Revenue Code 118: Tax Treatment of Capital Contributions

A corporation may receive funds or property without issuing stock, creating a transaction known as a contribution to capital. This infusion increases the corporation’s capital but is not a direct payment for goods, services, or shares. The tax implications of these contributions are governed by Internal Revenue Code (IRC) Section 118. The proper classification depends entirely on the source of the contribution.

Contributions from Shareholders

When a corporation receives money or property from an existing shareholder acting in their capacity as a shareholder, the contribution is not included in the corporation’s gross income. These transactions are viewed as an additional investment into the company. Common forms include direct cash payments, transfers of property like land or equipment, or the forgiveness of a debt the corporation owes to the shareholder.

For a transfer to qualify, it must be a voluntary payment not made in exchange for specific goods or services, with the intent to enhance the corporation’s capital structure. While contributions made proportionally by all shareholders are clear evidence of a capital contribution, non-pro-rata payments can also qualify if the intent is to increase the value of the shareholder’s investment.

The tax consequences are distinct for both parties. The shareholder increases their basis in their corporate stock by the amount of cash contributed or by their adjusted basis in the property they transferred. This adjustment is important because a higher stock basis reduces the taxable capital gain or increases the deductible loss when the shareholder eventually sells their stock.

Contributions from Non-Shareholders

The tax treatment for contributions from non-shareholders, such as government bodies or civic groups, was fundamentally altered by the Tax Cuts and Jobs Act of 2017 (TCJA). Before this legislation, many contributions from non-shareholders were excludable from a corporation’s income under Section 118. For instance, if a city offered a corporation land or cash as an incentive to build a new factory and create local jobs, that contribution was often treated as a non-taxable capital infusion.

The TCJA significantly narrowed this exclusion. Effective for contributions made after December 22, 2017, the law was amended to state that “contribution to capital” does not include any contribution from a governmental entity or civic group. As a result, these types of contributions are now taxable income to the recipient corporation, and the previous federal tax subsidy for state and local incentives was effectively removed.

Under current law, if a county provides a corporation with a $2 million cash grant to relocate its headquarters, that $2 million is included in the corporation’s gross income. Similarly, if a civic organization transfers a building to a company, the fair market value of that building is taxable to the corporation. While most of these contributions are now taxable, a few exceptions exist. The Infrastructure Investment and Jobs Act of 2021 created an exclusion for contributions to regulated public utilities that provide water or sewerage disposal services. A grandfather clause also protects contributions made pursuant to a master development plan approved before the TCJA’s enactment, and an exception applies if a governmental entity makes a contribution while acting as a shareholder.

Corporate Tax Basis and Reporting

The accounting and tax basis procedures a corporation must follow depend on whether the contribution was from a shareholder or a non-shareholder. The corporation must correctly record the asset and its corresponding basis on its financial statements, which has direct consequences for future tax calculations, such as depreciation deductions.

For a non-taxable contribution received from a shareholder, the corporation recognizes no income. Its basis in the property is determined by a carryover basis rule, meaning the corporation assumes the shareholder’s adjusted basis in the asset. On the balance sheet, the asset is recorded at this carryover basis, and the corresponding entry is an increase to “additional paid-in capital” (APIC), which does not affect the corporation’s earnings and profits (E&P).

Conversely, for a taxable contribution from a non-shareholder, the tax accounting is different. Since the fair market value of the property or cash is included in the corporation’s gross income, the corporation’s basis in the asset becomes its fair market value at the time of the contribution. This allows the corporation to take depreciation deductions on this higher basis. The contribution is reported as income on the income statement, which increases the corporation’s retained earnings and current E&P.