Friends, let’s talk about one of the most powerful and most misunderstood pre-sale tax strategies in the middle-market M&A world: the F Reorganization .

You’ve built a fantastic business. Private equity is at the door, LOI in hand, champagne literally chilling in the conference room fridge. Your investment banker is walking you through a deal involving cash at close, some rolled equity, and an earnout. And then your M&A attorney drops this gem into the conversation:

“We should probably do an F Reorg before we close.”

Cue the glazed eyes. Cue the polite nodding. Cue the desperate text to your CPA.

That’s where I come in. The F Reorganization is one of those rare structures where the IRS, the buyer, and the seller can all walk away happy. Well, as happy as anyone can be writing a big check to Uncle Sam.

Let’s break this down, step by step, using a real example. By the end, you’ll understand exactly what an F Reorg is, why it matters, what goes inside the deal, and critically what’s left in the HoldCo after the dust settles and the wire hits your bank account.

The Setup: Meet Marco’s Manufacturing

Let’s use Marco Rossi , sole owner of Rossi Manufacturing, Inc. — an S corporation with:

• Enterprise Value : $30,000,000
• Marco’s tax basis in his S Corp stock : $500,000 (practically nothing — he’s been building this thing since 1998)
• Built-in asset appreciation : Mostly goodwill and equipment

The deal structure PE is proposing:

• $20,000,000 cash at close
• $5,000,000 in rolled equity (Marco keeps a 20% stake in the new platform)
• $5,000,000 earnout (payable over 3 years based on EBITDA targets)

Without the right structure, Marco faces a tax nightmare. Let’s fix that.

First — What IS an F Reorganization? (The Non-Boring Explanation)

Section 368(a)(1)(F) of the Internal Revenue Code defines an F Reorganization as “a mere change in identity, form, or place of organization of one corporation, however effected.” That sounds deceptively simple. What it actually does in an M&A context is elegant financial engineering — a pre-closing restructuring that repositions the S corporation so that the buyer can purchase LLC interests (treated as an asset purchase for tax purposes) rather than S corp stock, achieving the same step-up in basis as a §338(h)(10) election — without all the restrictions .

Think of it this way: the F Reorg is like taking your business from one pocket and putting it into another pocket, on a tax-free basis, before you sell the second pocket to the buyer. You, the seller, end up holding the first (empty) pocket. That first pocket? That’s your HoldCo . More on that below.

Why Not Just Do a 338(h)(10) Election?

Great question. A §338(h)(10) election is a perfectly good structure and I’ve written about this battle before. But it has three crippling limitations for the modern PE deal:

• The buyer must be a corporation — not a PE fund organized as an LLC or partnership (which is basically every PE fund today)
• The buyer must acquire at least 80% of the S corp stock, no partial acquisitions
• Zero ability to roll equity on a tax-deferred basis — every shareholder recognizes gain on the deemed asset sale, including those trying to roll equity

The F Reorg eliminates all three of those constraints . That’s why it has become the dominant pre-closing structure for middle-market S corp M&A transactions.

The F Reorganization: Step-by-Step (With Marco’s Example)

Step 1: Form NewCo (HoldCo) — Day One

Marco’s attorney forms a brand new corporation — let’s call it Rossi Holdings, Inc. (HoldCo). This entity has no assets, no liabilities, no tax history, and no EIN (yet). It is a blank canvas.

Why it matters: The F Reorg regulations are strict. The resulting corporation (HoldCo) cannot have pre-existing assets or tax attributes before the reorganization. If HoldCo has anything in it before Marco’s contribution, the whole structure fails. Clean slate required. Think of this like a fresh pasta dough. You don’t add leftover ingredients.

Step 2: Shareholders Contribute OldCo Stock to HoldCo — Still Day One

Marco contributes 100% of his Rossi Manufacturing stock to Rossi Holdings, Inc. in exchange for 100% of the HoldCo stock.

After this step:

• Marco owns 100% of HoldCo (Rossi Holdings, Inc.)
• HoldCo owns 100% of OldCo (Rossi Manufacturing, Inc.)
• The ownership percentages must be identical before and after — same owners, same proportions

Why it matters: This is a tax-free exchange under the reorganization rules. Marco recognizes zero gain at this step. Zero. Niente. This is the beauty of the F Reorg. The restructuring itself is invisible to the tax system.

Critical compliance note: For the F Reorg to qualify, ownership percentages must remain exactly the same. If Marco has a partner — say he and his brother own 60/40 — both must contribute their shares in the same proportions. One holdout can derail the entire structure.

Step 3: HoldCo Makes a QSub Election for OldCo — Day Two

This is where the magic happens. HoldCo files IRS Form 8869 — the Qualified Subchapter S Subsidiary Election — making Rossi Manufacturing a QSub (Qualified Subchapter S Subsidiary) .

