Apportionment and allocation Single-sales factor and three-factor apportionment formulas, and nonbusiness income
Apportionment generally refers to the division of business income among states by the use of an apportionment formula. A trade or business with business income attributable to sources both inside and outside of California are required to apportion such income.
Business income
Generally, income earned in your business on a regular basis (transactional) or income earned from property used for your business (functional) is business income.
Business income is income from the regular course of trade or business and/or income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the corporation’s regular trade or business operations.
The critical element in determining whether income is “business income” is the identification of the transactions and activities that are the elements of a particular trade or business. In general, all transactions and activities of the corporation that are dependent on or contribute to the operations of the corporation’s economic enterprise as a whole give rise to business income.
The California Supreme Court held that the definition of business income contains both a transactional test and a functional test and includes income from the sale of a business asset or right, even if the income is derived from an extraordinary event (Hoechst Celanese Corp. vs. Franchise Tax Board, (2001) 25 Cal. 4th 508).
Nonbusiness income is not subject to apportionment. Visit allocation for more information.
Apportionment formulas
Business income is apportioned using one of these formulas:
- Single-sales factor
- Three-factor
Single-sales factor
All trade or businesses, except those that derive more than 50% of their gross receipts from qualified business activities (QBA), must apportion their business income to California using a single-sales factor. Visit Three-factor for a list of QBAs.
Use Instructions for Schedule R to help you calculate the single-sales factor. Use the form locator for prior years.
Three-factor
Trades or businesses that derive more than 50% of their gross receipts from QBA must use the three factor formula consisting of property, payroll, and single-weighted sales factor to apportion business income to California. QBAs include:
- Agricultural
- Extractive
- Savings and loan
- Banking or financial
Use Instructions for Schedule R to help you calculate the factors. Use the form locator for prior years.
Allocation
Allocation refers to the assignment of nonbusiness income to a particular state.
Nonbusiness income
Nonbusiness income is all income other than business income.
Use Apportionment and Allocation of Income (Sch R) to help you calculate nonbusiness income. Use the form locator for prior years.
California net income
California net income is apportioned business income plus allocated nonbusiness income to California.
Use Apportionment and Allocation of Income (Sch R) to help you calculate California net income. Use the form locator for prior years.
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Elections Available to S Corporations with Significant Ownership Changes
Please note: This item is from our archives and was published in 2010. It is provided for historical reference. The content may be out of date and links may no longer function.
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TOPICS
Editor: Michael D. Koppel, CPA, MSA, MBA, PFS, CITP
S corporations are flowthrough entities, and pertinent items of income and expense are allocated to shareholders on a per share per day basis. When there are no changes in ownership during a tax year, that allocation can often be overlooked. However, for S corporations that undergo ownership changes, tax elections are available to allocate income and expenses to shareholders to take into account the shifting of ownership during the tax year. In the event of a complete termination of a shareholder’s interest, the availability of an election under Sec. 1377(a)(2) to close the tax year is well known to CPAs. A lesser known election under Regs. Sec. 1.1368-1(g) is similar to the Sec. 1377(a)(2) election but has certain distinctions outlined below. This item examines why shareholders are typically motivated to request one of these elections and addresses why tax advisers should raise the question of the election at the time of ownership change and not at a later date. The following paragraphs will compare the situations in which elections under Sec. 1377(a)(2) and Regs. Sec. 1.1368-1(g) are applicable and the practical issues encountered when these elections are addressed at some point after the transaction date.
In the absence of a Sec. 1377(a)(2) or Regs. Sec. 1.1368-1(g) election, items of income and expense for the entire year of the ownership change are divided by 365 days (366 in a leap year) to calculate the per day amount. The per share amount is calculated based on their ownership on each day in the year. If no election is made, there is no closing of the books to allocate income and expense disproportionately to follow the disproportionate ownership during the tax year. The total of pre-change income and post-change income is spread evenly over the 365 days.
Sec. 1377(a)(2) applies to situations in which a shareholder terminates his or her complete interest in the S corporation. This does not apply when a new shareholder is admitted or acquires more stock during the tax year. While still following the per share per day rule, a Sec. 1377(a)(2) election causes the corporation to calculate a shareholder’s share of income and expense as if the year consisted of two tax years (or more if there is more than a single termination during the year): one before the termination and the other after the termination. This closing of the books causes the income and expense for a period to be allocated only to shareholders owning shares during that period.
In contrast, the lesser-known Regs. Sec. 1.1368-1(g) election applies when (1) a shareholder disposes of 20% or more of the corporation’s outstanding stock, (2) a shareholder redeems 20% or more of the corporation’s outstanding stock, or (3) there is an issuance of an amount of stock equal to or greater than 25% of the previously outstanding stock to one or more new shareholders during any 30-day period during the corporation’s tax year. Like the Sec. 1377(a)(2) election, this election causes shareholders to be allocated the income and expense that corresponds to their stock ownership. The significant difference of the Regs. Sec. 1.1368-1(g) election is its availability in situations other than when a shareholder is getting out of the S corporation (i.e., terminating his or her interest). This election is available when there are shifts of ownership meeting the 20%/25% threshold.
