How does California treat a Section 338(h)(10) election, and where does the gain land in the sales factor?
Edvin Givargis Published 12 minute read
The short answer
California follows the federal fiction. When the seller and buyer of an S corporation, or of a C corporation that is a member of an affiliated group, jointly elect under Internal Revenue Code section 338(h)(10) to treat a stock sale as a deemed asset sale, California disregards the stock transaction and taxes the deemed sale of assets as if it actually happened. That conformity runs through the state's general incorporation of federal Subchapter C at Revenue and Taxation Code section 24451, and for S corporations it is locked in further by section 23806, which bars a separate state-only election and simply follows whatever was elected federally. Once the deemed sale is on the table, the resulting gain, to the extent it is business income, gets apportioned like any other business income: tangible personal property under the destination rule of section 25135, everything else, including the deemed sale of intangibles such as goodwill, under the market-based rule of section 25136. But a large one-time disposition can distort the sales factor badly, so where the gain is substantial and occasional within the meaning of California Code of Regulations, title 18, section 25137(c)(1)(A), it drops out of the sales-factor fraction even though it remains taxable business income. Layered on top of all that, an S corporation target still owes California's 1.5 percent entity-level tax on its net income, deemed sale gain included, and the shareholders still pick up their pro rata share on their own returns. None of this applies to a plain stock sale with no election: stock is intangible personal property under section 17952, and a nonresident seller's gain from selling it generally is not California-source income at all, absent a business situs in the state.
Conformity: how California picks up the deemed asset sale
Section 338(h)(10) is a federal mechanic, not a state one. It lets the buyer and seller in a qualifying stock purchase, where the target is an S corporation or a member of a selling consolidated or affiliated group, jointly elect to have the transaction treated for federal tax purposes as if the target sold all of its assets to an unrelated buyer in a single transaction and then liquidated, rather than as a sale of stock by the shareholders. The buyer gets a stepped-up basis in the target's assets; the seller reports gain on a deemed asset sale instead of a stock sale.
California's conformity to that fiction is not a special 338(h)(10) statute. It is a byproduct of the state's general incorporation of federal corporate tax law. Section 24451 provides that Subchapter C of the Internal Revenue Code, the subchapter covering corporate distributions and adjustments and the subchapter in which section 338 sits, applies for California purposes except as otherwise provided. For S corporations specifically, section 23806 removes any doubt: it treats a valid federal section 338 election as automatically effective for California purposes, and it expressly disallows a separate state-only election under the general conformity carve-outs found in section 23051.5(e) and, for the personal income tax side, section 17024.5(e). Put simply, there is no California 338(h)(10) election to separately make or separately revoke. Whatever was elected federally controls.
This chain is confirmed by the Franchise Tax Board's own internal S Corporation Manual, which devotes a full chapter to the sale of stock and the section 338(h)(10) election. That manual is an internal procedures document, not a regulation or a published ruling, so it carries no independent legal weight and is not citable as authority; it is noted here only as non-precedential, persuasive confirmation that the department reads the conformity statutes the same way this analysis does, not attributed to any individual staff position, and not dispositive of anything.
The analysis here is limited to a joint section 338(h)(10) election. A unilateral section 338(g) election presents a materially different apportionment picture depending on whether Old Target was a standalone corporation, the common parent of a consolidated group, or a member of a consolidated group filing a "one-day" return for the deemed sale, and those variations sit outside the scope of this discussion. A reader working through a 338(g) fact pattern should not assume anything here translates directly.
Turning the deemed sale into apportioned business income
Once the stock sale is disregarded and the transaction is treated as an actual sale of the target's assets, the next question is how California taxes the resulting gain. To the extent the gain constitutes business income under the standard functional and transactional tests, it does not get specially allocated to any one state; it becomes part of the apportionable tax base and is apportioned using the target's regular formula.
The mechanics split along the same tangible and intangible line that governs any other apportionment question. Gain attributable to the deemed sale of tangible personal property is sourced under section 25135, which assigns sales of tangible personal property to California if the property is delivered or shipped to a California purchaser, regardless of the shipping terms, or shipped from a California location under the statute's dock-sale provisions. Gain attributable to everything else, real property, intangibles, and the deemed sale of the business as a going concern, including goodwill, is sourced under section 25136's market-based rules, which look to where the benefit of a service is received, where intangible property is used, and, for marketable securities, where the customer is located. The practical effect is that a deemed asset sale under a joint 338(h)(10) election tends to source gain to wherever the target's underlying business activity sits, often, though not automatically, into California for a target with California operations, and potentially into other states if the target's business was itself multistate. That is a meaningfully different result from a straight stock sale, where the gain typically never touches an apportionment formula at all.
The occasional sale exclusion from the sales factor
Business income gets apportioned, not allocated, but a single transaction that dwarfs a taxpayer's ordinary receipts can distort the apportionment percentage badly if it is simply added to the sales factor along with everything else. California's answer to that problem is the occasional sale rule at 18 California Code of Regulations section 25137(c)(1)(A). Where substantial amounts of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business, those gross receipts are excluded from the sales factor, without any separate showing that the standard formula produces a distorted result. The regulation supplies its own tests for both words: a sale is substantial if excluding it from the sales factor changes the denominator by five percent or more, and a sale is occasional if it falls outside the taxpayer's normal course of business and happens infrequently. The regulation's own illustrative examples, the sale of a factory, a patent, or an affiliate's stock, line up closely with a business sale effected through a 338(h)(10) election. The Franchise Tax Board reached the same conclusion in Legal Ruling 1997-1, applying the fixed-asset occasional-sale principle to an incidental or occasional sale of intangible property and excluding those gross receipts from the sales factor on the same reasoning.
