TCP CPA Exam: How to Calculate a Shareholder’s Tax Realized, Recognized Gain or Loss, and Basis on the Contribution of Noncash Property to an S Corporation

Introduction

Brief Overview of S Corporation Taxation

In this article, we’ll cover how to calculate a shareholder’s tax realized, recognized gain or loss, and basis on the contribution of noncash property to an S corporation. An S corporation is a pass-through entity, meaning that it generally does not pay corporate income taxes. Instead, the income, deductions, gains, and losses flow through to the shareholders, who report these items on their individual tax returns. This allows the S corporation to avoid the double taxation typically faced by C corporations, where both the corporation and shareholders are taxed on earnings. Shareholders of S corporations are taxed at their individual rates, which can offer tax benefits depending on the shareholders’ tax situation.

One key aspect of S corporation taxation involves the treatment of property contributions made by shareholders. When a shareholder contributes noncash property to an S corporation, there are specific rules that dictate how the transaction is taxed, both for the shareholder and the corporation. These contributions can result in tax consequences that affect the shareholder’s reported income and the S corporation’s basis in the contributed property.

Importance of Understanding Tax Consequences of Property Contributions

Contributing property to an S corporation can trigger a number of tax consequences for both the contributing shareholder and the corporation itself. If not handled properly, these contributions could result in unexpected taxable gains, limitations on loss recognition, or adjustments to the shareholder’s stock basis. Understanding these tax rules is crucial for effective tax planning, as it allows shareholders to make informed decisions about when and how to contribute property without facing adverse tax implications.

One of the central considerations in a property contribution is whether the transaction qualifies as tax-deferred under Internal Revenue Code (IRC) Section 351. When properly structured, Section 351 allows shareholders to defer recognition of gains or losses on the transfer of property to the corporation. However, certain situations, such as receiving cash or other property (referred to as “boot”) in the transaction, can trigger gain recognition. Additionally, liabilities associated with the contributed property can also complicate the tax treatment.

Key Concepts: Realized vs. Recognized Gain (Loss), and Basis in Contributed Property

When a shareholder contributes noncash property to an S corporation, several key tax concepts come into play. Understanding the difference between realized gain (loss) and recognized gain (loss), as well as the S corporation’s basis in the contributed property, is essential for accurate tax reporting.

• Realized Gain (Loss): The realized gain or loss represents the difference between the fair market value (FMV) of the contributed property and the shareholder’s adjusted basis in that property. This is a hypothetical gain or loss that occurs at the time of the contribution, whether or not it is immediately taxed.
• Recognized Gain (Loss): The recognized gain or loss is the portion of the realized gain or loss that is actually taxable in the year of the contribution. Under IRC Section 351, shareholders can defer recognizing a gain or loss if they meet certain conditions, but if they receive boot or the property is encumbered by liabilities, some or all of the gain may be recognized.
• Basis in Contributed Property: The S corporation’s basis in the contributed property is generally the same as the shareholder’s adjusted basis prior to the contribution, also known as a “carryover basis.” This basis is important for determining future depreciation, gain or loss on the sale of the property, and other tax consequences for the corporation. If a gain is recognized by the shareholder, the corporation’s basis may be adjusted accordingly.

Understanding these concepts is the foundation for calculating both the tax consequences to the shareholder and the basis the S corporation takes in the contributed property. These calculations ensure that both the shareholder and the S corporation comply with the tax rules, avoid unnecessary taxes, and report the transaction correctly.

Shareholder’s Contribution of Noncash Property: Overview

Explanation of How Contributions to an S Corporation Are Treated Under the Tax Code

When a shareholder contributes noncash property—such as real estate, equipment, or securities—to an S corporation, the tax treatment of this contribution depends on several factors. Under the tax code, contributions of property to an S corporation are generally not taxable events, provided certain conditions are met. This is primarily due to the fact that, in many cases, the contribution is seen as an exchange of property for equity (shares) in the corporation, rather than a sale of the property.

However, there are scenarios where the contribution can trigger immediate tax consequences for the shareholder. For instance, if the property contributed is subject to liabilities or if the shareholder receives “boot” (e.g., cash or other property in addition to stock), a portion of the transaction may be taxable. It’s important for shareholders and tax professionals to understand these rules to properly determine whether the contribution is taxable and, if so, to what extent.