Under the QSub election:

• Rossi Manufacturing is now a disregarded entity for federal tax purposes
• It is deemed to have been liquidated tax-free into HoldCo (per Rev. Rul. 2008-18)
• HoldCo inherits Rossi Manufacturing’s S corporation election, its EIN, its tax history, and its tax attributes
• HoldCo is now the S corporation , standing in OldCo’s shoes as if it had always been there

Why the one-day gap matters: The QSub election must be filed after the stock contribution — specifically, the effective date of the QSub election must be the day after HoldCo is formed and the stock is contributed. Mess up that sequencing and the IRS may treat HoldCo as making an S election on a non-S eligible entity. This is not a DIY project.

No short-year returns: Even though the F Reorg happens mid-year, there is no short-period return required at the OldCo level. HoldCo files one single Form 1120-S for the full year that includes OldCo’s pre-reorg activity and HoldCo’s post-reorg activity. It “steps into OldCo’s shoes” as if it existed all year.

Step 4: Convert OldCo (Now QSub) Into a Single-Member LLC — Day Three

Under state law, Rossi Manufacturing, Inc. (the QSub) is converted into Rossi Manufacturing, LLC, a single-member LLC (SMLLC) wholly owned by HoldCo.

Since HoldCo already made the QSub election (treating OldCo as a disregarded entity), converting it from a corporation to an LLC is a disregarded-entity-to-disregarded-entity conversion . The IRS sees this as a nonevent with no tax consequences.

Why it matters: This is the cornerstone of the whole structure. Now the buyer (Marco’s PE firm) can purchase LLC membership interests from HoldCo. Because Target LLC is a disregarded entity, the sale of those LLC interests is treated as an asset purchase for federal tax purposes giving the buyer the full step-up in asset basis they crave, even though legally it’s just a transfer of LLC interests.

BOOM. The buyer gets the economics of an asset purchase (step-up and amortization), and the seller maintains the legal simplicity of selling an interest rather than moving individual assets. Contracts, licenses, and vendor relationships generally remain intact because the assets never actually moved .

Now the Deal Closes: Cash, Rolled Equity, and the Earnout

The pre-closing restructuring is done. Now let’s actually sell the business and understand the three components of Marco’s deal.

Component 1: Cash at Close — $20,000,000

This is the part everyone understands. The PE buyer pays Marco’s HoldCo $20 million in cash in exchange for an 80% interest in Rossi Manufacturing LLC.

Tax treatment: Because the LLC is a disregarded entity, this is treated as an asset sale for tax purposes. The gain is allocated across the acquired assets per IRC §1060 (the same allocation rules as a formal asset sale). Marco’s HoldCo recognizes gain on the deemed sale of 80% of each underlying asset — ordinary income on depreciation recapture (§1245/§1250), capital gain on goodwill and Section 1231 assets, etc.

Since HoldCo is an S corporation, all of that gain flows through to Marco personally on Schedule K-1. He reports it on his Form 1040 for the year of sale. With nearly zero basis in his stock (~$500K), Marco is looking at approximately $19.5 million in taxable gain on the cash component alone.

This is where the planning before the sale — QSBS analysis, Opportunity Zones, charitable strategies, installment structure — really pays off. But that’s another blog post (or five).

Component 2: Rolled Equity — $5,000,000 (The “Second Bite of the Apple”)

What is rolled equity? Instead of receiving all cash, Marco contributes a portion of his remaining LLC interest — his 20% stake — into the PE buyer’s acquisition vehicle (typically a newly formed LLC or partnership controlled by the PE firm). In exchange, Marco receives a partnership/membership interest in the PE platform.

This is sometimes called a “second bite of the apple”. Marco gets initial liquidity today AND participates in the upside when the PE firm sells the business again in 3-5 years.

Tax treatment — the beautiful part: Under IRC §721 , a contribution of property to a partnership in exchange for a partnership interest is a tax-deferred event . Marco’s $5,000,000 in rolled equity (representing 20% of the business) is contributed tax-free into the PE platform. He defers recognition of the $4.9M+ gain embedded in that 20% interest until he eventually sells his PE partnership interest.

This deferral is possible because of the F Reorg structure. Under a §338(h)(10) structure, every shareholder, including the one rolling equity, is deemed to have sold all assets at FMV. The rollover partner gets fully taxed even on the portion they intended to keep. The F Reorg eliminates this problem entirely.

Reporting: Marco’s HoldCo will receive a Schedule K-1 from the PE partnership each year going forward. No gain recognition until eventual sale of the partnership interest. Marco’s HoldCo will file an 1120-S each year to report the PE K-1 and any other activity it had during the year, like paying expenses.

