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Know Your IRC State Rules Tax Considerations
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. Taxand US discusses the impact the decision to make an IRC Section 338(h)(10) election both from a federal and from the state's point of view may have on a business.
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 recognise gain or loss on the actual sale of stock. Instead, the gain or loss on the deemed asset sale is recognised by the target S corporation or on the consolidated federal Form 1120 of the selling corporation's affiliated group.
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 analysing 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 non business income?
- How is the gain on the sale of the assets treated for apportionment purposes?
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 non business 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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