Reference to IRC Section 351 and Its Relevance to Property Contributions

The key provision governing tax treatment of property contributions to an S corporation is Internal Revenue Code (IRC) Section 351. IRC Section 351 allows for tax-deferred treatment of property contributions, meaning that the shareholder does not have to recognize any gain or loss at the time of the contribution. This tax deferral is conditional upon certain requirements being met:

1. Control: The contributing shareholder(s) must own at least 80% of the S corporation’s stock immediately after the contribution. This control requirement ensures that the shareholder is not treated as having “sold” the property to a third party but rather as transferring it to a corporation in which they have a substantial ownership interest.
2. Property: The contribution must consist of property rather than services. Contributions of services in exchange for stock can result in taxable compensation to the shareholder.

If these conditions are satisfied, the shareholder can defer recognizing any gain or loss on the contribution, and the corporation takes a carryover basis in the property (i.e., the same basis the shareholder had in the property before contributing it).

IRC Section 351 is designed to facilitate the formation and capitalization of corporations by allowing shareholders to transfer property without immediate tax consequences. However, failure to meet these conditions, or the involvement of additional considerations like liabilities or boot, can result in taxable gains.

Importance of Determining Whether the Contribution Is Part of a Tax-Deferred Exchange

It’s critical to determine whether the contribution of noncash property to the S corporation qualifies as part of a tax-deferred exchange under IRC Section 351. If the transaction qualifies, the shareholder does not have to recognize any gain or loss on the contribution at the time of the exchange, which can lead to significant tax savings.

To assess whether the contribution qualifies, shareholders must evaluate the following:

• Control Test: Does the shareholder (or group of shareholders contributing property) retain at least 80% control of the S corporation immediately after the contribution?
• Boot and Liabilities: Is there any boot or assumption of liabilities involved in the transaction that could trigger gain recognition? Boot refers to any form of consideration other than stock, such as cash or other property, and can partially disqualify the deferral.
• Services vs. Property: Is the shareholder contributing services rather than property? Contributions of services do not qualify for tax deferral and are treated as compensation, which is taxable to the shareholder.

By determining whether a contribution is part of a tax-deferred exchange under Section 351, shareholders can avoid immediate tax liability and structure contributions to maximize tax benefits. For those that do not meet the deferral criteria, the realized gain may need to be recognized in the current tax year, resulting in taxable income for the shareholder. Therefore, careful planning is crucial to ensure the contribution is structured to meet the deferral requirements under IRC Section 351.

Calculating the Shareholder’s Realized Gain or Loss

Define Realized Gain/Loss as the Difference Between the Fair Market Value (FMV) of the Contributed Property and the Shareholder’s Adjusted Basis in the Property

When a shareholder contributes noncash property to an S corporation, the realized gain or loss is determined by comparing the property’s fair market value (FMV) at the time of contribution with the shareholder’s adjusted basis in that property. The adjusted basis generally refers to the shareholder’s original cost of acquiring the property, adjusted for any factors such as depreciation, improvements, or other adjustments that might have occurred over time.

The realized gain or loss represents the economic benefit or loss the shareholder experiences from the contribution, even if the gain or loss is not immediately recognized for tax purposes. It’s important to note that realized gain or loss is distinct from recognized gain or loss—which refers to the portion of the gain or loss that must be reported for tax purposes.

Formula for Realized Gain (Loss)

The formula for calculating the realized gain or loss is straightforward:

Realized Gain (Loss) = FMV of Property – Adjusted Basis of Property

Where:

• FMV of Property is the fair market value of the property at the time of contribution.
• Adjusted Basis of Property is the shareholder’s adjusted basis in the property, which accounts for any depreciation, improvements, or other factors that affect the property’s value for tax purposes.

Example Calculation Demonstrating How to Compute Realized Gain or Loss

Let’s walk through an example to illustrate how to compute the realized gain or loss when a shareholder contributes noncash property to an S corporation.

Example:

• Property Contributed: A shareholder contributes a piece of machinery to an S corporation.
• Fair Market Value (FMV): At the time of the contribution, the FMV of the machinery is $100,000.
• Adjusted Basis: The shareholder’s adjusted basis in the machinery, after accounting for depreciation and other adjustments, is $60,000.