Component 3: The Earnout — $5,000,000 (Spread Over 3 Years)

What is an earnout? An earnout is a contingent payment that is payable after closing if the business hits specified performance targets, typically revenue or EBITDA thresholds. PE buyers love earnouts because they allocate risk: if the business performs as the seller claimed, the seller gets paid. If not, they don’t. Sellers accept earnouts (sometimes reluctantly) because they often represent the only way to bridge a valuation gap with the buyer.

In Marco’s case: $5M payable over 3 years based on annual EBITDA targets.

Tax treatment — here’s where it gets spicy:

Earnout payments received after the year of sale are generally taxed as installment sales under IRC §453 . Under the installment method:

• Marco does not pay all the tax up front at closing on the full $30M
• Instead, each earnout payment received in Year 2, 3, and 4 is taxed using a gross profit percentage calculated at the time of the original sale
• The gain component of each payment is recognized as received

BUT — and this is the critical warning I give every client — there is a Section 453 trap lurking in the shadows for S corporation asset sales with earnouts:

When the installment sale rules apply to an S corp deemed asset sale, the seller’s stock basis must be allocated across both the cash received AND the present value of the earnout right at closing. This “basis stretch” can trigger significantly higher taxable income in Year 1, effectively taxing the seller on gains they haven’t yet received. If the earnout is ultimately never paid, the seller gets a future capital loss — but cannot carry it back to offset the Year 1 gain. That’s a painful mismatch.

Your options to manage the earnout tax risk:

• Elect out of installment treatment — recognize FMV of the earnout at closing (works if the earnout is valued conservatively)
• Careful structuring of the earnout cap — a fixed maximum amount helps manage the basis allocation problem
• Open transaction treatment (rare, but available in certain circumstances of genuine uncertainty)

The bottom line: work with experienced M&A tax advisors before you sign the purchase agreement. The earnout structure can make or break your after-tax result.

The HoldCo That Remains: What’s Left in Rossi Holdings After the Sale?

This is the part nobody talks about at the closing dinner, but it’s critically important. After the deal closes, HoldCo (Rossi Holdings, Inc.) still exists — and it is now a very different animal than it was before the sale.

Here’s what’s living inside HoldCo after closing:

Asset / Item

Description

PE Partnership Interest

Marco’s rolled equity — his 20% interest in the PE platform (§721 rollover)

Earnout Receivable

Right to receive up to $5M in contingent payments over 3 years

Excess Cash

Any post-closing liquidity management (net of taxes paid)

Transaction Costs

Deductible advisory fees, legal, banker success fees — allocable to the sale

Tax Liabilities/Reserves

Reserve for estimated taxes on the taxable gain recognized at closing

Historical Tax Attributes

NOLs (if any), built-in gains exposure, suspended losses

HoldCo is still an S corporation. Marco still owns 100% of it. It still needs to be managed, administered, and reported even though the operating business is gone.

This is where many sellers drop the ball post-closing. The HoldCo becomes a de facto family office entity — managing investments, receiving earnout payments, distributing cash to Marco, and eventually winding down. Done well, HoldCo can also serve as the vehicle for post-sale wealth planning strategies: deploying capital into Qualified Opportunity Zones, charitable vehicles, or other investments in a tax-efficient manner.

The Tax Reporting Calendar: Year of Sale and Beyond

Year of Sale (Let’s Say 2026)

Form 1120-S (HoldCo — Rossi Holdings, Inc.)

• HoldCo files a single Form 1120-S for the full calendar year 2026 — no short-year return for OldCo
• This return includes: Rossi Manufacturing’s pre-reorg operating income (Jan–date of F Reorg), the deemed asset sale gain from the closing (allocated per §1060), transaction deductions, and post-closing investment income
• Attach Form 8869 (QSub Election) if not already filed
• Attach a complete 1060 asset allocation schedule (consistent with the buyer’s Form 8594)

Form 8594 (Asset Acquisition Statement Under §1060)

• Both buyer and seller must file Form 8594 with their respective tax returns, consistently reflecting the agreed purchase price allocation across the seven asset classes
• This is non-negotiable, discrepancies between buyer and seller filings are an IRS red flag

Form 6252 (Installment Sale Income)

• If Marco elects installment treatment on the earnout, he files Form 6252 in the year of sale to establish the gross profit ratio and recognize the Year 1 installment gain

Marco’s Form 1040

• Reports his Schedule K-1 income from HoldCo (which includes the massive gain from the deemed asset sale)
• Reports his §721 rollover contribution (note: this is a nontaxable event , but the contribution to the partnership must be disclosed)
• Files Form 8949 / Schedule D for capital gains reporting
• Makes estimated tax payments — Marco will likely need a Q4 catch-up payment if the deal closes late in the year to avoid penalties

