Does making a federal IRC § 338(h)(10) election disqualify a stock sale from Nebraska's special capital gains exclusion, and which gains still qualify?

Plain-English summary

Nebraska lets qualifying shareholders exclude from state income tax the capital gains from selling capital stock of the corporation they worked for -- the "special capital gains exclusion" (Neb. Rev. Stat. §§ 77-2715.09 and 77-2715.08). This ruling answers what happens to that exclusion when a stock sale is dressed up, for federal tax purposes, as an asset sale via an IRC § 338(h)(10) election.

Two questions, two answers:

1. Does the § 338(h)(10) election disqualify the sale from the exclusion? No. The actual transaction is a sale of stock that would qualify. Making the election doesn't change that. For Nebraska, the federal election is binding, so the seller reports income in the same amount and character as on the federal return.

2. If it still qualifies, which gains can be excluded? Only the gains attributable to the stock. Under § 338(h)(10), the deal is taxed as if "Old Target" sold all its assets to "New Target" at fair market value and then liquidated. In that fiction:

   • Gains from the deemed sale of assets -- ordinary income like depreciation recapture and gains under IRC §§ 1231, 1245, and 1250 -- do not qualify for the exclusion (they're deemed to arise from selling assets), whether or not they flow through to the shareholder.
   • Gains from the deemed liquidation are treated as gains from the sale or exchange of capital stock, so those do qualify and can be excluded.

The takeaway: the election doesn't cost you the exclusion, but it does split your gain -- the asset-level/ordinary pieces are outside the exclusion, and only the stock-level (deemed liquidation) gain is inside it.

What this means for you

Selling shareholders of a Nebraska corporation (and their advisors)

If you qualify for the special capital gains exclusion and your buyer wants a § 338(h)(10) election, you don't have to give up the exclusion to get the deal done. But model the split: depreciation recapture and §§ 1231/1245/1250 gains from the deemed asset sale are taxable in Nebraska (no exclusion), while the capital gain from the deemed liquidation of your stock can be excluded. Because Nebraska follows the federal election's amount and character, your federal § 338(h)(10) computations drive the Nebraska result.

Buyers structuring the acquisition

A § 338(h)(10) election gives you a stepped-up asset basis without, by itself, stripping the seller's Nebraska stock-gain exclusion -- useful context when negotiating price and gross-up.

Common questions

Q: Does electing § 338(h)(10) blow the special capital gains exclusion?
A: No. The election to treat the stock sale as a deemed asset sale does not disqualify the transaction from the exclusion.

Q: Then what part of my gain is actually excluded?
A: Only the capital gain from the deemed liquidation, which is treated as gain from the sale or exchange of capital stock. Gains from the deemed asset sale (IRC §§ 1231, 1245, 1250, and recapture/ordinary income) are not excluded.

Q: Does Nebraska follow the federal election?
A: Yes -- the federal § 338(h)(10) election is binding for Nebraska, and the seller's Nebraska income is the same amount and character as on the federal return.

Q: Who qualifies for the exclusion in the first place?
A: Broadly, a shareholder who acquired the capital stock on account of, or while, employed by the corporation, when the corporation meets the criteria in Neb. Rev. Stat. §§ 77-2715.08 and 77-2715.09. Check those statutes for the full eligibility rules.

Citations and references

• Neb. Rev. Stat. § 77-2715.09 -- allows a resident individual to subtract from income the extraordinary dividends and capital gain from the sale or exchange of qualifying employer capital stock.
• Neb. Rev. Stat. § 77-2715.08 -- sets the eligibility criteria the corporation and stock must meet for the exclusion.
• IRC § 338(h)(10) -- the federal election to treat a stock sale as a deemed sale of assets (Old Target / New Target), which Nebraska treats as binding.
• IRC §§ 1231, 1245, 1250 -- the asset-level/recapture gains that are excluded from the special capital gains exclusion.