To calculate the realized gain, we apply the formula:

Realized Gain = FMV of Property – Adjusted Basis of Property

Substituting the values:

Realized Gain = 100,000 – 60,000 = 40,000

In this example, the shareholder realizes a gain of $40,000 on the contribution of the machinery to the S corporation. This represents the economic gain the shareholder has experienced from holding the property. However, whether this gain is recognized (taxable) will depend on additional factors, such as whether the transaction qualifies for nonrecognition under IRC Section 351 or if any boot or liabilities are involved.

By calculating the realized gain or loss, shareholders can determine the potential tax implications and the economic value associated with the property they are contributing to the S corporation. This also forms the basis for understanding whether any part of the gain will be recognized and reported on their tax return.

Determining the Shareholder’s Recognized Gain or Loss

Definition of Recognized Gain (Loss)

The recognized gain or loss refers to the portion of the realized gain or loss that a taxpayer must report for tax purposes in the year the transaction occurs. While realized gain or loss represents the economic outcome of the contribution, only the recognized portion affects the shareholder’s tax liability. In some cases, the entire realized gain may be deferred under specific tax provisions, while in other cases, a portion or all of the gain must be reported as taxable income.

Recognized gain or loss is typically triggered by certain events, such as receiving cash or property (referred to as “boot”) in addition to stock or when liabilities exceed the basis of the contributed property. The determination of recognized gain or loss is critical because it directly impacts the shareholder’s taxable income for the year.

Explanation of Nonrecognition Rules Under IRC Section 351 (for Tax-Deferred Contributions)

IRC Section 351 allows shareholders to contribute property to an S corporation without immediately recognizing any gain or loss on the transaction, provided specific conditions are met. This is known as nonrecognition treatment, and it applies when:

1. Control: After the property contribution, the contributing shareholder(s) must own at least 80% of the S corporation’s stock. This control requirement ensures that the shareholder retains a significant ownership interest in the corporation after the contribution.
2. Property: The contribution must consist of property (e.g., real estate, machinery, or stock) and not services. If a shareholder contributes services in exchange for stock, the value of the services is treated as taxable compensation, and no deferral applies.

Under these rules, if a transaction meets the requirements of IRC Section 351, the shareholder’s realized gain is not recognized in the year of the contribution. Instead, the gain is deferred until the stock received in exchange for the property is sold or disposed of in a taxable transaction. This tax deferral can be advantageous, as it allows the shareholder to avoid immediate taxation on the contribution.

Situations Where Recognition May Be Required

Even when a contribution qualifies under IRC Section 351, there are certain circumstances where recognition of gain or loss may still be required. These include:

• Boot Received: If the shareholder receives “boot”—cash or other property—along with stock in the exchange, the shareholder must recognize a portion of the realized gain. The recognized gain is typically limited to the value of the boot received. For example, if a shareholder contributes machinery worth $100,000 and receives $10,000 in cash and stock, the $10,000 is taxable as recognized gain.
• Liabilities Exceed Basis: If the property contributed to the S corporation is subject to liabilities (e.g., a mortgage), and the amount of those liabilities exceeds the shareholder’s adjusted basis in the property, the excess liabilities are treated as boot. The excess amount must be recognized as taxable gain.
• Contribution of Services: If the shareholder contributes services rather than property, the value of the services is treated as ordinary income and is fully recognized in the year of the contribution.

In these situations, even if the contribution is otherwise eligible for nonrecognition treatment under IRC Section 351, recognition of some or all of the gain may still be required, depending on the nature of the transaction.

Example: Recognized Gain vs. Deferred Gain

Example 1: Recognized Gain Due to Boot

• Property Contributed: A shareholder contributes equipment with a fair market value of $80,000 and an adjusted basis of $50,000 to an S corporation.
• Boot Received: The shareholder receives $20,000 in cash (boot) and stock worth $60,000.

In this scenario, the total realized gain is calculated as:

Realized Gain = FMV of Property – Adjusted Basis of Property = 80,000 – 50,000 = 30,000

However, because the shareholder received $20,000 in boot, they must recognize gain up to the amount of the boot received. Therefore, the recognized gain is $20,000, and the remaining $10,000 is deferred. The shareholder will report $20,000 as taxable income, while the deferred gain will be recognized when the stock is sold or otherwise disposed of.

