In a Section 338(h)(10) deemed asset sale of an S corporation holding QSSSs, which entities recognize gain for Texas franchise tax, and how is the goodwill gain sourced?

Plain-English summary

Two individuals planned to sell their stock in ABC Corp., a Texas S corporation holding two QSSS subsidiaries (DEF and GHI) that do business in Texas, and to make an IRC Sec. 338(h)(10) election so the stock sale is treated as a deemed asset sale. Unlike the federal rules (which treat the QSSSs as part of ABC), Texas treats ABC, DEF, and GHI as separate taxpayers. The Comptroller answered:

• Goodwill is sourced to the payor. Each subsidiary recognizes a $3 million deemed-asset-sale gain, about $2.5 million of it goodwill. That goodwill is sourced to the location of the payor (the stock purchaser) under Rules 3.557(e)(10) and 3.557(e)(25)(B). (Yes to the taxpayer's question.)
• The parent recognizes no gain. If ABC Corp.'s only asset is the stock of the subsidiaries, ABC recognizes no gain on the deemed asset sale, and its basis in DEF and GHI is not adjusted.
• Nothing to source at the parent. Because ABC recognizes no gain, there is nothing to source at the parent level.
• "Location of the payor" defined. It is the legal domicile of the payor (Rule 3.549(b)(7)), which is defined in Rule 3.549(b)(6) - not simply commercial domicile or state of incorporation.
• No push-down; use cost method. ABC, DEF, and GHI may not use push-down accounting to compute surplus for taxable capital (Sec. 171.109(m)), and ABC must use the cost method to account for its investments in DEF and GHI (Sec. 171.109(h)).

Currency note: This 2000 letter applies the pre-2008 franchise tax and its separate-entity QSSS treatment, location-of-payor sourcing, and push-down/cost-method rules (replaced by the margin tax effective January 1, 2008 under House Bills 3 and 3928). The margin tax can require combined reporting; confirm current law.

What this means for you

Buyers and sellers of S corporations with QSSS subsidiaries

The federal 338(h)(10) "single seller" treatment did not carry over: Texas taxed the subsidiaries on their deemed-asset-sale gain and the holding parent on nothing (where it holds only the subsidiaries' stock). The goodwill portion followed the buyer's legal domicile, which could push a large gain out of Texas if the buyer is domiciled elsewhere. And you could not use push-down accounting to reshape taxable capital.

Tax professionals

Key moves: separate-entity treatment of QSSSs; subsidiary-level gain recognition with no parent gain (only-stock parent, no basis step-up); goodwill sourced to the payor's legal domicile (Rules 3.549(b)(6)-(7), 3.557(e)(25)(B)); and the push-down bar (Sec. 171.109(m)) plus cost-method requirement (Sec. 171.109(h)). All pre-2008 and single-entity in framing - re-verify under the margin tax's combined-reporting regime.

Common questions

Q: In a 338(h)(10) sale of an S corp with QSSSs, who recognizes the gain for Texas franchise tax?
A: The QSSS subsidiaries recognize the deemed-asset-sale gain; the holding parent recognizes none if its only asset is the subsidiaries' stock.

Q: How is the goodwill gain sourced?
A: To the location of the payor - the stock purchaser - which is the payor's legal domicile (Rules 3.549(b)(6)-(7), 3.557(e)(25)(B)).

Q: Can the entities use push-down accounting?
A: No. They may not use push-down accounting to compute surplus for taxable capital, and the parent must use the cost method for its investments (Secs. 171.109(m), 171.109(h)).

Citations and references

Statutes and rules:

• Texas Tax Code Sec. 171.109(m) - no push-down accounting to compute surplus for taxable capital
• Texas Tax Code Sec. 171.109(h) - parent must use the cost method to account for its investment in subsidiaries
• 34 Tex. Admin. Code Sec. 3.557(e)(10) and Sec. 3.557(e)(25)(B) (Rule 3.557) - earned surplus apportionment; goodwill sourced to the location of the payor
• 34 Tex. Admin. Code Sec. 3.549(b)(7) and Sec. 3.549(b)(6) (Rule 3.549) - location of the payor is the payor's legal domicile, as defined

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/200005344L

Original ruling text

From: "Jeffcoat, Bob"

To: "**"

Subject: Texas Franchise Tax Follow-Up Questions

Date: May 15, 2000

Dear **:

In your e-mail, you asked about the franchise tax treatment of a proposed
transaction. I have restated the facts and questions in your e-mails below
followed by my response.

