S Corporation A, an S corporation, merged into buyer Corporation B in a Sec 338(h) transaction. For federal and Utah (UT) purposes, gain from the sale of stock is treated as a sale of assets by A and a liquidation of the proceeds to the shareholders. The gain on the sale is $350,000. The liquidating distribution is also $350,000.
Each shareholder has a federal stock basis before the sale of $0. Income from operations in the year of sale is $5,000. $350,000 (pro-rata share of Sec 338(h)) of the gain is apportioned to Utah (UT) [benefit derived state]. The character of UT income is ordinary business income, which is passed through to the shareholders to report on their individual UT income tax returns. Each A shareholder will file an individual UT personal income tax return and reports income from the year of sale as $355,000 ($350,000 gain from the sale of assets plus $5,000 income from operations).
PA resident shareholders will file individual PA personal income tax returns. PA does not allow Sec 338(h) for S Corporations; therefore gain on sale is taxed at the shareholder and not the corporate level for PA purposes. PA resident shareholders report the $5,000 on PA-40, line 4 as income from the operation of a business and a gain of $345,000 on Schedule D as a sale of stock (Stock basis increases from $0 to $5,000 ($5,000 income from operations) before the sale. Sales proceeds of $350,000 less stock basis of $5,000.)
The same income (gain) is taxed to UT and PA but reported in a different class of income in each state. Will PA allow resident shareholders to take a credit for tax paid on the Sec 338(h) income in UT?
Yes. See PA PIT Guide Chapter 16. On page 46 it states: A resident shareholder may claim a resident credit for taxes paid to another state on Schedule D gain resulting from an IRC § 338(h)(10) transaction.