Example 2: Deferred Gain Under IRC Section 351

• Property Contributed: A shareholder contributes real estate with a fair market value of $200,000 and an adjusted basis of $150,000 to an S corporation.
• No Boot Received: The shareholder receives only stock in exchange for the property, and no cash or other property is involved.

In this case, the realized gain is:

Realized Gain = 200,000 – 150,000 = 50,000

Because no boot was received and the contribution qualifies for nonrecognition under IRC Section 351, none of the $50,000 realized gain is recognized in the current tax year. The entire $50,000 gain is deferred, meaning the shareholder will not have to pay taxes on it until the stock is sold or transferred in a taxable transaction.

These examples highlight how the presence of boot or other factors can impact the recognition of gain, and why it is important to carefully structure property contributions to take full advantage of the nonrecognition provisions under IRC Section 351.

S Corporation’s Basis in the Contributed Property

Definition of Basis from the S Corporation’s Perspective

From the perspective of the S corporation, the basis in the contributed property is crucial because it determines how the corporation will handle the property for tax purposes. The S corporation’s basis in the contributed property is used to calculate depreciation deductions, the gain or loss upon sale, and other tax-related consequences. Generally, the S corporation’s basis in the property begins with the shareholder’s adjusted basis in that property at the time of the contribution. However, certain factors, such as recognized gain or liabilities associated with the property, can affect this initial basis.

Explanation of Carryover Basis (S Corporation Takes the Same Basis in the Property as the Contributing Shareholder’s Adjusted Basis)

In most cases, when a shareholder contributes noncash property to an S corporation, the S corporation takes a carryover basis in the property. This means that the corporation’s basis in the contributed property is the same as the shareholder’s adjusted basis in the property at the time of contribution.

For example, if a shareholder’s adjusted basis in a piece of machinery is $50,000, and the shareholder contributes that machinery to the S corporation, the corporation’s basis in the machinery will also be $50,000. This carryover basis rule ensures that the S corporation does not get an inflated or reduced basis in the property, which would otherwise distort the tax consequences, such as depreciation and future gain or loss upon sale.

Situations Where Adjustments to Basis Are Required

While the general rule is that the S corporation takes a carryover basis, there are situations where adjustments to the basis may be required. The most common reasons for adjusting the basis include:

• Recognized Gain by the Shareholder: If the contributing shareholder recognizes gain on the transaction, the S corporation’s basis in the contributed property is increased by the amount of the recognized gain. For instance, if a shareholder recognizes a $10,000 gain on the contribution, the S corporation’s basis in the property is increased by $10,000 over the shareholder’s adjusted basis.
• Boot or Other Property Received: If the shareholder receives cash or other property (boot) as part of the contribution, the corporation’s basis may also be adjusted to reflect the value of that boot.

These adjustments ensure that any gain recognized by the shareholder is reflected in the S corporation’s basis in the contributed property.

Basis Adjustments When Liabilities Are Assumed by the S Corporation

Another situation that can affect the S corporation’s basis in the contributed property is when the property is subject to liabilities, such as a mortgage. When the S corporation assumes liabilities attached to the contributed property, it can impact both the shareholder’s recognized gain and the corporation’s basis in the property.

The general rule is that the amount of the liability is added to the S corporation’s basis in the property. For example, if a shareholder contributes property with an adjusted basis of $60,000 and a liability of $20,000, the S corporation’s basis in the property would be:

S Corporation’s Basis = Adjusted Basis of Property + Liability Assumed

In this case:

S Corporation’s Basis = 60,000 + 20,000 = 80,000

However, if the shareholder’s liability exceeds their adjusted basis in the property, the excess is treated as gain for the shareholder, which could trigger a basis increase for the S corporation. For instance, if the property has an adjusted basis of $40,000 but the liability is $60,000, the $20,000 excess liability is treated as recognized gain for the shareholder, and the S corporation’s basis is adjusted accordingly.

These adjustments ensure that both the shareholder’s gain and the corporation’s future tax consequences reflect the reality of the contribution, particularly when liabilities are involved.

The S corporation’s basis in the contributed property is primarily determined by the shareholder’s adjusted basis, but can be adjusted for recognized gains, liabilities assumed by the corporation, or other factors. These adjustments play a key role in future tax consequences for the corporation, such as depreciation and the calculation of gain or loss on the sale of the property.

