State tax implications of the expanded sec. 338(h) (10) election.

• Author: Ryan, Karen Rauch

Tax planning for corporate acquisitions requires careful analysis of Federal tax implications. All too often, however, an equally thorough analysis of state tax implications is overlooked, with significant adverse consequences to the parties. The 1994 issuance of final Sec. 338 regulations, permitting nonconsolidated affiliates and S shareholders to make Sec. 338(h)(10) elections, dramatically changed the Federal tax rules and materially affected state tax planning.

State Tax Treatment of Sec.

338(h)(10) Elections

If a Sec. 338(h)(10) election is not respected at the state level, the parties' state tax liabilities could be substantial and, in some cases, could "kill" a transaction. While many states generally conform their tax rules to the provisions of the Internal Revenue Code, most states remain fairly silent or vague with respect to their treatment of a Sec. 338(h)(10) election, and only a few have statutes or regulations governing the effect of the election. The expanded scope of the election under the final Sec. 338 regulations has resulted in increased uncertainty. In most cases, therefore, taxpayers must act on the basis of informal guidance from the taxing authorities.

In general, states recognize the underlying Sec. 338(a) election and reflect the deemed asset sale at the target level. Without specific authority to shift the resulting tax liability to the selling group, however, taxpayers in separate-return states should assume that the target will be solely liable for tax resulting from the deemed asset sale. It is very important, therefore, that contracts for sale be drafted with this result in mind.

Over the years, states have taken several differing approaches to the Sec. 338(h)(10) election. For example, Alabama follows Federal treatment for elections made under Sec. 338(a) and (h)(10); accordingly, the gain or loss is recognized by the target on the deemed asset sale, while the gain on the sale of the target's stock goes unrecognized by the parent.

New York has struggled for several years with its policy on Sec. 338(h)(10). In 1987, New York issued TSB-M-87(4)C, which followed Federal tax treatment of a Sec. 338(h)(10) election if the Federal consolidated group was the same as the New York combined group, but defaulted to a Sec. 338(a) election if the groups were not the same. In 1990, however, New York issued a letter ruling that Sec. 338(h)(10) elections would be ignored in all cases and that only Sec. 338(a) elections...