Many buyers and sellers of businesses do not consider state income tax consequences until after a deal has been completed. Ignoring state tax considerations at the outset of a transaction may put you in an adverse negotiation position, particularly in a deemed asset sale under Internal Revenue Code (IRC) Section 338(h)(10). It may come as a surprise that significant state taxes can result from such an election.
Elections under IRC Section 338(h)(10) typically provide federal and state tax benefits for the buyer. However, in some states they can create worrisome results. Such elections may raise concerns about federal conformity, the proper classification of gains as apportionable or allocable income, and inclusion in the income tax apportionment formula. Thus, buyers and sellers alike should carefully consider the state tax implications associated with any IRC Section 338(h)(10) election.
What Is an IRC Section 338(h)(10) Election?
An IRC Section 338(h)(10) election is available when one corporation is purchasing the stock of either an S corporation or a C corporation that is a member of an affiliated group of corporations. Generally, the consequences of the election are that the sale of stock is disregarded and treated as a deemed asset sale for income tax purposes. As such, the seller does not recognize gain or loss on the actual sale of stock. Instead, the gain or loss on the deemed asset sale is recognized by the target S corporation or on the consolidated federal Form 1120 of the selling corporation's affiliated group.
The IRC Section 338(h)(10) election is made when the buyer desires a stepped-up basis in the purchased assets, but wants to avoid the added complications generally associated with an asset sale. While the election results for federal income tax purposes are typically advantageous for the buyer, the seller is usually at a disadvantage because of the higher tax cost. Therefore, the buyer generally has to gross up the seller for the incremental tax cost related to the IRC Section 338(h)(10) election. Varying state income tax treatment of the IRC Section 338(h)(10) election must be considered to determine the overall benefit, including the adequate compensation to the seller, of making such election.
States' Positions on the Election Under IRC Section 338(h)(10)
Most states conform to the federal treatment of IRC Section 338(h)(10) and allow the federal election to stand for state income tax purposes. However, as with many federal concepts, several states have exceptions or modifications to the federal tax consequences of IRC Section 338(h)(10). When analyzing the state tax consequences of an IRC Section 338(h)(10) election, a company should consider, among other matters, the following as points of emphasis:
- Does the state conform to the federal treatment of the IRC Section 338(h)(10) election?
- Is the gain on the sale of the assets treated as business or nonbusiness income?
- How is the gain on the sale of the assets treated for apportionment purposes?
The considerations mentioned above may have a significant impact on the desirability of making an election to treat a stock sale as a deemed asset sale.
Most states follow the federal tax treatment of the IRC Section 338(h)(10) election simply because the starting point for determining state taxable income is federal taxable income, which would include the gain or loss from the deemed asset sale under IRC Section 338(h)(10).
Certain states, however, have statutes or regulations that specifically address the state tax treatment or consequences of an IRC Section 338(h)(10) election. For instance, Pennsylvania provides that taxable income generated as a result of a Section 338 election is subject to Pennsylvania Corporate Net Income Tax and treated as business income subject to apportionment, if the taxpayer was entitled to apportionment for the taxable year ending immediately prior to the acquisition date. Furthermore, the income consequences of a Section 338 election are reflected on a separate company basis and not as part of a combined or consolidated report.
While most states generally conform to the federal rules, a few states deviate from the federal rules in significant ways. For example, California and Wisconsin permit the parties to make an IRC Section 338(h)(10) election for state tax purposes regardless of whether an election was made for federal income tax purposes.
The various state income tax consequences of the IRC Section 338(h)(10) election may make the analysis quite frustrating, but they may also create unique planning opportunities based on a state's position on the gain or loss from the deemed sale of assets as business or nonbusiness income.
Business vs. Nonbusiness Income
Nonbusiness income is typically assigned or allocated to the state in which the asset is located or to the taxpayer's state of domicile. On the other hand, business income is generally apportioned among the states in which the taxpayer conducts its business activities. States that decouple from the federal treatment of the IRC Section 338(h)(10) election generally treat the gain from sale of stock as nonbusiness income and source such gain to the taxpayer's state of domicile. However, the proper classification of the gain from a deemed sale of assets under IRC Section 338(h)(10) is uncertain in many states.
Many states take the position that the gain from the sale of assets under IRC Section 338(h)(10) should be business income apportionable to states in which the taxpayer conducts business. However, this approach has been questioned. For instance, the treatment of the gain or loss from a deemed asset sale has been determined by case law in Missouri and New Jersey. In ABB C-E Nuclear Power, Inc. v. Director of Revenue (Missouri) and McKesson Water Products Company v. Director, Division of Taxation (New Jersey), it was determined that gains from the deemed sale of assets under IRC Section 338(h)(10) constituted nonbusiness income.
The fact that gains resulting from IRC Section 338(h)(10) elections may be treated as business income in one state and nonbusiness income in another provides the opportunity for state tax planning. For example, if the target's assets are located in a state that treats the gain from a deemed asset sale as business income, the state would generally only impose tax on the gain apportioned to that state. If the target also has nexus with a state that treats the gain as nonbusiness income or a state that decouples from the IRC Section 338(h)(10) election, the taxpayer may not be subject to tax on the part of the gain that otherwise would be apportioned there.
IRC Section 338(h)(10) Gains for Sales Factor Purposes
When a company has a gain from a deemed asset sale under IRC Section 338(h)(10), a determination must be made as to the amount of the gain that should be included in the sales factor of the apportionment formula.
Most states apply their standard apportionment rules to the target corporation's deemed asset sale. Thus, the gross receipts from the deemed asset sale are generally included in the target corporation's sale factor. Certain states, however, provide special apportionment rules for an IRC Section 338(h)(10) election. For instance, Wisconsin provides that the deemed sale of inventory should be included in the old target corporation's sales factor. However, the gain or loss on the deemed sale of the old target's other tangible assets is not included in its sales factor. Given the lack of uniformity, a determination of the includible amount should be made on a state by state basis.
Alvarez & Marsal Taxand Says:
In most cases, states follow the federal treatment of the IRC Section 338(h)(10) election. Even with the general acceptance of the election by most states, there are still several issues, as discussed above, that may impact the decision to make an IRC Section 338(h)(10) election. A thorough analysis of a state's position on business versus nonbusiness income should be made, along with a subsequent determination of the sales factor and tax attribute treatment under an IRC Section 338(h)(10) election. In any acquisition where an IRC Section 338(h)(10) election is being considered, it is crucial to consider the income tax benefits and detriments not only from a federal perspective but also from a state perspective.
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Emillio E. Martinez, Director, and Cole Flanagan, Senior Associate, contributed to this article.
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