Impact of Liabilities on Basis and Gain Recognition

Discuss the Effect of Contributed Property Subject to Liabilities (e.g., Mortgage)

When a shareholder contributes property to an S corporation that is subject to liabilities, such as a mortgage, the assumption of those liabilities by the S corporation can significantly affect both the shareholder’s tax consequences and the S corporation’s basis in the property.

In general, if the property is subject to a liability and the S corporation assumes or takes over that liability as part of the contribution, it is treated as if the shareholder received “boot” in the transaction. This means that the assumption of liabilities can trigger recognized gain for the shareholder, even if the transaction would otherwise qualify for tax deferral under IRC Section 351.

The presence of liabilities complicates the tax treatment because the amount of the liability assumed may exceed the shareholder’s adjusted basis in the property. When this happens, the excess is treated as recognized gain for the shareholder, which is taxable in the year of the contribution. Additionally, the S corporation’s basis in the property will be adjusted to reflect the liabilities it assumes.

How Liabilities Assumed by the S Corporation Affect Both the Shareholder’s Recognized Gain and the S Corporation’s Basis in the Property

When an S corporation assumes liabilities attached to contributed property, two key tax consequences arise:

1. Shareholder’s Recognized Gain: If the amount of the liability exceeds the shareholder’s adjusted basis in the property, the excess amount is treated as recognized gain for the shareholder. This gain is taxable in the year of the contribution, and the amount recognized is generally equal to the difference between the liability and the adjusted basis of the property.
2. S Corporation’s Basis in the Property: The S corporation’s basis in the contributed property is increased by the amount of the liabilities it assumes. The general rule is that the corporation’s basis in the property is equal to the shareholder’s adjusted basis, plus any gain recognized by the shareholder, and any liabilities assumed by the corporation.

These rules ensure that the transaction is reflected appropriately in both the shareholder’s taxable income and the S corporation’s tax records, including depreciation calculations and future gain or loss on the sale of the property.

Example Calculation of Gain Recognition and S Corporation’s Basis When Liabilities Are Involved

Let’s look at an example to clarify how liabilities impact both gain recognition for the shareholder and the S corporation’s basis in the contributed property.

Example:

• Property Contributed: A shareholder contributes a building to an S corporation.
• Fair Market Value (FMV) of the building: $200,000.
• Adjusted Basis: $120,000.
• Liability (Mortgage): $150,000, which is assumed by the S corporation.

Step 1: Calculate the Realized Gain

Realized Gain = FMV of Property – Adjusted Basis of Property
Realized Gain = 200,000 – 120,000 = 80,000

In this case, the realized gain is $80,000.

Step 2: Determine the Shareholder’s Recognized Gain

The shareholder will recognize gain to the extent that the liability assumed by the S corporation exceeds the shareholder’s adjusted basis in the property.

Liability Assumed by S Corporation = 150,000
Adjusted Basis of Property = 120,000
Recognized Gain = 150,000 – 120,000 = 30,000

Here, the recognized gain is $30,000, which the shareholder must report as taxable income in the year of the contribution.

Step 3: Calculate the S Corporation’s Basis in the Contributed Property

The S corporation’s basis in the contributed property is determined by taking the shareholder’s adjusted basis and adding any recognized gain and the liabilities assumed by the corporation. The formula is:

S Corporation’s Basis = Adjusted Basis of Property + Recognized Gain + Liabilities Assumed

In this case:

S Corporation’s Basis = 120,000 + 30,000 = 150,000

Thus, the S corporation’s basis in the property is $150,000, which includes the recognized gain and the liability assumed.

Summary of Tax Consequences:

• The shareholder recognizes a gain of $30,000, which must be reported as taxable income.
• The S corporation assumes the mortgage and takes a basis of $150,000 in the property, which it will use for future depreciation calculations and potential gain or loss on disposition.

This example demonstrates how liabilities assumed by an S corporation can trigger recognized gain for the shareholder and affect the corporation’s basis in the contributed property.