It might seem obvious, but let us examine why shareholders are motivated to make either of these elections. Either election serves as protection for each of the shareholders involved in the transfer. In other words, the election assures the seller that he or she will not be allocated income earned after he or she has transferred the shares. Likewise, the election assures the buyer that losses incurred after the transaction date will not be allocated to the seller. Because these elections allocate only the total earnings of the tax year from the dates shares are owned, the future income/loss is being allocated to those shareholders, and only those shareholders, who still have ownership in the S corporation after the transfer date.
Advisers should recognize that both elections override the nonelective default “entire year” allocation method. Neither election changes the year’s total of income and expense that are allocated. What is different is the period to which they are allocated. Assuming the year’s results are not equally earned throughout the year and after the year’s results are tabulated, it will be clear that an election causes some shareholders to achieve beneficial tax consequences and others to achieve detrimental tax consequences by an equal amount. Said differently, when this is compared with a situation of no election, not everyone will save taxes because an election is made. Some will have a greater tax liability; some will have a decreased tax liability.
It might not be apparent why an adviser should get the parties to address the election when negotiating the transaction, rather than at some time after the transaction is finalized. Furthermore, upon agreement of the parties involved in such an election, it is easy to see why signing the election at or near the closing date is preferred. The following examples illustrate these points.
Example 1: S (seller) and B (buyer) are the only shareholders in S corporation SB, Inc. S and B have equal ownership in SB, and each owns 100 of the 200 total shares. On March 31, 2010, B buys out S. Taxable income from January 1, 2010, through March 31, 2010, is $500. Taxable income for the entire year (January 1, 2010–December 31, 2010) is $2,028. See Exhibit 1.
In Example 1, S’s allocation in both cases is $250 and B’s is $1,778; with the benefit of hindsight, they are therefore indifferent to making or forgoing the election. Of course, if the parties are both indifferent to making the election, they will likely just forgo making it because the income allocated to each shareholder will be the same in either case. In this example, S is terminating his interest on March 31, 2010, and SB’s total taxable income is $2,028. As was noted above, the difference between making the election and forgoing it is merely the allocation of the total taxable income.
Example 2: The facts are the same as in Example 1, except taxable income for the entire year (January 1, 2010–December 31, 2010) is $700. See Exhibit 2.
In Example 2, S’s allocation could be $250 or $86.30, depending on whether a Sec. 1377(a)(2) election is made. In this case, S would prefer to forgo the election, since his allocation of income would be less than if a Sec. 1377(a)(2) election were made. In this example, S is still terminating his interest on March 31, 2010, and SB’s total taxable income is $700. If the year’s results were known at the time of the transaction, S would likely not be motivated to make the election. Of course, B wants the election. If the parties had not previously agreed to make the election, S would have no incentive to make the election after the fact.
Example 3:The facts are the same as in Example 1, except that taxable income for the entire year (January 1, 2010–December 31, 2010) is $2,700. See Exhibit 3.
In Example 3, S’s allocation could be $250 or $332.88, depending on whether a Sec. 1377(a)(2) election is made. S would prefer to make the election because his allocation of income would be less in this case than if the election were forgone. In this example, S is still terminating his interest on March 31, 2010, and SB’s total taxable income is $2,700. Of course, B would not want the election. If the parties had not previously agreed to make the election, B would have no incentive to agree to make the election after the fact.
The three examples above illustrate scenarios in which S is:
- Not helped or hurt by a Sec. 1377(a)(2) election (Example 1);
- Hurt by a Sec. 1377(a)(2) election (Example 2); and
- Helped by a Sec. 1377(a)(2) election (Example 3).
In every example, the single constant was that taxable income through March 31 was $500. The corresponding variables were the proportion of taxable income earned for the period after March 31 through December 31, relative to the period January 1–March 31. Deciding whether the election helped or hurt is a calculation that a shareholder can only make with hindsight.
Conclusion
The examples above illustrate why it is of utmost importance for the parties involved to address and sign the election on or very close to the transaction date if they intend for the election to be made. If the parties wait until the tax return is due, it is likely that each party will examine the situation as it pertains only to his or her tax consequences. Unless individuals find themselves in a scenario like that in Example 1, where income is earned evenly throughout the year, individuals who take a hindsight approach to the election will never be indifferent to the choice between making the election and not making it. There will be an increased likelihood for conflict between the two parties because each party will have competing motivations to make or to forgo the election. The allocation will serve as a benefit to one party and as a detriment to the other party. It is important for tax practitioners to see these elections not necessarily as a tax-saving technique; rather, they should be viewed as a means to bring certainty to the individual shareholders by closing the books on the transaction date and allowing the selling shareholders to be allocated income earned only while they held their interest in the S corporation. Like agreeing to the price to be paid on the purchase of the stock, making the election is one of the terms of a transaction that is best addressed at the time of the transaction.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
https://www.ftb.ca.gov/file/business/income/apportionment-and-allocation.htmlhttps://www.thetaxadviser.com/issues/2010/dec/clinic-dec2010-story-09/
