New York: Mandatory S-Corporation Rules Applied Following 338(h)(10) Election

Pursuant to a unique New York provision, a federal S-corporation that did not make a separate New York S-election was treated as a New York S-corporation following a sale of the business in which the parties made a 338(h)(10) election, resulting in a large New York tax assessment against the S-corporation shareholders.

By Kristen Davis, SALT Associate

If there is one thing that those of us dealing with multistate taxes learn – many times throughout one’s career and often the hard way – is that there are always exceptions to the general rules.  For example, while almost all states treat validly electing federal S-corporations as S-corporations for state tax purposes, there are states that require a separate state S-election (such as New York) or do not conform to S-corporation pass-through treatment (such as Texas).  However, sometimes there is an exception to the exception, and a recent New York Division of Tax Appeals decision highlights the unintended tax consequences that may occur if those issues are not addressed in advance.[1]

The taxpayers in the case were individuals that owned two corporations that were treated as S-corporations for federal income tax purposes, but were treated as C-corporations for New York tax purposes because the shareholders did not make the required separate New York S-elections.  None of the shareholders resided in New York, and all but one resided in Florida.  The effect of this tax structure is that for federal income tax purposes, the S-corporations and their shareholders had pass-through treatment (i.e., the shareholders paid federal income tax), but for New York purposes, the corporations paid tax at the entity level and the shareholders did not file New York returns unless they had another source of New York income.

In 2012, the shareholders sold their stock in the S-corporations to the same purchaser, and the purchaser and sellers jointly made an IRC 338(h)(10) election to treat the transaction as a sale of assets for federal income tax purposes.  On their 2012 short-year federal income tax returns, the S-corporations reported a combined gain from the deemed sale of assets of approximately $215 million, which passed-through to the shareholders who paid federal income tax.

For New York tax purposes, the 338(h)(10) election was not followed since the corporations were not treated as S-corporations.[2]  Therefore, the income reported to New York was reduced by the $215 million gain from the deemed sale of assets reported on the federal income tax returns.  Any remaining income subject to apportionment resulted in nominal New York tax liability for the corporations.

Upon audit, the state issued assessments to the individual shareholders for 2012 in the combined amount of over $2 million (including interest and penalties).  The auditor determined that the corporations should have been treated as S-corporations for the 2012 short tax year under the state’s mandated S-corporation election statute.[3]  That statute applies to federal S-corporations whose shareholders have not made a New York S-election (i.e., New York C-corporations).  It states that if the corporation’s investment income is more than 50 percent of its federal gross income, the corporation’s shareholders will be deemed to have made the state’s S-corporation election for such tax year. Investment income means the sum of the corporation’s “gross income from interest, dividends, royalties, annuities, rents and gains derived from dealings in property . . . to the extent such items would be includable in federal gross income for the taxable year.[4]

In this case, since almost all of the gross income reported on the corporation’s federal income tax returns consisted of the gains from the sale of assets pursuant to the 338(h)(10) election, the state determined that the 50 percent test was met.  Therefore, the corporations were treated as S-corporations for New York tax purposes, and the shareholders owed New York income tax on their share of the New York income.

The shareholders argued that the 50 percent test should not be based on the income reported on the federal income tax returns, but instead based on the New York returns filed as if the corporations were New York C-corporations.  Those returns excluded the gains from the deemed sale of assets, leaving basically operational income/loss that did not meet the 50 percent investment income test.  The Administrative Law Judge, after reviewing the statutory language and legislative history, determined that the test was properly calculated based on the income reported on the federal income tax return.

Admittedly, it is difficult for a tax advisor (even those that specialize in state and local taxes) to know the tax rules in all 50 states, and it is impractical for a taxpayer to engage a separate tax advisor in each state in which the taxpayer does business.  However, as this case shows, failure to properly identify and address potential state tax issues can lead to very unfavorable consequences.  In this case, for example, had the shareholders accounted for the New York income tax, they may have been able to negotiate a higher “gross-up” on the purchase price due to the 338(h)(10) election.

Aprio’s SALT team is experienced with the unique state tax issues that may arise when a taxpayer engages in significant transactions outside the normal course of business.  It is often these transactions whose state tax treatment is governed by exceptions to the general rules.  In these cases, it is important to reach out to a tax advisor with specific expertise before engaging in such transactions in order to understand the state tax impact and to ensure that your transactions are properly structured to minimize state taxes.  We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Kristen Davis, SALT associate, at kristen.davis@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the January 2020 SALT Newsletter.

[1] In the Matter of the Petitions of Albert R. LePage, Francoise O. LePage, Ronald A. Jalbert, Mariette Jalbert, and Andrew P. Barowsky, Determination DTA Nos. 828035, 828036, 828037 and 828038 (NY Div. Tax App., Dec. 19, 2019).

[2] C-corporations owned by individuals are not eligible to make a federal 338(h)(10) election.

[3] N.Y. Tax Law § 660(i)(1).

[4] N.Y. Tax Law § 660(i)(3).  This includes the corporation’s share of such income passing through from a partnership, estate or trust.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.