Tax Implications for the Shareholder

Tax Impact of Recognized Gains (Capital Gains or Ordinary Income)

When a shareholder contributes property to an S corporation and recognizes gain, the type of gain (capital or ordinary) depends on the nature of the property contributed and the transaction itself. The recognized gain can be classified as:

• Capital Gain: If the property contributed is a capital asset (such as investment real estate or securities), the recognized gain is generally treated as a capital gain. The tax rate on capital gains depends on the shareholder’s holding period and individual tax situation. Long-term capital gains, from assets held for more than one year, are taxed at preferential rates (0%, 15%, or 20%, depending on the taxpayer’s income bracket). Short-term capital gains, from assets held for one year or less, are taxed at ordinary income rates.
• Ordinary Income: If the contributed property is subject to depreciation recapture rules, such as Section 1245 or Section 1250 property, the recognized gain may be treated as ordinary income to the extent of previously claimed depreciation. Ordinary income is taxed at the shareholder’s individual income tax rates, which can be higher than capital gains rates.

Recognized gain may also be triggered if the S corporation assumes liabilities that exceed the shareholder’s adjusted basis in the contributed property, as previously discussed. This gain is typically recognized as part of the transaction in the year the contribution is made.

Reporting Requirements (Where to Report on Tax Returns)

Shareholders who recognize gain on the contribution of noncash property to an S corporation must report this gain on their individual income tax return (Form 1040). The specific forms used for reporting depend on the type of gain:

• Capital Gains: If the recognized gain is classified as a capital gain, it must be reported on Schedule D (Capital Gains and Losses) of Form 1040. Additionally, if the gain is from investment property or real estate, the transaction details may need to be included on Form 8949 (Sales and Other Dispositions of Capital Assets) before transferring the summary to Schedule D.
• Ordinary Income: If any portion of the recognized gain is classified as ordinary income (due to depreciation recapture, for example), this amount is reported on Form 4797 (Sales of Business Property). The gain will be taxed at ordinary income rates and reported alongside other business income.

It is critical that the shareholder accurately reports any recognized gain or loss, as failure to do so can lead to penalties and interest from the IRS. The shareholder’s tax basis in the S corporation stock must also be adjusted to reflect the contribution and any recognized gain.

Special Considerations for Contributions of Depreciable Property and Recapture Rules

When a shareholder contributes depreciable property to an S corporation, there are special tax considerations related to depreciation recapture. Depreciation recapture rules apply to property that has been depreciated for tax purposes before being contributed, and they require the shareholder to recapture (report as income) some or all of the previously deducted depreciation as ordinary income when the property is sold or exchanged.

Two primary types of depreciable property and their related recapture rules are:

• Section 1245 Property: This includes tangible personal property, such as machinery and equipment. When Section 1245 property is contributed to an S corporation, the shareholder may have to recognize ordinary income to the extent of the depreciation previously claimed on the property. The amount of depreciation recapture is the lesser of the gain realized or the total depreciation deductions taken. This ordinary income is taxed at the shareholder’s regular income tax rates.
• Section 1250 Property: This applies to real property, such as buildings. When Section 1250 property is contributed to an S corporation, the recapture rules are less stringent. Depreciation recapture is limited to the portion of depreciation claimed over the straight-line depreciation method. Any gain due to straight-line depreciation is generally taxed as a capital gain, but any excess depreciation is recaptured as ordinary income.

Example of Depreciation Recapture:

• A shareholder contributes machinery (Section 1245 property) with an adjusted basis of $50,000 and a fair market value of $100,000. The shareholder had claimed $30,000 of depreciation deductions. In this case, if the machinery is contributed to an S corporation and the shareholder recognizes gain, $30,000 of that gain may be subject to recapture as ordinary income, while the remaining gain is treated as capital gain.

When contributing depreciable property to an S corporation, shareholders must be aware of the potential for depreciation recapture and the resulting ordinary income tax liability. These rules ensure that previously claimed tax benefits from depreciation are recaptured and taxed appropriately when the property is disposed of, whether by sale or contribution to an S corporation.

Tax Implications for the S Corporation

How the S Corporation Uses the Basis in Contributed Property for Depreciation and Gain/Loss on Future Sale

Once property is contributed to an S corporation, the corporation must use the basis it receives in the property to calculate future depreciation, as well as to determine the gain or loss upon the eventual sale or disposal of the property. The basis that the S corporation receives is generally the carryover basis, which is the same as the adjusted basis the contributing shareholder had in the property. This basis is crucial for:

• Depreciation: The S corporation will use the basis to compute depreciation deductions over the useful life of the property. The corporation can depreciate the property starting in the year of contribution, using the applicable method (e.g., Modified Accelerated Cost Recovery System, or MACRS).
• Gain or Loss on Sale: If the S corporation later sells or disposes of the contributed property, the corporation will compare the adjusted basis (original basis minus any accumulated depreciation) to the sale price or fair market value at the time of sale. If the sale price exceeds the adjusted basis, the corporation recognizes a gain; if the sale price is less than the adjusted basis, the corporation recognizes a loss.

