Are You an S Corporation in California? Really?

Case:
Golden West Health Plan, Inc. v. Franchise Tax Board of the State of California, (court of appeal, second appellate district, division seven, B205246, Los Angeles County Super. Ct. No. BC353849)Click on the following link to access the case:http://www.courtinfo.ca.gov/opinions/nonpub/B205246.PDFAnalysis and Application to You

Taxpayer filed an election with the IRS to be treated as an S corporation for federal income tax purposes in 1989. Taxpayer received notice in November, 1989 that its election was effective; despite the fact it had failed to file required consents of all shareholders and shareholder spouses.

In 2002, in preparation for a sale of its stock, the taxpayer discovered the lack of consents and sought relief. The IRS granted relief in April, 2003 and deemed the election valid as of its date of initial filing in 1989.

In December 2003, the taxpayer applied for a Chief Counsel Ruling from the Franchise Tax Board as to its status for California tax purposes; the opinion, indicated that the corporation had a valid S election as of January 1, 1997, and expressed no opinion as to status for prior years.

Why does this matter?

If the taxpayer did not have a valid S corporation election in California for 10 years prior to the 2003 sale, the taxpayer would be subject to an additional California gains tax on the sale of its assets in June 2003. The taxpayer filed a tax return for 2003, paid the additional tax of $699,045 and timely sought a refund.

ResultThe matter was taken to court. The trial court ruled in the taxpayer’s favor. However, California appealed and the appeals court of the second appellate district, division seven, ruled in California’s favor. Meaning, the S election for California purposes was ruled to only be retroactive to 1997. Therefore, the taxpayer still had to pay the additional tax of $699,045.
Basis for Result

  1. Internal Revenue Code (IRC) was amended in 1996 to treat late filed S corporation elections as timely (treating the election as valid as of the original date of the election).
  2. California generally follows federal statutes in implementing California’s tax provisions; however, the IRC is revised on an ongoing basis. As a result, changes in federal law do not automatically apply, but must be reviewed by the California legislature and adopted.
  3. California did adopt the IRC 1996 amendments, but specifically stated the relief for California purposes, only applied to taxable years beginning on or after January 1, 1997.

Takeaways

  1. If you are an S corporation operating in California, review your election filings and ensure that all consents were obtained.
  2. If all consents were not obtained, you could apply for relief with the IRS and California. (The resulting effective date of the election may not be the same).
  3. Do not assume a state follows the IRC. Each state has rules they follow regarding “conformity” to the IRC (i.e., adopting and effective dates, etc.).
  4. When the IRC and a state’s statutes do not agree, the state’s statutes most likely will “trump” the IRC for state purposes; however, as with all matters, do not assume anything. The appellate court in this case reviewed the legislative intent of California’s statute to conclude California’s relief should only be retroactive to January 1, 1997.

If you have any questions regarding how to apply for relief or determine a state's conformity with the IRC, please contact me at leveragesalt@earthlink.net.

This blog

Brian Strahle is the owner of LEVERAGE SALT, LLC where he provides state and local tax technical services to accounting firms, law firms and tax research organizations across the United States.  He also writes a weekly column in Tax Analysts State Tax Notes entitled, "The SALT Effect."  For more info, visit his website: www.leveragestateandlocaltax.com

You can reach Brian at strahle@leveragesalt.com.

Connect with Brian on LinkedIn. Follow Brian on Twitter. Join the Leverage | SALT LinkedIn Group, connect and contribute with your colleagues!  

Because state and local taxes are deceptively simple and endlessly complicated.

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