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Els Educational Services, Inc v. Franchise Tax Board

August 10, 2011

ELS EDUCATIONAL SERVICES, INC., PLAINTIFF AND RESPONDENT,
v.
FRANCHISE TAX BOARD, DEFENDANT AND APPELLANT.



(Super. Ct. No. 07AS03070)

The opinion of the court was delivered by: Duarte ,j.

ELS Educational Services v. Franchise Tax Bd.

CA3

NOT TO BE PUBLISHED

California Rules of Court, rule 8.1115(a), prohibits courts and parties from citing or relying on opinions not certified for publication or ordered published, except as specified by rule 8.1115(b). This opinion has not been certified for publication or ordered published for purposes of rule 8.1115.

This case involves the capital gains treatment of a sale of one corporation to another. In particular, it tenders the question whether Revenue and Taxation Code,*fn1 section 23806, subdivision (a), has "modified" Internal Revenue Code section 338 (26 U.S.C. § 338).

Plaintiff/respondent ELS Educational Services, Inc. (ELS), a subchapter S corporation (under which the income of the corporation is passed through to its stockholders), was acquired by Berlitz Languages, Inc. (Berlitz) on August 28, 1997. The state imposed capital gains taxes on its stockholders as of that date, the taxes were paid, and the stockholders filed suit for a refund. The trial court ruled in their favor and ordered a refund. This appeal followed.

ELS and Berlitz made a joint federal election under Internal Revenue Code section 338(h)(10), to treat the sale of ELS's stock to Berlitz as a sale of its assets at fair market value on the date of the sale. At the time of the sale, California Law--namely, Revenue and Taxation Code section

23806--provided that an election under section 338 "for federal purposes shall be treated as an election for purposes of [California law]."

Defendant/appellant Franchise Tax Board (the Board) reads the plain language of this section to require application of the federal rule. As a consequence, the ELS stockholders' capital gains were taxed by the Board as of the date of the sale of ELS to Berlitz.

ELS seeks to avoid the plain meaning of section 23806 by resort to the section's Legislative history. However, legislative history applies only to resolve a statutory ambiguity, and here there is none. Further, the stockholders' subsequent attempt to file a non-conforming election under California law so as to deem the asset sale not to have occurred was filed too late. We shall reverse.

DEFINITIONS AND DESCRIPTIONS

I

C and S corporations

"For federal income tax purposes, there are two kinds of corporations: 'C corporations' (so named because their governing provisions are found in subch. C, ch. 1, subtit. A of the Int[ernal] Revenue Code) and 'S corporations' (governed by subch. S of the same chapter). A C corporation is a separate entity which pays corporate income taxes 'according to or measured by its net income.' (§ 23151, subd. (a).)" (Heller v. Franchise Tax Bd. (1994) 21 Cal.App.4th 1730, 1733 (Heller).)

"[A]n S corporation . . . files only an informational return reporting for the taxable year its gross income (or loss) and deductions, its shareholders, and the shareholders' pro rata shares of each item. (26 U.S.C. § 6037(a).) The items are then 'passed through' on a pro rata basis to the shareholders, who report them on their personal income tax returns. [Citations.] 'The S corporation is, in effect, a Code-created hybrid combining traits of both corporations and partnerships.' [Citation.]" (Heller, supra, 21 Cal.App.4th at p. 1733.)

"Until 1987, California did not distinguish between C corporations and S corporations for state tax purposes, instead treating all corporations as C corporations. [Citation.] Beginning in 1987, California modified its position so that 'Subchapter S of Chapter 1 of Subtitle A of the Internal Revenue

Code, relating to the tax treatment of "S corporations" and their shareholders, shall apply, except as otherwise provided in this chapter.' (§ 23800, subd. (a).) . . . [U]nder federal law, . . . , S corporations [generally] do not pay federal income tax. (26 U.S.C. § 1363(a); 26 C.F.R. § 1.1363-1 (1993).) However, California imposes a state tax upon the S corporation's net income. (§ 23802, subd. (b)(1).)" (Heller, supra, 21 Cal.App.4th at pp. 1733-1734.)

