IRS Code 362: Basis of Property to Corporations
Understand how a corporation's tax basis in received property is determined, exploring rules that link it to the transferor's basis and limit loss transfers.
When a corporation receives property, it does not record the asset at its market value for tax purposes. Instead, rules under Internal Revenue Code Section 362 dictate how the corporation determines its “basis” in that property. This basis is the figure used for calculating depreciation and determining gain or loss when the corporation later sells or disposes of the asset.
The laws governing a corporation’s basis ensure continuity of tax treatment between the person transferring the property and the corporation. In many corporate formations, transactions are structured to be tax-free, meaning no immediate tax is due. The basis rules are part of this tax-deferral system, preserving the potential for future taxation.
The Carryover Basis Rule
For corporations receiving property in certain tax-free exchanges, the primary principle for determining basis is the carryover basis rule. This rule dictates that the corporation’s basis in the acquired property is the same as the basis the transferor had in that property just before the transfer. This concept is central to transactions governed by Internal Revenue Code Section 351.
These transactions allow a person to transfer property to a corporation for stock without immediate gain or loss, provided they are in “control” of the corporation after the exchange. Control means owning at least 80 percent of the voting stock and at least 80 percent of all other classes of stock. The carryover basis rule ensures the transferor’s built-in gain or loss is preserved within the corporation.
For example, a shareholder transfers a building to a new corporation. The shareholder’s basis in the building is $200,000, and its fair market value is $500,000. The corporation’s basis in the building is the shareholder’s $200,000 basis, not the $500,000 market value. The $300,000 of appreciation is not taxed at the time of transfer but is embedded in the asset on the corporation’s books.
This transfer of basis is accompanied by a “tacked” holding period under Internal Revenue Code Section 1223. This means the corporation’s holding period for the asset includes the period the transferor held it. If the shareholder owned the building for five years, the corporation is considered to have owned it for five years, which affects whether a future sale results in a long-term or short-term capital gain.
The carryover basis rule treats the corporation as stepping into the shoes of the transferor. This is a mechanism of deferral, not forgiveness. The potential tax liability associated with the property’s appreciation is not eliminated but is transferred to the corporation to be recognized if it sells the asset.
Adjustments to Carryover Basis
The carryover basis is the starting point, but it must be increased by the amount of any gain the transferor recognizes on the exchange. While certain transfers are designed to be tax-free, a transferor must sometimes recognize a portion of their realized gain. Gain recognition occurs when the transferor receives not just stock in exchange for their property, but also other property or cash.
This non-stock consideration is commonly referred to as “boot.” A shareholder who receives boot must recognize any realized gain on the exchange, up to the fair market value of the boot received. The corporation’s basis in the asset is then increased by this recognized gain amount.
Using the previous example, a shareholder transfers a building with a $200,000 basis and a $500,000 value. The shareholder’s realized gain is $300,000. If the corporation gives the shareholder stock plus $50,000 in cash (boot), the shareholder must recognize $50,000 of that gain.
Consequently, the corporation’s basis in the building is adjusted. The calculation starts with the $200,000 carryover basis and is increased by the $50,000 gain the shareholder recognized. The corporation’s final adjusted basis in the building becomes $250,000, which prevents the same gain from being taxed twice.
The Built-In Loss Limitation Rule
An exception to the carryover basis principle is the built-in loss limitation rule, which was enacted to prevent taxpayers from duplicating a single economic loss. Previously, a shareholder could transfer property with a built-in loss to a corporation, allowing both the shareholder (in their stock) and the corporation (in the asset) to potentially recognize the same loss. The rule is triggered when the total basis of all property transferred by a shareholder exceeds its total fair market value (FMV).
When this condition is met, the corporation’s total basis in the transferred properties is limited to their total FMV. This required basis reduction must then be allocated among the properties that have built-in losses, in proportion to the size of their respective losses.
For example, a shareholder transfers two assets. Asset 1 has a $150,000 basis and an $80,000 FMV (a $70,000 built-in loss). Asset 2 has a $60,000 basis and a $100,000 FMV. The total basis is $210,000, and the total FMV is $180,000. Since the basis exceeds the FMV, the limitation rule applies.
The total required basis reduction is $30,000, which is the difference between the aggregate basis ($210,000) and the aggregate FMV ($180,000). This reduction is allocated entirely to Asset 1. The corporation’s basis in Asset 1 is reduced from $150,000 to $120,000, while the basis of Asset 2 remains $60,000.
As an alternative, the transferor and corporation can jointly elect to instead reduce the transferor’s basis in the stock received. In the example, making this election would mean the corporation keeps the $150,000 basis in Asset 1, but the shareholder’s stock basis would be reduced by the $30,000 net built-in loss. This election must be formally made and is irrevocable once filed, allowing the parties to decide where the tax attribute of the loss is more valuable.
Basis from Contributions to Capital
Property can also enter a corporation as a contribution to capital, meaning it is given without an exchange for stock. The rules for determining the corporation’s basis depend on the source of the contribution, with different outcomes for shareholders and non-shareholders.
When an existing shareholder contributes additional property, the transaction is treated as a contribution to capital. In this scenario, the basis rule mirrors the carryover basis principle. The corporation takes a basis in the contributed property equal to the basis the shareholder had in it.
The treatment changes when the contribution comes from a non-shareholder. If a non-shareholder, such as a government entity providing an incentive, contributes property other than money to a corporation, the corporation’s basis in that property is zero. This rule prevents the corporation from gaining a tax basis in an asset for which it made no economic outlay.
If a non-shareholder contributes cash, a different set of rules applies. The corporation must use that cash to reduce the basis of any property it acquires within a 12-month period beginning on the day the contribution was received. If the contributed cash exceeds the cost of property acquired in that timeframe, the excess amount is then used to reduce the basis of other property held by the corporation.