The California Office of Tax Appeals (OTA) recently sustained the Franchise Tax Board’s (FTB) income tax treatment of an IRC 338(h)(10) election. In return for all the outstanding stock in the target S-Corporation taxpayer, third-party buyers paid an initial (fixed) purchase price and agreed to make deferred contingent earnout payments totaling up to $50 million if the taxpayer’s earnings exceeded certain thresholds during the three years immediately following the transaction. The earnout payments ultimately totaled more than $33 million.
The OTA made three determinations regarding the transaction:
- The unreported installment gain should be accelerated for inclusion in the taxpayer’s taxable income for the final short tax year. While a taxpayer generally recognizes gain in the year received under the installment method, California law provides an exception which includes such installment income in the measure of tax for the last year the taxpayer is subject to California tax. Acceleration was warranted even though the taxpayer continued California business operations as a C corporation. This is because when an IRC 338(h)(10) election is made, the corporation is treated as if it sold its assets, liquidated, and ceased to exist, and thus the subsequent C-Corporation was a different entity.
- The income from the deemed asset sale relating to intangibles such as goodwill and going concern value constitutes business income because these assets were integral to the taxpayer’s regular trade or business operations and thus satisfied the “functional” test for business income.
- Gross receipts from the deemed asset sale should be excluded from the taxpayer’s sales factor pursuant to Regulation section 25137(c)(1)(A) as receipts arising from a substantial and occasional sale. As a result, the taxpayer was required to exclude the fixed portion of the sale amount from the sales factor numerator and denominator. This increased the taxpayer’s California sales factor apportionment percentage and California taxable income, resulting in a tax liability.
Finally, the OTA determined that the taxpayer was not entitled to alternative apportionment. The taxpayer argued that excluding the gross receipts from the sales factor while including the corresponding net gain in its apportionable tax base was distortive and did not fairly reflect the extent of the taxpayer’s California business activity during the period that the value of the intangible assets were generated. The OTA evaluated the distortion arguments under both the qualitative and quantitative approaches, as well as for reasonableness. The OTA held that it was not necessary to include the gross receipts from the sale of goodwill in the apportionment factor for the year at issue to represent the gradual effects of the buildup of the goodwill’s value over several years as such value was already represented within the regular sale of inventory. The OTA also held that the deemed sale of assets was substantial and occasional and it would be distortive to treat the proceeds from this transaction the same as proceeds from the taxpayer’s regular business operations.