Revenue Ruling 83-17: Tax Consequences

Revenue Ruling 83-17 establishes the tax framework for a “bargain sale,” where a corporation sells property to a shareholder for a price below its fair market value. This transaction is not treated as a simple sale but as a multi-faceted event with distinct tax implications for both parties. The Internal Revenue Service (IRS) guidance ensures that the economic substance of the transaction—a distribution of value from the corporation to its owner—is properly reflected for tax purposes. This ensures the transaction’s true economic nature is taxed correctly. The ruling outlines a methodology for calculating the tax impact, which depends on several financial figures related to the property and the corporation.

Tax Consequences for the Shareholder

When a shareholder purchases property from their corporation for less than its fair market value (FMV), the difference is not a tax-free discount. This “bargain element” is treated as a property distribution under Internal Revenue Code (IRC) Section 301. The tax treatment for the shareholder follows a three-tiered system linked to the corporation’s earnings and profits (E&P).

The first tier dictates that the distribution is taxed as a dividend, but only to the extent of the corporation’s available E&P. If the corporation has sufficient current or accumulated E&P to cover the bargain amount, the shareholder must report that full amount as dividend income, which is often taxed at preferential qualified dividend rates.

Should the distribution amount exceed the corporation’s E&P, the excess is treated as a non-taxable return of capital. A return of capital is not immediately taxed; instead, it reduces the shareholder’s adjusted basis in their stock. This basis represents the shareholder’s investment in the corporation for tax purposes, and reducing it reflects that the company has returned a portion of that original investment.

If the distribution exceeds both the corporation’s E&P and the shareholder’s stock basis, the third tier applies. Any remaining amount is taxed as a capital gain, as if the shareholder sold a portion of their stock. The character of the gain, whether short-term or long-term, depends on how long the shareholder has held the stock. The shareholder’s basis in the newly acquired property is its full FMV, not the discounted price paid.

Tax Consequences for the Corporation

The corporation also faces tax consequences from a bargain sale to a shareholder, governed by IRC Section 311. This section addresses distributions of appreciated property. In a bargain sale, the corporation is treated as if it sold the property for its full fair market value, even though it received less cash from the shareholder.

The corporation must calculate its gain by subtracting its adjusted basis in the property from the property’s FMV at the time of the transfer. The resulting figure is the gain that the corporation must recognize and report on its income tax return, which increases its taxable income. This gain is recognized regardless of the amount of cash actually received in the transaction.

This treatment ensures that the appreciation in the property’s value is taxed at the corporate level. The character of the gain for the corporation—whether it is ordinary income or capital gain—depends on the nature of the asset itself. For example, the sale of inventory would result in ordinary income, while the sale of a capital asset held for more than a year would result in a long-term capital gain.

A rule in IRC Section 311 addresses losses. If the property’s adjusted basis is higher than its fair market value, the corporation is not permitted to recognize a loss on the distribution to a shareholder. This prevents corporations from creating artificial tax losses by distributing devalued property.

Required Information and Calculation Example

To correctly apply the principles of Revenue Ruling 83-17, several specific pieces of financial data must be gathered.

• Fair Market Value (FMV): The price the property would sell for on the open market, often established through a qualified appraisal.
• Corporation’s Adjusted Basis: The original purchase price of the asset plus any capital improvements, minus any depreciation taken.
• Amount Paid: The cash amount the shareholder pays the corporation for the property.
• Earnings & Profits (E&P): A specific tax accounting calculation, distinct from retained earnings, that measures the corporation’s capacity to make distributions that are considered dividends.

Calculation Example

Assume a corporation sells a parcel of land to its sole shareholder. The land has an FMV of $200,000, and the corporation’s adjusted basis in the land is $50,000. The shareholder pays $120,000 for the property. At the time of the sale, the corporation has $100,000 in E&P, and the shareholder has a basis of $40,000 in their corporate stock.

For the shareholder, the bargain element is the FMV less the amount paid: $200,000 – $120,000 = $80,000. This $80,000 is the amount of the distribution. Since the corporation’s E&P is $100,000, which is greater than the distribution, the entire $80,000 is treated as a dividend. The shareholder’s basis in the newly acquired land is its full FMV of $200,000.

For the corporation, it is treated as having sold the land for its FMV. The recognized gain is the FMV minus the corporation’s adjusted basis: $200,000 – $50,000 = $150,000. The corporation must report a $150,000 gain on its tax return, which will increase its taxable income and also its E&P.