San Francisco Tax Preparation / CPA: CA – Unreported installment sale gain properly accelerated – San Francisco Small Business / Individual CPA Tax Service

An out of state S corporation and its shareholders group (taxpayers) were properly subject to additional California corporate income tax assessment as the S corporation (corporation) was dissolved and the taxpayers were properly subject to accelerated reporting requirement.

In 2013, the taxpayers sold all of the corporation’s stock for a fixed price, and the third-party buyers agreed to provide deferred installment gain payments (earnout) of up to $50 million if the corporation’s earnings before interest and taxes (EBIT) would exceed certain thresholds in the three years after the sale.

According to the taxpayers, the corporation’s EBIT climbed from $1,018,000 in 2011 to $3,838,000 in 2012 and to $12,996,000 in 2013. The taxpayers and the buyers then mutually decided to consider the stock sale as an asset sale under IRC section 338(h)(10). The corporation’s 2013 tax year ended with stock sale.

The corporation’s 2013 California tax return indicated that the return was the corporation’s final California tax return and reported its California apportionment percentage based solely on its sales factor, rather than based on its property, payroll and doubleweighted sales factors. The S corporation reported the gain in taxable income, which was calculated without factoring any contingent sums that may be received in subsequent years. The corporation reported the $101,201,823 of gross receipts attributable to the fixed portion of the deemed asset sale as other gross receipts “everywhere” resulting in the inclusion of this amount in the corporation’s sales factor denominator. Of this amount, the corporation assigned $22,395 to California for inclusion in the numerator of its sales factor; however, the corporation did not report any taxable income or gross receipts from the earnout.

Subsequently, the Franchise Tax Board (FTB) examined the corporation’s 2013 tax return and determined that:

  • since the 2013 return was the corporation’s final California tax return, it should have accelerated the reporting of earnout; and

  • the sale at issue was a substantial and occasional sale, and the corporation should have excluded the fixed portion of the sale amount from the sales factor.

Subsequently, the taxpayer filed an appeal against the FTB’s assessment. The Office of Tax Appeals (OTA) decided the matter on the following issues:

Accelerated Reporting of Unreported Installment Gain

Generally, under California law, a taxpayer is allowed to accelerate future installment payments when the entire income from a sale has not been reported before dissolution or cessation of a business.

In this matter, the taxpayers asserted that although the corporation was dissolved, the taxpayers’ continued their business in the state as C corporation therefore, the taxpayers should not be subject to the provisions related to accelerated reporting. However, it was noted that when an IRC 338(h)(10) election is made, a company is generally considered as if it had sold its assets, liquidated its assets, and ceased to exist, and therefore, the resulting C corporation was viewed as if it were a completely distinct entity from the original corporation.

Tax Treatment of Income from Deemed Asset Sale Relating to Intangibles

The corporation’s revenue from the presumed asset sale of intangibles like goodwill and going concern value constituted business income since these assets were important to the corporation’s ordinary trade or business activities and so met the “functional” requirement for business income.

Substantial and Occasional Sales

Generally, gross receipts from the deemed asset sale should be excluded from the taxpayer’s sales factor pursuant to Regulation section 25137(c)(1)(A), as receipts arising from a substantial and occasional sale. As a result, the taxpayers were required to exclude the fixed portion of the sale amount from the sales factor numerator and denominator. This increased the taxpayers’ California sales factor apportionment percentage and California taxable income, resulting in a tax liability.

Accordingly, the taxpayers’ protest was denied. Amarr Company, California Office of Tax Appeals, No. 20046125 & 20046127, December 9, 2021, released March 2022