Is the California S corporation tax deductible on the shareholders' California returns?

The tax and where it lands

A California S corporation pays a franchise tax of 1.5 percent of its net income (3.5 percent for a financial S corporation), with the minimum franchise tax as the floor (Revenue and Taxation Code Section 23802), and its income passes through to shareholders under the usual S corporation rules, so the same income is taxed once lightly at the entity and again at the shareholder level. The 1.5 percent figure is not the only entity-level rate in the statute, and the exception matters most in the transaction discussed here. Revenue and Taxation Code Section 23809 taxes the net recognized built-in gain of an S corporation that was a C corporation within the recognition period, which California sets at 10 years, at the rate imposed under Revenue and Taxation Code Section 23151, 8.84 percent, or 10.84 percent for a financial S corporation, and credits may not be applied against that tax. That tax displaces the 1.5 percent tax on the built-in gain rather than adding to it: Revenue and Taxation Code Section 23802(e) removes built-in gains taxed under IRC Section 1374 from the 1.5 percent base, so the entity-level tax for a converted corporation is a two-part computation rather than a single 1.5 percent number. When a stock purchase is made with a Section 338(h)(10) election, the California treatment follows the federal treatment as a matter of incorporation rather than analogy: Revenue and Taxation Code Section 24451 incorporates Subchapter C of the Internal Revenue Code, which includes Section 338, none of the modification sections that follow it alters Section 338, and Section 24451.1 makes the point express for elections, providing that a Section 338 election made for federal purposes binds the taxpayer for California purposes and that no separate California election is permitted. The corporation is accordingly treated as having sold its assets, the deemed sale gain runs through the final S corporation return, the entity-level tax applies to it, and the gain passes through to the selling shareholders. Which entity-level rate applies is a question the parties should settle before the gross-up language is drafted. It is 1.5 percent where the corporation has always been an S corporation. Where the target was a C corporation within the 10-year recognition period, Section 23809 adds a built-in gains tax on the net recognized built-in gain portion of the deemed sale at the Section 23151 rate, 8.84 percent, or 10.84 percent for a financial S corporation, with no credits available against it, and Section 23802(e) removes that gain from the 1.5 percent base. The entity-level tax on the built-in gain portion, 8.84 percent (10.84 percent for a financial S corporation), can therefore run nearly six times the 1.5 percent figure the clause usually assumes, on the same deemed sale gain, because of the target's C corporation history. Purchase agreements in these deals routinely make the buyer responsible for the incremental taxes the election creates, which is what turns the deductibility question from a compliance footnote into a priced term.

The federal wash

For federal purposes the analysis is symmetrical. The entity-level California tax is a deductible state tax in computing the S corporation's income, so the additional amount the buyer funds to cover the tax raises the sellers' proceeds while the tax itself reduces the flow-through income, and the two effects offset. A seller modeling only federal consequences correctly concludes that no gross-up is needed for the entity tax beyond the tax itself. The error is stopping there.

The California mismatch

California builds its personal income tax without the federal deduction. Section 17220 turns off IRC Section 164(a)(3) in the terms quoted above, and for good measure it denies any deduction for taxes imposed under Part 11 of the Revenue and Taxation Code, which is where the S corporation tax lives. The same section also declines the federal limitation on the state and local tax deduction (subdivision (c)), so the California property tax deduction was never capped, and the income tax deduction the cap would have limited does not exist in California at all. The consequence in the deal is a one-way street. The amount the buyer pays to fund the entity tax is additional consideration the selling shareholders must report, their basis computations absorb the entity tax without a corresponding deduction, and, apart from any built-in gains tax, which passes through as a loss, no California deduction offsets the inclusion. Resident sellers therefore pay California personal income tax on money that exists only to pay the corporation's California tax. They are taxed on the tax.

The gross-up arithmetic

Making the sellers whole requires a second payment: compensation for the personal tax on the tax-funding payment. The parties in these negotiations typically compute it one of two ways, and the difference should be a drafting decision rather than a surprise. The single-round computation multiplies the entity tax amount by the sellers' marginal California rate, on the theory that the gross-up itself will not be treated as additional taxable proceeds. The iterative computation divides the entity tax amount by one minus the rate and takes the difference, which compensates for tax on the gross-up, on the tax on the gross-up, and so on, on the theory that every dollar the buyer adds is itself consideration the sellers must report. The iterative number is always larger, the gap grows with the rate, and which formula the agreement calls for should be stated in the tax adjustment provision expressly, because both sides can cite a coherent theory and the difference on a large deemed sale gain is real money.

Practice notes

Three drafting points prevent most of the disputes. First, define the taxes being grossed up: the entity-level tax on the deemed sale, at 1.5 percent plus, where the target's C corporation history reaches into the recognition period, the Section 23809 built-in gains tax, the shareholders' California tax on the inclusion of the payment funding the 1.5 percent tax, and the formula, single-round or iterative, that closes the loop. A clause that names the 1.5 percent rate rather than the entity-level tax as computed will underfund the payment badly in a converted-target deal. Second, sort the sellers: the computation runs on each seller's own facts, resident sellers bear California tax at their marginal rates while nonresident sellers present their own sourcing questions, and a single blended gross-up rate is a negotiation convenience that should be recognized as one. Third, reconcile the returns to the agreement: the final S corporation return, the shareholders' returns, and the tax adjustment schedule should tell one consistent story about who bore which tax, because the gross-up clause will be read again if any of those returns is examined. G&G State Tax Group provides transaction tax analysis, including gross-up and entity-level tax modeling for Section 338(h)(10) sales, alongside its state and local tax practice.