The buyer is insisting on an F-reorganization before close so they can get a step-up in basis under Section 197 while allowing us to execute a stock purchase agreement. What are the operational and tax risks of an F-reorg for an S-corporation seller, and how should we structure the indemnities around it?

Question

Tyler Smith · Accepted Answer

Buyers prefer an F-reorganization under Section 368(a)(1)(F) because it allows them to treat the transaction as an asset purchase for tax purposes, giving them a fifteen-year amortizable step-up in basis under Section 197. At the same time, it is structured as a purchase of equity in a newly formed subsidiary, preserving customer contracts and operating licenses that forbid assignment.

While this provides mutual benefits, the seller absorbs specific risks that must be managed.

The first risk is historical S-corporation status invalidation. If your historic S-election was technically flawed due to disproportionate distributions or an ineligible shareholder, executing an F-reorganization can surface those defects, triggering corporate-level taxation.

The second risk is execution timing. The restructuring involves creating a new holding company, contributing the historic operating entity shares to it, and electing qualified subchapter S subsidiary status for the operating company. Any flaw in the sequence or filing delays can cause the restructuring to fail.

To protect yourself, require the buyer to structure the definitive agreement with the following provisions:

- The buyer must bear all legal, accounting, and state filing fees associated with drafting and executing the F-reorganization documents.
- Limit your tax representations and warranties solely to your historic S-corporation status prior to the restructuring, refusing to warrant the buyer intended post-closing tax consequences.
- Insist on an explicit indemnity from the buyer covering any additional state, local, or transfer tax liabilities generated specifically by the restructuring steps that would not have occurred under a standard stock sale.

Run this directly through experienced tax counsel before agreeing to the LOI terms.