How did a Section 338(h)(10) stock sale affect the target's former Texas tax bases, loss carryforwards, and the seller's receipts?

Plain-English summary

Texas ignored the Section 338(h)(10) deemed asset sale for the target's taxable capital but recognized it for earned surplus, where qualifying old business losses could offset the gain.

Buyer, a Delaware corporation, planned to buy all stock of XYZ, a Texas S corporation, from Seller, another Texas corporation. The parties would elect under I.R.C. Sec. 338(h)(10) to treat the stock purchase as a deemed asset sale. The Comptroller answered four questions:

1. Target taxable capital: no deemed-sale receipts. Taxable capital generally began with GAAP, and Section 171.109(m) prohibited push-down accounting. With no statutory basis to recognize the federal deemed sale, XYZ did not recognize it in taxable capital or taxable-capital gross receipts.
2. Target earned surplus: deemed-sale receipts recognized. Earned surplus began with reportable federal taxable income, so the federal Section 338(h)(10) treatment carried through. Rule 3.557(e)(10) treated amounts deemed received by XYZ as asset-sale receipts, sourced under the rules for each asset; the stock buyer was treated as the asset buyer.
3. Target business losses: available if still timely. A qualifying prior loss could offset Section 338(h)(10) gain during the next five taxable years under Section 171.110(e) and Rule 3.555(g). The loss applied only to earned surplus.
4. Seller's stock gain: taxable-capital net gain used the cost method and location-of-payor rule. Gain paid by a Delaware buyer was non-Texas; gain paid by a Texas buyer was a Texas receipt. For earned surplus, Seller had no gross receipt if the stock sale produced no reportable revenue on its federal return.

Currency note: This ruling applies the two-component franchise tax replaced by the margin tax effective January 1, 2008. Confirm current entity, transaction, and combined-reporting rules.

What this means for you

Buyers and sellers making Section 338(h)(10) elections

The same federal transaction produced different results across the former Texas tax components. Target-level deemed receipts appeared in earned surplus but not taxable capital.

Corporations with old Texas business losses

A stock ownership change did not itself erase the target's qualifying loss carryforward. The loss remained subject to its five-year window and applied only to earned surplus.

Common questions

Q: Did the target recognize the deemed sale for taxable capital?
A: No.

Q: Did it recognize the deemed sale for earned surplus?
A: Yes, with receipts sourced under the rule for each asset.

Q: Could old business losses offset the gain?
A: Yes, if they satisfied the five-year carryforward requirements.

Q: How was the seller's stock gain sourced for taxable capital?
A: By the buyer's domicile under the location-of-payor rule.

Citations and references

• Texas Tax Code Secs. 171.109(b), 171.109(h), 171.109(m), 171.110(a)(1), 171.110(e), and 171.1121(a)
• 34 Tex. Admin. Code Secs. 3.555(g), 3.557(e)(10), and 3.549(e)(3)(B)
• I.R.C. Sec. 338(h)(10)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9909262L

Original ruling text

September 21, 1999

Dear **:

Thank you for the information contained in your letter of August 24, 1999
concerning the federal section 338(h)(10) election as it applies to various
Texas taxes. This response represents the franchise tax implications of the
situations described in the ruling request.

You have indicated that XYZ, a Texas corporation, is an S corporation for
federal income tax purposes. Buyer, a Delaware corporation, will purchase all
of the stock of XYZ from Seller, a Texas corporation. The parties will make an
election under section 338(h)(10) of the Internal Revenue Code of 1986, as
amended, to treat the stock purchase as a deemed asset sale.

I have listed each question with the accompanying response.

1. Will the deemed asset sale for federal income tax purposes give rise to
   Texas gross receipts for purposes of determining the taxable capital of XYZ
   corporation?

Response: The starting point for computing the taxable capital component is
generally accepted accounting principles (GAAP). Sec. 171.109(b) of the Texas
Tax Code. The statute does provide exceptions to the GAAP standard, including
the use of FIT accounting methods for S corporations. However, the FIT
provision is limited to accounting methods and as such may be overridden by
specific statutory requirements, such as Sec. 171.109(m).

Sec. 171.109(m) states that a corporation may not use the push-down method of
accounting in computing or reporting its surplus. Thus, a corporation whose
stock has been acquired cannot revalue its assets pursuant to push-down
accounting.

Because there is no statutory basis to recognize the section 338(h)(10)
treatment, it is not recognized in the computation of taxable capital or gross
receipts for taxable capital. Thus, the described transaction would not give
rise to Texas gross receipts in the apportionment of XYZ's taxable capital.

2. Will the deemed asset sale for federal income tax purposes give rise to
   gross receipts for purposes of determining the taxable earned surplus of XYZ
   corporation.

Response: Sec. 171.110(a)(1) of the Tax Code holds that a corporation's earned
surplus is computed by determining its reportable federal taxable income (with
certain modifications). Sec. 171.110(d) specifically refers to the Internal
Revenue Code for purposes of determining reportable federal taxable income.
Because of the requirements set out in these statutory provisions, the section
338(h)(10) treatment is recognized in the computation of earned surplus.

Franchise Tax Rule 3.557(e)(10) provides that amounts deemed received by the
target corporation are treated as sales of assets by the target corporation.
The receipts from these sales are apportioned according to rules otherwise
applicable to sales of such assets under Sec. 171 of the Tax Code or Rule
3.557. In this situation, the purchaser of the target's stock is considered
the purchaser of the assets.

3. After the sale of stock, will XYZ Corporation be able to use any prior
   franchise tax business losses that it may have? May these business losses be
   used to offset any gain recognized by XYZ Corporation pursuant to 1 or 2 above?

Response: A business loss, as defined by Sec. 171.110(e), that XYZ incurred
prior to the sale of its stock can be carried forward to the year succeeding
the loss year as a deduction to XYZ's net taxable earned surplus, and then
successively to the succeeding four taxable years after the loss year.
Therefore, a business loss can be offset against any section 338(h)(10) gains
recognized by XYZ as long as the deduction falls within the specifications of
Sec. 171.110(e) and Franchise Tax Rule 3.555(g). The Section 171.110(e)
business loss applies only to the earned surplus component.

4. Will the sale of XYZ Corporation stock give rise to gross receipts for
   purposes of determining either taxable capital or taxable earned surplus of
   Seller? Would the answer be different if Buyer was a Texas corporation?

Response: For taxable capital purposes, Seller must report as gross receipts
the net gain from the sale of the XYZ stock. Pursuant to Sec. 171.109(h),
Seller must use the cost method of accounting to report the XYZ investment.
Therefore, the gain from the sale of the XYZ investment must be computed in
accordance with the cost method. The net gain from the sale will be
apportioned under the location of payor rule. Therefore, if Buyer is a
Delaware corporation, the receipts from the gain would not be Texas receipts.
However, if Buyer is a Texas corporation, these receipts must be reported as
Texas receipts. Franchise Tax Rule 3.549(e)(3)(B).

For earned surplus, there would be no gross receipts to Seller as long as it
did not have any reportable revenue on its federal tax return from the sale of
the XYZ stock. Sec. 171.1121(a), Texas Tax Code.

This response is based on the facts presented. It is presumed that all federal
income tax reporting requirements related to the described transaction have
been met. If there are different or additional facts, the response may change.

If you have any questions, please call toll-free 1-800-531-5441, extension
3-4496 or (512) 463-4496.

Sincerely,

Jerry Bobbitt
Tax Policy Division