Choosing the type of entity to form and where to form it are two of the most common early legal decisions that founders make when they start their own businesses. Founders typically register their companies in the state where they conduct business, which is often the most logical choice. Legal considerations are likely to be secondary when the company is still ramping up and building its business operations. However, eventually, legal considerations may materially influence certain business decisions involving such factors as the applicable tax rates and reporting obligations, a shift in the company's business direction, the founders' exit strategies, and requests of potential investors. If it is determined that the company needs to change its entity type or jurisdiction of formation, it is critical to involve tax and legal advisors as soon as possible to map out the most efficient and advantageous structure and path thereto.
If a company desires to change its entity type or re-domicile to another location as its formation jurisdiction, there are several reorganization tools that companies can employ. One option is a tax-free "F Reorganization" under Internal Revenue Code (I.R.C.) §368(a)(1)(F), which defines the F Reorganization as a "mere change in identity, form, or place of organization of one corporation, however effected."[1] The resulting corporation is considered the same as the original corporation, generally carries the same tax attributes as the original corporation, and may carry back a net operating loss or net capital loss to a taxable year of the original corporation. The I.R.C.'s vague F Reorganization definition of "however effected" aside, there are, in fact, six requirements that a series of transactions must satisfy to qualify as an F Reorganization:
- The resulting corporation's stock must be distributed to the original corporation in exchange for the original corporation's stock.
- Example: Stockholders Bob and Frank each own 50% of the original corporation. Each transfers his 50% in the original corporation in exchange for 50% in the resulting corporation.
- The corporate ownership must remain the same.
- Example: Only Bob and Frank can own stock in the resulting corporation immediately after the conclusion of an F Reorganization. If Chuck becomes a stockholder alongside Bob and Frank as a result of the reorganization, it does not qualify as an F Reorganization. If Bob ceases to be a stockholder as part of the reorganization, it does not qualify as an F Reorganization.
- The resulting corporation cannot have assets or attributes prior to an F Reorganization (but note that there is a narrow de minimis exception).
- Example: The resulting corporation cannot accept investments from anyone prior to an F Reorganization and cannot hold any material property.
- The original corporation must liquidate, but please note that this is not the same as the legal dissolution of the corporation.
- The resulting corporation is the only acquiring entity, and
- The original corporation is the only acquired entity.
- Example: Essentially, there can be only two corporations going through an F Reorganization. Only one company may initiate such an F Reorganization, and only one company may result from the F Reorganization. If multiple entities are involved at either end of this process, the reorganization does not qualify as an F Reorganization.
A tricky situation may arise if the original corporation has multiple stockholders, and one of those stockholders does not want to participate in the F Reorganization. This complicates the reorganization because the equityholders must collectively agree to contribute their shares in the original corporation to the resulting corporation. Typically, each equityholder signs the reorganization agreement and a stock power actually transferring his or her shares. What are the company's options if an equityholder does not want to participate in the F Reorganization?
If the equityholder wants to exit the company entirely, this can be done before or after the F Reorganization without jeopardizing the tax-free treatment of the F Reorganization. Using our example above, if Bob does not want to go through with the F Reorganization, then immediately before or after the F Reorganization, the company can pay Bob cash for his shares of stock. This would not jeopardize the tax-free treatment of the exchange of Frank's shares in the company with the resulting corporation's comparable shares. Regulations specifically allow for this scenario without invalidating the company's F reorganization efforts. The Regulations[2] provide an example where the company redeemed 75% of its issued stock right before the reorganization.
Alternatively, if a minority stockholder does not want to participate in the F Reorganization but isn't amenable to a buyout or redemption, such reorganization may still be achieved without the stockholder's consent if it is structured as a merger. Specifically, the original corporation can form a wholly owned subsidiary, HoldCo, which would then form another wholly owned subsidiary, MergerCo. These formations do not require unanimous consent of the original corporation's stockholders. HoldCo then can cause MergerCo to merge into the original corporation, with the original corporation surviving that merger as the resulting corporation. Such a merger transaction would need to be approved by the requisite percentage of the stockholders as required by applicable state law or the original corporation's bylaws, as applicable, but it is unlikely that it will require unanimity. As a result of such a merger, HoldCo will become a sole owner of the resulting corporation, and the stockholders of the original corporation will become owners of HoldCo. The corporation thus has undertaken the typical F Reorganization restructuring (i.e., the creation of a holding company above the operating company without incurring tax), but without the unanimous consent of the stockholders.
Even though the law offers a framework to resolve scenarios like the one described above, it is important to keep in mind that, if a stockholder takes a position that it does not want to participate in the F Reorganization and/or sell the stockholder's investment in the company, the chances of conflict are high, and the situation needs to be handled delicately. It is possible that a dissenting stockholder will not want to sell its shares and will prefer to stick with the status quo. In that case, the stockholders should take a close look at the entity's governing documents (e.g., operating agreement, stockholders agreement, etc.) and determine if they contain any redemption provisions and drag-along or call rights. The redemption option may not be available if the governing documents are silent on the matter. The merger option discussed above may be available, depending on the ownership percentage held by the dissenting stockholder. Finally, the stockholders may consider bringing a legal action forcing the straggling stockholder to sell its shares, but that would entail a protracted legal process with uncertain results and potentially significant costs—most would consider such legal action a "last resort."
In sum, business owners should consider an F Reorganization whenever there is a need to convert a corporation into another legal entity or change its jurisdiction. This type of restructuring is a popular strategy in M&A contexts because it permits a buyer to buy equity in the resulting corporation, with such transaction being deemed an asset sale and offering the buyer better tax treatment, among other benefits. However, an F Reorganization requires taking specific legal steps in a particular order, such that coordination among the business principals and their legal and tax advisors is crucial and should be initiated sooner rather than later.
Questions? If you have questions or concerns regarding this client alert, please contact the authors, any member of Venable's Corporate Group, or your regular Venable contact.
[1] I.R.C. § 368(a)(1)(F).
[2] Example 2 of Prop. Reg. §1.368-2(m)(4)