment advice. Business valuations depend on many factors specific to each situation. Always consult with qualified professionals — including business brokers, CPAs, and M&A attorneys — before making acquisition or sale decisions. LegacyVector is not a licensed broker, financial advisor, or attorney. Data shown may be based on limited samples and may not reflect current market conditions.
LegacyVector Research Team
Reviewed by M&A professionals · Updated April 2026