The exclusion is worth being precise about, because it is easy to overstate. It removes the transaction's gross receipts from the sales-factor fraction; it does not remove the gain from the tax base. A target that clears both tests still reports and pays tax on the full apportioned share of its deemed sale gain. What changes is which apportionment percentage applies to that gain, since a one-time transaction that would otherwise swing the sales factor sharply in one direction is taken out of the calculation instead. Whether a particular 338(h)(10) transaction clears both tests is a facts-and-circumstances question, most obviously on the substantiality side, where the five-percent threshold is measured against the taxpayer's own sales-factor denominator and varies from one target to the next.
The S corporation layer: entity tax and shareholder flow-through
Section 338(h)(10) is the classic S corporation transaction, since an S corporation target does not need to be part of an affiliated group the way a C corporation target does. That makes the entity-level consequences worth stating plainly. An S corporation remains subject to California's franchise or income tax at the reduced 1.5 percent rate under section 23802, and that tax applies to the corporation's net income, which includes the deemed sale gain generated by the 338(h)(10) election. If the target was previously a C corporation, or acquired assets from one, within California's built-in-gains recognition window, a separate built-in-gains tax under section 23809 can also apply; that section conforms to the federal built-in-gains mechanism of Internal Revenue Code section 1374 but substitutes a ten-year California recognition period for the shorter five-year period currently used at the federal level, so a transaction that has cleared the federal recognition window can still sit inside California's.
Above the entity-level tax, the apportioned gain flows through to the shareholders pro rata and keeps its character and sourcing as it flows. California courts have been consistent on this point outside the 338(h)(10) context specifically: a shareholder's or partner's distributive share of an entity's business income is sourced at the entity level using the entity's own apportionment factors, not reallocated based on the owner's residence or domicile. The Court of Appeal applied that principle directly to an S corporation sale transaction in The 2009 Metropoulos Family Trust v. Franchise Tax Board, holding that a nonresident trust shareholder's share of gain from the S corporation's disposition of a subsidiary retained its character as apportionable business income sourced to California under the entity's own apportionment, rather than allocated away under the intangible-property sourcing rule that otherwise protects a nonresident's investment income. The same entity-level reasoning appears in the older partnership case Valentino v. Franchise Tax Board. The upshot for a 338(h)(10) transaction: an out-of-state shareholder does not get to treat deemed sale gain as personally sourced to home state simply by having never lived in California; the S corporation's own business income characterization and apportionment travel with the gain onto the shareholder's return.
When there is no election: the stock sale baseline
All of the above depends on the election actually being made. Without it, a sale of S corporation or C corporation stock is exactly what it looks like: a sale of stock, and stock is intangible personal property. For a nonresident individual seller, section 17952 governs, and it is a narrow rule: income of a nonresident from stocks, bonds, notes, or other intangible personal property is not California-source income unless the property has acquired a business situs in the state, or the nonresident is regularly and systematically trading such property in California to a degree that amounts to doing business here. For the ordinary case of a nonresident individual selling stock in a company, that means the gain generally is not taxed by California at all, regardless of where the target company operates.
That baseline is exactly what makes the 338(h)(10) election such a consequential choice from a state tax planning perspective, and exactly why Metropoulos is worth keeping in mind even outside the S corporation context: the label on a transaction does not control. A transaction that looks like a stock sale but is recharacterized, whether by an affirmative federal election or by the underlying economics of what was actually sold, can lose the benefit of section 17952's narrow sourcing rule and land squarely inside the apportionment machinery instead. The choice to make, or not make, a joint 338(h)(10) election is therefore not just a federal basis-step-up decision; for any seller with a state tax profile worth thinking about, it is a decision about whether the transaction remains outside California's reach or walks directly into it.
Practice notes
The recurring point worth remembering is that section 338(h)(10) does two things at once from a California perspective: it changes what was sold, from stock to assets, and by changing what was sold it changes which sourcing regime applies, from the narrow intangible-property rule that protects most nonresident stock sales to the full apportionment regime that reaches business income wherever it is earned. Both halves of that shift are settled by conformity statutes and are not really open to debate once the federal election is validly made. What takes more judgment is the second-order question, whether the resulting gain clears the substantial and occasional tests for the sales-factor exclusion, since that turns on the specific taxpayer's numbers and cannot be answered in the abstract. An S corporation target adds a further layer that a straight asset sale by a C corporation would not: the 1.5 percent entity-level tax, a possible built-in-gains tax if the target has C corporation history inside California's ten-year window, and the entity-level apportionment that follows the gain onto every shareholder's return regardless of where that shareholder lives. None of this reaches a 338(g) unilateral election, which was intentionally left out of this analysis and should be evaluated on its own terms, particularly around one-day-return situations where the occasional sale mechanics do not translate directly.
This article states the law as of September 19, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group to confirm what has changed since this was written and how the rules apply to a specific situation.
G&G State Tax Group, LLC is a state and local tax advisory firm. The firm provides state and local tax consulting and representation in state and local tax controversies. G&G does not prepare or file tax returns, perform attest services, or provide bookkeeping, and is not a CPA firm.