How do states treat an S corporation's 338(h)(10) election?
Edvin Givargis Published 6 minute read
The short answer
Not uniformly, and the differences are usually where the deal economics hide. In states that recognize S corporations and conform to IRC Section 338(h)(10), the election converts the stock sale into a deemed asset sale: the target recognizes the gain, pays any entity-level tax such as California's 1.5 percent, and flows the gain through to shareholders, who are taxed on their apportioned shares wherever the entity did business. In jurisdictions that do not recognize S status or the election, most prominently New York City, the same transaction remains a stock sale: no entity gain, but also no basis step-up for the buyer in that jurisdiction. Layered on top are apportionment questions, since the deemed sale proceeds are often excluded from the receipts factor as a substantial and occasional sale, and a shareholder-level wrinkle, because the deemed liquidation typically produces a capital loss that may be sourced to the shareholder's residence rather than netted against the apportioned gain. For nonresident shareholders in states with no income tax, the election converts a tax-free stock sale into a real multistate liability, which is why the gross-up negotiation is where these deals are actually decided.
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 simply 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 gross receipts from a substantial and occasional sale of a business under its apportionment regulations (CCR Section 25137(c)(1)(A)): where the sale is outside the ordinary course and the receipts are substantial, they 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 exactly 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 simply a C corporation for city corporate tax purposes, and a Section 338(h)(10) election that rides on S status does not convert the transaction. 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. 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 it routinely produces a shareholder-level capital loss, because the shareholders' outside basis, increased by the flow-through gain from the deemed asset sale, usually exceeds the liquidation proceeds. Federally the loss 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 exactly where compliance separated from the transaction goes wrong.
This article states the law as of September 13, 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.