How would Virginia treat nonresident S corporation shareholders if a stock purchase uses an IRC § 338(h)(10) election?

Plain-English summary

A prospective buyer asked about capital-gain treatment for four nonresident shareholders of a Virginia S corporation. The request described a possible stock purchase and mentioned the result if no IRC § 338(h)(10) election were made.

The published ruling's operative analysis addresses the election scenario. Virginia follows a federal § 338(h)(10) election: the target S corporation is treated as selling its assets, and gain or loss recognized federally is recognized for Virginia purposes. Because the deemed sale involves the corporation's Virginia assets and business, the gain is Virginia-source income to the nonresident shareholders, who must file unless a statutory filing exception applies. The ruling does not expressly state the no-election stock-sale result.

Citations and references

• IRC §§ 338 and 338(h)(10), and IRC § 332
• Va. Code § 58.1-301
• Va. Code §§ 58.1-325, 58.1-321, and 58.1-302
• P.D. 91-317

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 18-20

Original ruling text

March 9, 2018

Re: Request for Ruling: Individual Income Tax

Dear *:

This will reply to your letter in which * (the “Taxpayer”) requests a ruling as to the treatment of capital gains by nonresident individuals.

FACTS

An S corporation that is incorporated and located in Virginia has four nonresident individual shareholders. The Taxpayer is contemplating purchasing the stock of this S corporation by utilizing an Internal Revenue Code (IRC) § 338(h)(10) election. The Taxpayer asks how the capital gains would be treated by the nonresidents if it does not make the IRC § 338(h)(10) election. Specifically, the Taxpayer asks whether the nonresidents would report the capital gain as Virginia source income or as a deduction from Virginia taxable income on their nonresident Virginia returns.

RULING

IRC § 338(h)(10) Election

Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For Virginia, federal taxable income (FTI) and federal adjusted gross income (FAGI), the starting points for determining income taxable in Virginia for corporations and individuals, respectively, are identical to that as defined by the IRC. As such, Virginia's treatment of the IRC § 338(h)(10) election will mirror federal treatment as closely as possible, while ensuring that any Virginia tax accurately reflects the business activity in Virginia.

An election under IRC § 338 allows a purchaser of stock in a target corporation to obtain a stepped up basis in the target's assets as if there had been a direct purchase of the assets. In order to avoid potential double taxation, IRC § 338(h)(10) allows the purchaser and seller to make a joint election, provided that the target and seller are part of an affiliated group of corporations that file a consolidated federal return. The result of the election is that a series of fictitious steps are deemed to have occurred:

The target is deemed to have sold its assets, recognizing gain or loss that must be included in the selling group's consolidated federal return;

The target is deemed to have distributed all its assets in a complete liquidation to which IRC § 332 applies; and

Any gain or loss on the sale of target stock incurred by the selling group is ignored.

In all cases, if the seller, target, purchaser or any combination thereof are Virginia taxpayers, the IRC § 338(h)(10) election actually made on a federal return will be recognized exactly as it is for federal purposes. See Public Document (P.D.) 91-317 (12/30/1991). To the extent that any gain or loss is deemed to be recognized for federal purposes by any party, it will be similarly recognized by the applicable entity for Virginia purposes. Under the facts presented, the S corporation will be deemed to have sold its Virginia assets, and the recognized the gain or loss from the sale would be income from Virginia sources.

Nonresidents

Pursuant to Virginia Code § 58.1-325, a nonresident individual who has income from carrying on a business, trade, profession, or occupation within Virginia is required to file a Virginia individual income tax return, unless the individual meets the filing exception described in Virginia Code § 58.1-321. The Virginia taxable income of a nonresident is computed by multiplying his Virginia taxable income (computed as if he were a resident) by the ratio of his net income, gain, loss, and deductions from Virginia sources to his net income, gain, loss, and deduction from all sources. Under Virginia Code § 58.1-302, “income and deductions from Virginia sources” includes income from “a business, trade, profession or occupation carried on in Virginia.” Because Virginia follows the federal treatment of the IRC § 338(h)(10) election, the sale of the S corporation's assets would be deemed to be income from carrying on a business, trade, profession or occupation within Virginia.

The Code of Virginia sections and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department's web site. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1426.B