"C corporations are taxed upon their income as separate entities, and [their] distributions of earnings and profits

. . . to their shareholders generally are taxable to the shareholders as dividends. [Citation.] In contrast, S corporation shareholders are taxed on their share of the S corporation's income. . . . [Citation.]" (Heller, supra, 21 Cal.App.4th at p. 1734.)

II

Federal Tax Election Upon Acquisition--Section 388

Federal tax law provides that, except as otherwise specified, the rules governing C corporations (Int. Rev. Code, §§ 301 et seq.) apply to S corporations and their shareholders. (Id., § 1371(a).) One such rule states that when one corporation acquires another, the parties may elect to treat the stock purchases involved in the transaction as asset acquisitions. (Id., § 338.)

Section 338 provides in part (italics added):

"(a) General rule. For purposes of this subtitle, if a purchasing corporation makes an election under this section

. . . , then, in the case of any qualified stock purchase, the target corporation -- [¶] (1) shall be treated as having sold all of its assets at the close of the acquisition date at fair market value in a single transaction, and [¶] (2) shall be treated as a new corporation which purchased all of the assets referred to in paragraph (1) as of the beginning of the day after the acquisition date.

"[¶] . . [¶]

"(d) Purchasing corporation; target corporation; qualified stock purchase. For purposes of this section -- [¶] (1) [] The term 'purchasing corporation' means any corporation which makes a qualified stock purchase of another corporation. [¶] (2) [] The term 'target corporation' means any corporation the stock of which is acquired by another corporation in a qualified stock purchase. [¶] (3) [] The term 'qualified stock purchase' means any transaction or series of transactions in which stock

. . . of [one] corporation is acquired by another corporation by purchase[.]

"[¶] . . [¶]

"(g) Election. (1) When made. . . . An election under this section shall be made not later than the 15th day of the 9th month beginning after the month in which the acquisition date occurs. . . .

"(h) Definitions and special rules. For purposes of this section . . . . [¶] (10) Elective recognition of gain or loss by target corporation . . . . (A) In general. Under regulations prescribed by the Secretary, an election may be made under which if -- [¶] (i) the target corporation was, before the transaction, a member of the selling consolidated group, and [¶] (ii) the target corporation recognizes gain or loss with respect to the transaction as if it sold all of its assets in a single transaction, [¶] then the target corporation shall be treated as a member of the selling consolidated group with respect to such sale, and . . . no gain or loss will be recognized on stock sold or exchanged in the transaction by members of the selling consolidated group."*fn2 (Int. Rev. Code, § 338.)

III

California Law Prohibiting Separate Election--Section 23806

In 1987, the Legislature enacted section 23800 et seq., titled "Tax Treatment of S Corporations and Their Shareholders"

(Stats. 1987, ch. 1139, § 55), which conformed California tax law to federal tax law by treating S corporations and their shareholders in the manner prescribed by subchapter S of the Internal Revenue Code, except as otherwise provided. (§ 23800.) Section 23806 at the time stated only: "Section 1371(d) of the Internal Revenue Code shall not be applicable."*fn3

In 1997, the Legislature amended section 23806 by inserting the following provision (italics added):*fn4

"(a) Section 1371(a) of the Internal Revenue Code, relating to application of Subchapter C rules, is modified to provide that, notwithstanding subdivisions (a) and (e) of Section 23051.5, an election under Section 338 of the Internal Revenue Code, relating to certain stock purchases treated as asset acquisitions, for federal purposes shall be treated as an election for purposes of this part and a separate election under paragraph (3) of subdivision (e) of Section 23051.5*fn5 shall not be allowed." (Stats. 1997, ch. 611, § 75.)

FACTUAL AND PROCEDURAL HISTORY

I

Stipulated Facts

The case came before the trial court on the following ...


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