Tax Consequences of Contributions to C Corporations

The tax consequences of contributions to C corporations depends on whether the contribution meets the Internal Revenue Code's strict requirements.
Jeramie Fortenberry, J.D., LL.M.

Jeramie Fortenberry, J.D., LL.M.

Attorney

Published Mar 06, 2013 Last updated Jan 13, 2023

The tax consequences of contributions to C corporations mirror the tax consequences of contributions to S corporations. If the mechanical requirements of Code 351 are satisfied, the transfer is not taxable to the shareholders. Otherwise, the transfer is treated as a sale to the corporation. Whether or not this matters depends on whether the assets contributed by the shareholders to the corporation in exchange for stock are appreciated assets.

Shareholder Tax Consequences

Shareholders do not recognize gain or loss on the transfer of assets to a corporation in exchange for stock (capitalization) as long as three requirements are satisfied. First, the shareholder must transfer “property” to the corporation in exchange for stock. The term “property” includes cash and real or intangible property, but not services.1

Attorney Practice Note: Comparison to Partnerships and Limited Liability Companies

A partner of a partnership (or member of a limited liability company that is taxed as a partnership) is not taxed on the receipt of an interest in the entity in exchange for services, as long as the interest is a mere profit interest and not a capital interest.2 This allows the partner to receive a tax-free (but limited) economic interest in the partnership. A shareholder’s receipt of stock in exchange for services provided to the corporation is taxable unless the stock is nontransferable or subject to a substantial risk of forfeiture.3 This often makes a partnership (or limited liability company taxed as a partnership) the preferred choice of entity if the parties wish to provide a tax-free economic interest in exchange for services.

Second, the transfer must be “solely in exchange for stock” in the corporation. If the shareholder receives assets other than stock as part of the transfer, the shareholder is taxed on any gain realized up to the full value of the non-stock assets received in the transaction.4 The shareholder cannot, however, deduct any loss recognized in the exchange.

Finally, the shareholder or group of shareholders transferring the assets in exchange for stock must have “control” of the corporation immediately after the exchange.5 In this context, “control” means that the contributing shareholder(s) must own stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.6

While the 80 percent control requirement is easily satisfied when the corporation is first capitalized, it presents problems for later contributions of appreciated assets in exchange for stock. There are situations where less than all of the original contributing shareholders will want to transfer assets to the corporation in exchange for stock. If these new contributing shareholders have less than 80 percent control of the corporation after the transfer, the contribution does not qualify for tax-free treatment. Instead, the transaction is treated as a sale to the corporation for fair market value. If the contribution includes appreciated property, the contributing shareholder is taxed on the appreciation.

Attorney Practice Note: Comparison to Partnerships and Limited Liability Companies

Partnerships and limited liability companies taxed as partnerships also qualify for tax-free capitalization, but without the 80 percent control requirement, making them a more flexible business structure for capitalization purposes.

Contributions to an “investment company” do not qualify for tax-free treatment.7 An investment company is generally defined for this purpose as a corporation in which more than 80 percent of the fair market value of contributed property (exclusive of cash and non-convertible debt obligations) consists of publicly-traded securities held for investment

If the shareholder’s contribution qualifies for tax-free treatment, the shareholder’s basis in the stock received in the transaction is the same as the shareholder’s basis in the property transferred to the corporation in exchange for the stock, with a few adjustments.8 If the capitalization does not qualify for tax-free treatment, the shareholder’s basis equals his cost.9

Attorney Practice Note: Special rules apply if the shareholders are contributing property that is subject to a liability.10 If liabilities exceed the adjusted basis of the contributed assets, the transferring shareholder must recognize gain to the extent of the excess.11 Similar rules apply to partnerships.12 This gain recognition can be avoided if the transferring shareholder also contributes a bona fide note in the amount of the difference. It is important to address this issue at the time the organization is first capitalized.

Corporate Tax Consequences

A corporation’s receipt of property in exchange for stock is not taxable to the corporation.13 The corporation’s basis in the contributed property equals the shareholder’s basis in the property before the transfer, increased by any gain recognized by the contributing shareholder.14

  1. I.R.C. § 351(d).
  2. See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 C.B. 191. But see Notice 2005-43.
  3. I.R.C. §§ 351(d), § 83(a).
  4. I.R.C. § 351(b).
  5. I.R.C. § 351(a).
  6. I.R.C. §368(c); Rev. Rul. 59-259, 1959-2 C.B. 115.
  7. I.R.C. § 351(e).
  8. I.R.C. § 358. Specifically, the shareholder’s basis is decreased by any money received from the corporation, the fair market value of property (other than money) received from the corporation, and the amount of loss the shareholder recognized in the exchange. I.R.C. § 358(a)(1)(A). The shareholder’s basis is increased by any amount treated as a dividend and any gain that the shareholder recognized in the exchange. I.R.C. § 358(a)(1)(B).
  9. I.R.C. § 1012.
  10. See I.R.C. §§ 357, 362(d).
  11. I.R.C. § 357(c).
  12. I.R.C. § 752(c).
  13. I.R.C. § 1032(a).
  14. I.R.C. § 362(a).