State Returns

• HoldCo must notify state taxing jurisdictions of the name/structure change from OldCo to HoldCo
• The gain from the deemed asset sale flows through to Marco’s state return(s) — multi-state allocation rules may apply depending on where the business operated
• Coordinate timing and matching of pass through entity taxes

Subsequent Years (2027, 2028, 2029…)

HoldCo — Form 1120-S (Annual)

• Reports passive investment income from PE partnership interest (K-1 from the PE fund)
• Reports earnout payments received — picks up installment gain per Form 6252 gross profit ratio
• Distributes net cash to Marco and issues him a Schedule K-1
• Watch for S corp passive income rules — if HoldCo has accumulated Subchapter C E&P (from any prior C corp years) and more than 25% of gross receipts are passive, HoldCo could face the excess net passive income tax and potentially lose its S election after three consecutive years

Marco’s Form 1040 (Annual)

• Reports HoldCo K-1 income (ordinary income and capital gains as applicable) including PE partnership K-1 (his allocable share of partnership income/loss) and installment sale gain from earnout payments

Form 6252 — Installment Gains (Years 2, 3, 4)

• Filed each year an earnout payment is received
• Reports the gain component based on the gross profit percentage established in Year 1
• If earnout is not received in a given year — no loss allowed in that year; basis is simply suspended

Eventually — When HoldCo Winds Down

• If/when Marco sells his PE partnership interest (the rolled equity) at the next PE exit, the deferred §721 gain is fully recognized at that time
• HoldCo can be dissolved and its S election terminated after all assets are distributed — final Form 1120-S filed
• Consider a formal plan of dissolution to manage the timing of income recognition and distributions

The F Reorg vs. 338(h)(10) — Quick Reference

Factor

F Reorganization

§338(h)(10)

Buyer entity type

Any — LLC, partnership, PE fund

Must be a corporation

Minimum acquisition %

None — even 51% works

Must acquire ≥80%

Tax-deferred rollover

✅ Yes — via §721

❌ No — roller is fully taxed

S election validity risk

Neutralized — step-up via asset mechanics

Entire deal at risk if S election has defect

Business continuity (EIN, contracts)

✅ Preserved

Generally disrupted

Complexity

Higher — precise sequencing required

Simpler execution

Best for

PE buyer, rollover equity, any acquisition %

Strategic/corporate buyer, 100% clean deal

The Six F Reorg Requirements (Don’t Skip These)

Treasury Regulation §1.368-2(m) is not a suggestion box. All six requirements must be satisfied:

1. All stock of HoldCo (resulting corporation) must be distributed in exchange for stock of OldCo (transferor corporation)
2. Identical ownership — same shareholders, same proportions before and after
3. HoldCo must have no pre-existing assets or tax attributes prior to the reorganization
4. OldCo must completely liquidate for federal tax purposes (the QSub election accomplishes this)
5. HoldCo (resulting corporation) must be the only acquiring entity
6. OldCo (transferor) must be the only acquired entity — no combining multiple corporations into one F Reorg

Miss any one of these and you don’t have an F Reorg — you have a very expensive mess. Non è una cosa bella.

What You Need to Do Right Now

If you’re an S corporation owner with a business worth $5M or more, and M&A is anywhere on your radar in the next 1-5 years, here is your action list:

• Audit your S corp election history. Have your tax advisor review every year of S corp status for potential defects — ineligible shareholders, second-class-of-stock issues, improper transfers. Find and fix problems before buyers do.
• Get your basis analysis done. Know your stock basis, inside basis on key assets, and potential §1374 built-in gains exposure. These numbers drive your tax modeling.
• Define your rollover equity goals. How much do you want to keep in the deal? 10%? 20%? 30%? That decision shapes your structure and your HoldCo management strategy.
• Think about the earnout before you negotiate it. The tax structure of an earnout can cost you real money if handled wrong. Don’t let the banker negotiate it without tax counsel at the table.
• Plan for HoldCo life. The entity you’re holding after closing — your new “family office” — deserves a plan. What goes into it, what comes out, how long it lives. Make it work for you.

The F Reorganization has become the dominant pre-closing structure for middle-market S corp M&A transactions precisely because it solves the biggest pain points of the 338(h)(10) — buyer entity restrictions, rollover equity limitations, and S election validity risk — while delivering the same core benefit: a full step-up in tax basis for the buyer. When it’s executed correctly, everybody wins. When it’s executed poorly… well, there’s a reason your humble tax advisor sleeps lightly the week before a major deal closes.

Interested in learning more? Rob’s books — “A Framework for Growth” and “The Cordasco Compass” — are available at robcordasco.com and on Amazon. For questions about your specific situation, reach out to us at [email protected].

Grazie Mille, Ciao!