Tax Consequences of Contributions to S Corporations

The tax consequences of contributions to S corporations are similar to the rules governing C corporations.

Except as otherwise provided in the Internal Revenue Code, and except to the extent inconsistent with subchapter S, the provisions relating to C corporations apply to an S corporation and its shareholders.1  Because the Internal Revenue Code does not contain any special rules for capitalization of S corporations, a shareholder’s contribution of stock in exchange for an interest in the S corporation is governed by the same rules that apply to capitalization of C corporations.

Shareholder Tax Consequences

S corporation shareholders do not recognize gain or loss on the transfer of property to an S corporation in exchange for stock of the corporation if, immediately after the transfer, the contributing shareholders are in control of the corporation.2 In this context, “control” means ownership of stock possessing at least 80 percent of the total voting power of all classes of voting stock and 80 percent of the number of shares of each class of nonvoting stock.3 A shareholder’s receipt of consideration other than the corporation’s stock is taxable up to the fair market value of the non-stock consideration, but the shareholder cannot recognize a loss on the transfer.4 A shareholder’s contribution of services to an S corporation in exchange for stock does not qualify for tax-free treatment.

Attorney Practice Note: Comparison to Partnerships and Limited Liability Companies. A partner of a partnership (or member of a limited liability company 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.5 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.6 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.

The shareholder’s basis in the stock received from the corporation is initially determined using the C corporation rules.  Assuming the transfer qualifies as a tax-free capitalization, the shareholder’s initial basis equals the adjusted basis of any property and cash contributed to the corporation, increased by any gain recognized and decreased by the fair market value of any assets other than stock received from the corporation and by any loss recognized on the transfer.7 If the capitalization does not qualify for tax-free treatment, the shareholder’s basis equals the amount paid for the stock.8

Attorney Practice Note: Special rules apply if the shareholders contribute property subject to liability.9 If liabilities exceed the adjusted basis of the contributed assets, the transferring shareholder must recognize gain to the extent of the excess.10 Similar rules apply to partnerships.11 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.

Later transfers of property to a corporation are treated the same as initial transfers.  The transfer is not taxable if the shareholders transfer property solely in exchange for stock and, immediately after the exchange, the contributing shareholders own 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.12

Attorney Practice Note: Comparison to Partnerships and Limited Liability Companies. The 80 percent control rule can be problematic if a contribution of appreciated property is made at a later time by less than all of the original contributing shareholders. If one or more shareholders want to contribute appreciated property to the corporation and, immediately after the transfer, those these newly-contributing shareholders will have less than 80 percent control, the contribution will not qualify as a tax-free contribution. 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.

Corporate Tax Consequences

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

  1. I.R.C. § 1371.
  2. I.R.C. § 351(a).
  3. I.R.C. §368(c); Rev. Rul. 59-259, 1959-2 C.B. 115.
  4. I.R.C. §351(b).
  5. See Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 C.B. 191; Notice 2005-43.
  6. I.R.C. §§ 351(d) and § 83(a).
  7. I.R.C. § 358(a).
  8. I.R.C. § 1012.
  9. See I.R.C. §§ 357 and 362(d).
  10. I.R.C. § 357(c).
  11. I.R.C. § 752(c).
  12. I.R.C. §§ 351(a) and 368(c).
  13. I.R.C. § 1032(a).
  14. I.R.C. § 362(a).