An election under section 338(h)(10) of the Internal Revenue Code is often used to characterize the sale of stock of an S corporation as a deemed sale of all of the corporation’s assets. A proper federal election under section 338 will be deemed a proper election for California tax purposes, unless the taxpayer separately elects otherwise. The election will trigger corporate-level tax at the current rate of 1.5% on the hypothetical sale of assets arising from the election.
The same is not necessarily true in other states, however. For example, the New York Tax Appeals Tribunal recently held that the fictitious deemed asset sale is not applicable to the sale of S corporation stock for New York tax purposes. (See In re Baum, N.Y. Tax App. Trib., Nos. 820837 and 820838, 2/12/09). As such, gain from the deemed asset sale may not be included in the net income of the S corporation for purposes of determining its New York state franchise tax and may not be passed through, pro rata, as New York source income to the shareholders of the S corporation. Conversely, the Georgia Court of Appeals recently held that a sale of S corporation stock coupled with a 338(h)(10) election triggers corporate-level tax for Georgia tax purposes on the deemed asset sale. (See Georgia Dept. of Rev. v. Trawick Construction Co., Ga. Ct. App., No. A08A2323, 2/23/09).
Whenever an S corporation involved in an acquisition is doing business outside of California, this factor should be considered in evaluating transaction structuring alternatives. Note that elections under section 338 are also available upon the sale of a subsidiary in a consolidated group and the relevant state tax treatment of such elections should also be considered.