How do states treat an S corporation's 338(h)(10) election?

The conforming-state baseline

Where a state recognizes the federal S election and conforms to Section 338(h)(10), the federal fiction carries through: the target is treated as having sold its assets and liquidated, and the stock sale disappears. The gain lands first at the entity, where S corporation states with an entity-level tax collect it; California's 1.5 percent franchise tax on S corporation net income is the standard example, so the deemed asset gain bears 1.5 percent at the entity on its California-apportioned share before anything reaches the shareholders. The gain then flows through, retaining its character and its apportionment: each shareholder picks up a distributive share of gain sourced according to the entity's factors, not the shareholder's residence. That last point is the entire economics for nonresident sellers. A shareholder residing in a state with no personal income tax pays nothing on a stock sale, but pays tax in every state where the target's deemed asset gain is apportioned once the election is made, and a seller who agrees to the election without a gross-up has donated that difference to the buyer's basis step-up.

Apportioning the deemed sale

The deemed asset sale is usually the largest receipt in the company's history, and the reflex to throw it into the sales factor denominator is wrong in many states. California excludes substantial gross receipts from an occasional sale of fixed assets or other property held or used in the regular course of business (18 CCR Section 25137(c)(1)(A)); a sale is substantial if excluding it reduces the sales factor denominator by five percent or more, tested for the combined reporting group where one exists, and occasional if it is outside the normal course of business and infrequent. The deemed asset sale's proceeds are gross receipts under California's statutory definition (Revenue and Taxation Code section 25120(f)(2)), measured at the gross amount realized rather than the gain, so the five percent test is usually met with room to spare. Where both tests are met, the receipts come out of the factor entirely, and the gain is then apportioned using the factor the target built from its ordinary operations through the closing date. Many states have a comparable occasional or incidental sale rule; some do not, and in a state that includes the proceeds, the factor may be diluted in a way that helps or hurts depending on where the deal receipts would be sourced. The state-by-state factor analysis is therefore not compliance trivia; it moves the sourcing of the entire gain, it is the kind of assumption a counterparty's model may have made silently, and it deserves independent verification against each state's own rule rather than an assumption that every state mirrors the biggest one.

The jurisdictions that say no

Not every jurisdiction plays along. New York City is the standing example: the city has never recognized the federal S election, so an S corporation is taxed as a C corporation for city corporate tax purposes, and because city taxable income is computed as though no S election were in effect, the better reading is that a Section 338(h)(10) election that rides on S status does not convert the transaction for city purposes. In such a jurisdiction the deal remains what it actually was, a stock sale: the target recognizes no gain there, the shareholders' stock gain is an intangible generally sourced to their residences, and, the half that buyers forget, there is no step-up in that jurisdiction, so the future depreciation and amortization the buyer modeled does not exist for that tax. Pennsylvania is the canonical nonconformity for the individual shareholder, and it works by a different mechanism that is easy to miss because half the state conforms. Pennsylvania recognizes S corporations, and its corporate net income tax follows the federal treatment of a Section 338(h)(10) election, so the entity-level analysis runs the way a practitioner would expect. The personal income tax does not follow. The Pennsylvania Department of Revenue's Personal Income Tax Guide states that no provision of the personal income tax law permits gain on the sale of stock to be treated as gain on the sale of the corporation's assets, so the deemed asset sale is reversed for personal income tax purposes and the transaction is reported as what it was in form, a sale of stock. The consequence is a Pennsylvania personal income tax return that departs from the federal return on the central fact of the deal, while a corporate net income tax return in the same state tracks it, which means the entity-level and shareholder-level analyses in Pennsylvania have to be run separately rather than assumed to move together. That reversal lands on the individuals who sign the purchase agreement, which is why it belongs in the grid before a gross-up is priced rather than after, and why an analysis that treats New York City as the whole of the nonconformity problem has looked only at the half that costs the buyer.

Qualified subchapter S subsidiaries add a second layer of the same problem: in states that do not recognize QSub status, the subsidiaries are regarded entities with their own filing obligations, and the deemed asset sales at their level produce entity-level consequences in those states even where the parent-level analysis runs cleanly. A deal model that shows one national answer for a multi-entity S corporation structure has almost always missed one of these jurisdictions.

The deemed liquidation and the loss that goes nowhere

The election's final step is a deemed liquidation of the target, and where a shareholder's outside basis exceeds its share of inside basis, as with stock purchased from a prior owner or inherited with a stepped-up basis, the liquidation produces a shareholder-level capital loss, because outside basis, increased by the flow-through gain, exceeds the liquidation proceeds. Where outside basis tracks inside basis, the flow-through gain raises outside basis to about the liquidation proceeds and no material loss results. Federally, where a loss arises, it nets against the flow-through gain and the arithmetic is tidy. For state purposes the netting should not be assumed. The flow-through gain is apportioned business income sourced by the entity's factors; the liquidation loss arises from the disposition of stock, an intangible, and is arguably sourced separately to the shareholder's state of residence. A nonresident shareholder in a no-tax state may therefore be taxed in the entity's states on the gross flow-through gain while the offsetting loss lands, uselessly, at home. Any model that presents the state tax on the net figure has embedded a position on this sourcing question, and the seller pricing a gross-up should test that position rather than inherit it, because the difference between gross-gain and net-gain state taxation can be the largest single number in the negotiation.

Practice notes

The working method is a jurisdiction grid built before anyone signs: for each state and city where the target or its subsidiaries file, whether S status and the election are recognized, whether an entity-level tax applies, how the deemed sale enters or exits the factor, and where each shareholder's gain and loss items land. The election is made or broken at the shareholder level, so the seller-side analysis should always be run per shareholder, per residence, and the gross-up clause should be drafted against the grid rather than against a single blended rate. On the buyer side, the step-up should be valued jurisdiction by jurisdiction too, because paying for basis that a non-conforming city will never allow overprices the election. Alternative structures for closing the gap between stock-sale sellers and asset-basis buyers exist, but each carries its own body of law and examination risk and deserves its own analysis rather than adoption from a slide. And whatever is agreed, the target's final-period returns should be prepared by someone holding the deal documents, because the deemed sale, the factor exclusion, and the short period they create are where compliance separated from the transaction goes wrong. G&G State Tax Group provides multistate transaction tax analysis, including the state treatment of Section 338(h)(10) elections, alongside its state and local tax practice.