Source

• Landing page: https://revenue.nebraska.gov/about/legal-information/revenue-rulings-issued-tax-commissioner
• Original PDF: https://revenue.nebraska.gov/sites/revenue.nebraska.gov/files/doc/legal/rulings/rr221001.pdf

Original ruling text

Revenue Ruling 22-10-1
Nebraska Individual Income Tax

September 8, 2010
SPECIAL CAPITAL GAINS FOR FEDERAL § 338 ELECTION
Issues:

1. The shareholders of a corporation have decided to sell all the stock of the corporation to
   another corporation. They have elected to treat the sale of stock under Internal Revenue Code
   (IRC) § 338(h)(10) as though it was the sale of assets. Some of the shareholders hold shares of
   stock that would qualify for Nebraska’s special capital gains exclusion (Exclusion). Does the
   IRC § 338(h)(10) election disqualify the transaction from the Exclusion?
2. If the sale is not disqualified, what portion of the capital gains from the sale of the capital stock
   can be excluded?
   Conclusions:
3. The election under IRC § 338(h)(10) to treat the sale as the sale of assets does not disqualify
   the sale from the Exclusion.
4. The capital gains determined on the deemed sale of assets under IRC §§ 1231, 1245, or 1250
   do not qualify for the Exclusion, but any capital gains from the sale of capital stock attributed
   to redemption of capital stock in the deemed liquidation do qualify.
   Definition:
   Special Capital Gains Exclusion. A special capital gains exclusion is an exclusion provided in
   Neb. Rev. Stat. § 77-2715.09 that reduces Nebraska taxable income by the amount of the capital
   gains from the sale or exchange of capital stock of one corporation selected by a shareholder who
   received the stock while employed by the corporation, or on account of employment with the
   corporation, when the corporation meets certain other criteria (see Neb. Rev. Stat. § 77-2715.08).
   Analysis:
   The ownership of a business operated by a corporation is normally transferred either by the
   shareholders selling the stock of the corporation or by the corporation selling its capital assets.
   There are significant tax and nontax business reasons for using each of the two methods. In addition
   to the federal tax differences which are recognized by Nebraska, the Revenue Act of 1967, as
   amended, provides for an additional difference between the two methods. The Exclusion applies to
   the capital gains from the sale or exchange of capital stock, but does not apply to the capital gains
   related to the sale of the assets of a corporation.
   In order to minimize the tax differences between the two types of transactions, the IRC provides
   an election under § 338(h)(10). This particular election is an election to treat the sale of stock as
   the deemed sale of assets. The transaction is taxed as if there were two separate corporations, “Old
   Target” and “New Target.” Old Target is deemed to sell all of its assets to New Target at fair market
   value. New Target has a new depreciation basis for the assets, and Old Target recognizes gain on

Nebraska Department of Revenue, P.O. Box 94818, Lincoln, Nebraska 68509-4818

Revenue Ruling 22-10-1

September 8, 2010

Page 2 of 2

the assets as though the assets were sold at fair market value. The shareholder’s basis of the stock
in Old Target is adjusted, and then Old Target is deemed to make a distribution in liquidation which
may create additional capital gains for the shareholders.
The actual transaction is the sale of stock that would qualify for the Exclusion. The making of the
election does not disqualify the transaction. For Nebraska purposes, the federal election to treat
the sale of the stock as the deemed sale of assets and liquidation is binding. The seller will have
income for Nebraska in the same amount and of the same character as on the federal return.
Any ordinary income recognized, such as a recapture of accelerated depreciation, or gains on the
sale of capital assets used in a trade or business under IRC §§ 1231, 1245, and 1250, recognized
by Old Target, whether or not the gains flow through to, and are reported on, the shareholder’s
return are not allowable under the Exclusion. These items are deemed to arise from the sale of the
assets.
Only the capital gains relating to the sale of stock recognized by the selling shareholder are eligible
for the Exclusion. In the deemed transaction, the capital gains that arise from the deemed liquidation
of the corporation are considered to be capital gains from the sale or exchange of capital stock.
These capital gains on the deemed liquidation can be excluded from income subject to tax in
Nebraska as indicated in Neb. Rev. Stat. § 77-2715.09 below (emphasis added):
77-2715.09 Capital stock; sale or exchange; extraordinary dividend and capital
gains treatment.
(1) Every resident individual may elect under this section to subtract from federal
adjusted gross income, or for trusts qualifying under subdivision (2)(c) of this
section from taxable income, the extraordinary dividends paid on and the capital
gain from the sale or exchange of capital stock of a corporation acquired by the
individual (a) on account of employment by such corporation or (b) while employed
by such corporation.
APPROVED:

Douglas A. Ewald
Tax Commissioner
September 8, 2010