You indicated that two resident individuals own a 50% interest in ABC Corp., a
Texas corporation that made an S election for federal income tax purposes. ABC
Corp. is a holding company that owns two subsidiaries, DEF Corp. and GHI Corp.,
that do business in Texas. These corporations have elected to be treated as
QSSSs for federal income tax purposes. The shareholders of ABC Corp. propose
to sell their stock on July 1, 2000. The sellers and purchasers propose to
make an IRC Sec. 338(h)(10) election so the stock sale will be treated as a
deemed asset sale.

Tax on Earned Surplus

1. For federal income tax purposes, DEF Corp. and GHI Corp. will each recognize
   a $3 million deemed asset sale gain. Approximately $2.5 million of the gain
   will be attributable to goodwill. Under 34 TAC Secs. 3.557(e)(10) and
   3.557(e)(25)(B), would the goodwill be sourced to the location of the payor
   (i.e., purchaser of the stock)?

Response: Yes.

2. In determining ABC Corp.'s gain on the sale of DEF Corp. and GHI Corp.
   stock, will ABC Corp. get to adjust its basis in those corporations to reflect
   gain recognized by the subsidiaries. What basis in DEF Corp. and GHI Corp.
   will ABC Corp. utilize in recognizing gain on the deemed asset sale?

Response: ABC Corp. will not recognize any gain on the deemed asset sale if the
only asset held by ABC Corp. is the stock of the subsidiaries. Accordingly,
ABC Corp.'s basis in DEF Corp. and GHI Corp. will not be adjusted as a result
of the sale.

3. Assuming that the only assets on ABC Corp.'s books are its investments in
   DEF Corp. and GHI Corp. would any gain on the deemed asset sale be sourced to
   the location of the payor?

Response: As indicated in the reply to No. 2, ABC Corp. will not recognize any
gain on the deemed asset sale.

4. How do you determine "location of the payor" (i.e., commercial domicile,
   state of incorporation or other basis)?

Response: The location of the payor is the legal domicile of the payor (Rule.
3.549(b)(7)). The legal domicile of the payor is defined in Rule 3.549(b)(6).

Finally ABC Corp., DEF Corp., and GHI Corp. may not use push down accounting to
compute surplus for taxable capital purposes (Texas Tax Code Sec. 171.109(m)).
ABC Corp. must use the cost method to account for its investment in DEF Corp.
and GHI Corp. (Texas Tax Code Sec. 171.109(h)).

If you have any questions, my internet address is [email protected],
or you may call me toll free at 1-800-531-5441, extension 3-4662.

Sincerely,

Bob Jeffcoat
Tax Policy Division

On Mon, 3 Apr 2000 13:41:44 -0400 "**" wrote:

Dear Mr. Jeffcoat:

The transaction has not taken place yet. ABC Corp. qualifies as an S Corp. for
federal income tax purposes. DEF and GHI qualify as QSSSs (treated as part of
ABC Corp.) For federal income tax purposes, it is my understanding the old
Target group will file a single return and report the deemed asset sale gain
on that return. Under IRS Treas. Reg. sec 1.338(h)(10)-1T(d)(3)(i), "... Also,
when T is an S corporation target, any direct and indirect subsidiaries of T
which T has elected to treat as qualifed subchapter S subsidiaries under
section 1361(b)(3) remain qualified subchapter S subsidiaries through the close
of the acquisition date. ..." For Texas Franchise Tax purposes, ABC, DEF and
GHI would be treated as separate taxpayers. Therefore, the federal income tax
rules would not apply.

The rules regarding the federal income tax treatment of tiered entities are
found in Treas. Reg. sec. 1.338(h)(10)-1T(d)(4)(ii) and illustrated in Treas.
Reg. sec. 1.338(h)(10)-1T(e)(Ex. 1). Under those rules the deemed liquidation
of a subsidiary corporation is considered to preceed the deemed liquidation of
its parent. Because ABC, DEF and GHI will be treated as separate entities for
Texas Franchise Tax purposes, (1) DEF and GHI recognize gain on their sale of
assets; and (2) ABC not recognize gain on its sale of stock in DEF and GHI. Is
that correct?

After the transaction, ABC Corp., DEF and GHI will be C corporations for
federal income tax purposes and become part of the new parent's consolidated
group. It is our understanding that the tax year of the old target group and
the new target group will be 12/31.

Please write or call if you have any additional questions. Thank you for your
assistance.