California Opinion Addresses Implications of Stock Sale and Election Under IRC 338(h)(10)

March 30, 2022

At a glance

  • The main takeaway: The state of California determined that a sale of stock sale with an election under IRC 338(h)(10) to treat the transaction as a sale of assets for income tax purposes required the inclusion of the contingent earnout income and the exclusion from the sales factor of the receipts from the deemed asset sale.
  • Assess the impact: Failure to accurately address state income tax issues such as the treatment of any installment income and the inclusion or exclusion of the sale proceeds in the computation of the sales factor can result in unexpected liabilities and penalties.
  • Take the next step: Aprio’s State and Local Tax (SALT) Team has experience with a variety of sales transactions and can help your business identify opportunities to avoid penalties and minimize potential state income tax consequences.

Schedule a free consultation today to learn more!

The full story:

Recently, the California Office of Tax Appeals (OTA) issued an opinion addressing the income tax implications of a company’s sale of stock and election under Internal Revenue Code (IRC) § 338(h)(10) to treat the transaction as a deemed sale of assets.

The taxpayer, and S corporation, is in the business of selling garage doors and does business in several states, including California. In November 2013, the taxpayer and its shareholders entered into a transaction whereby the shareholders sold their stock for an initial fixed price plus a contingent earnout of up to $50 million based on meeting specific earnings thresholds. The parties elected to treat the sale as a deemed sale of assets pursuant to IRC § 338(h)(10).

Since the transaction resulted in the close of the taxpayer’s 2013 tax year, the taxpayer filed a final California tax return and apportioned its income based on the state’s single sales factor method.[1] In addition to reporting $285 million of sales from its regular trade or business activity (of which $23 million of sales were attributed to California), the taxpayer also included $101 million of fixed proceeds from the sale transaction (of which $22,000 was assigned to the California numerator). 

In subsequent years, the buyer made earnout payments to the sellers totaling about $33 million. No income from the earnout was included in California taxable income by the taxpayer or the shareholders.

The state assessed the taxpayer and shareholders for the 2013 tax year for additional income tax resulting from the inclusion of the earnout income[2] and the exclusion of the receipts from the deemed asset sale from the sales factor.

Issue 1 – Inclusion of Earnout in the Taxpayer’s 2013 Short Tax Year

California’s tax statutes require that when a taxpayer reports income from a sale but ceases to be subject to tax before all the income from the sale is reported, then the taxpayer must include the unreported income in the taxpayer’s final California return.[3]

In this case, the earnout is treated as part of an installment sale, but the 338(h)(10) election results in the S-corporation taxpayer as being treated as a different corporation following the transaction. Therefore, the taxpayer’s final California return was for the short tax year ending on the date of the transaction in 2013. The fact that the taxpayer continued operations after the transaction as a C-corporation did not change the fact that the selling S-corporation taxpayer ceased to exist for tax purposes after the sale.

The amount of the contingent earnout to be included in the taxpayer’s final tax return is the fair market value of the earnout at the time of distribution less any basis. Based on the taxpayer’s earnings growth in the years prior to the sale, it appeared that the taxpayer would achieve the thresholds required to receive the maximum earnout payment. Therefore, the Court agreed that inclusion of the actual earnout received was reasonable, and the taxpayer was not able to establish that such amount was in error.

Issue #2 – Exclusion of Sale Proceeds from the Sales Factor[4]

For purposes of California’s sales factor computation, the regulation provides for the exclusion of “substantial amounts of gross receipts aris[ing] 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.”[5]

Based on this rule, the Court agreed that it was proper to exclude the proceeds from the sale factor and that the taxpayer had not supported its assertion that such exclusion would create a distortive sales factor. In fact, exclusion of the sale proceeds from the sales factor resulted in an apportionment percentage of approximately 8% (as opposed to about 6% with inclusion of the sale proceeds), which was more in line with the taxpayer’s sales factor in the years prior to the sale.

The bottom line

When a business sale occurs, there are several important state income tax issues that need to be addressed, including the treatment of any installment income, whether the income from the sale will be treated as business or non-business income and whether the proceeds are included or excluded from the sales factor. Aprio’s SALT team has experience with these issues, and we work with businesses to identify opportunities to minimize the state income tax consequences of these transactions. 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.

This article was featured in the March 2022 SALT Newsletter.

For more information contact Jeff Glickman at [email protected] or call 770-353-4791.

[1] For tax years beginning on or after January 1, 2013, California required that taxpayers use a single sales factor apportionment method; previously, the state utilized a three-factor double-weighted sales factor apportionment formula.

[2] The amount of earnout included was approximately $31 million, based on the $33 million actually received less the taxpayer’s basis.

[3] Cal. Rev. & Tax Code § 24672(a). Without such a rule, any proceeds received in subsequent years by the selling shareholders may not be reported to California if those shareholders no longer have a California filing obligation after selling the company.

[4] The Court concluded that the income from the deemed sale of assets, which consisted mainly of the sale of goodwill, constituted apportionable business income. The discussion of that issue is not addressed in this article.

[5] Cal. Reg. 25137(c)(1)(A). Under the regulation, a sale is substantial if its exclusion results in a five percent or greater decrease in the sales factor denominator.


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.

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About the Author

Jeff Glickman

Jeff Glickman is the partner-in-charge of Aprio, LLP’s State and Local Tax (SALT) practice. He has over 18 years of SALT consulting experience, advising domestic and international companies in all industries on minimizing their multistate liabilities and risks. He puts cash back into his clients’ businesses by identifying their eligibility for and assisting them in claiming various tax credits, including jobs/investment, retraining, and film/entertainment tax credits. Jeff also maintains a multistate administrative tax dispute and negotiations practice, including obtaining private letter rulings, preparing and negotiating voluntary disclosure agreements, pursuing refund claims, and assisting clients during audits.

(770) 353-4791