For example, if a shareholder contributes equipment with an adjusted basis of $70,000 to an S corporation, and the corporation later sells the equipment for $90,000, the S corporation would recognize a gain of $20,000 ($90,000 – $70,000).

Effect of the Contributed Property on the S Corporation’s Balance Sheet and Future Tax Deductions

The contribution of noncash property to an S corporation impacts both the corporation’s balance sheet and its ability to claim future tax deductions.

1. Balance Sheet Impact:
   • Upon the contribution of property, the S corporation will reflect the property’s basis as an asset on its balance sheet. If the property is depreciable (e.g., machinery, buildings), the corporation will report the property as a fixed asset and start depreciating it according to IRS guidelines.
   • If the property is subject to liabilities (such as a mortgage on real estate), the liability will also be recorded on the balance sheet. The net effect on the balance sheet will be the difference between the property’s basis and the amount of the liabilities assumed by the corporation.
2. Future Tax Deductions:
   • The S corporation can take depreciation deductions on the contributed property over time. The amount and method of depreciation depend on the property type (e.g., machinery, real estate) and the relevant IRS depreciation schedules (such as MACRS).
   • These depreciation deductions reduce the corporation’s taxable income, which can benefit both the corporation and its shareholders since the taxable income of the S corporation flows through to the shareholders’ personal tax returns.

Example of How the S Corporation Would Treat Depreciation of Contributed Property

Let’s consider an example to illustrate how the S corporation would handle depreciation on contributed property:

Example:

• Property Contributed: A shareholder contributes a piece of machinery to the S corporation.
• Fair Market Value (FMV): $150,000.
• Adjusted Basis: $100,000.
• Depreciation: The machinery is classified as 5-year property under MACRS.

Step 1: Establish the Corporation’s Basis in the Property

Since the S corporation takes a carryover basis in the property, its basis is the same as the shareholder’s adjusted basis—$100,000.

Step 2: Calculate Annual Depreciation Deduction

Using the MACRS 200% declining balance method for 5-year property, the S corporation will compute its depreciation deduction as follows:

• Year 1 Depreciation: $100,000 × 20% = $20,000.
• Year 2 Depreciation: $100,000 × 32% = $32,000.

The corporation will continue depreciating the property for a total of five years, reducing its taxable income by the amount of depreciation deducted each year.

Step 3: Balance Sheet Impact

On the balance sheet, the machinery will be recorded as a fixed asset at its adjusted basis of $100,000. Over time, as the S corporation takes depreciation deductions, the book value of the machinery will decrease, reflecting the accumulated depreciation.

Step 4: Future Sale of the Machinery

If the S corporation sells the machinery in Year 3 for $80,000, the corporation will calculate its gain or loss as follows:

• Adjusted basis at the time of sale:
  Adjusted Basis = 100,000 – (20,000 + 32,000) = 48,000
• Gain on sale:
  Gain = Sale Price – Adjusted Basis = 80,000 – 48,000 = 32,000

The S corporation will recognize a $32,000 gain on the sale of the machinery, which will be passed through to the shareholders and reported on their personal tax returns.

In this example, the depreciation deductions taken by the S corporation reduced its taxable income each year, and the gain recognized on the sale of the machinery will also flow through to the shareholders. This demonstrates how the basis of the contributed property impacts both the ongoing tax deductions and the gain or loss on future sales for the S corporation.

Example Scenarios

Scenario 1: Tax-Deferred Contribution Under IRC Section 351 (No Gain Recognized)

Facts:
A shareholder contributes real estate with a fair market value (FMV) of $300,000 and an adjusted basis of $200,000 to an S corporation in exchange for stock. No liabilities are attached to the property, and no cash or other property (boot) is received.

Analysis:
This transaction qualifies for tax deferral under IRC Section 351 because:

• The shareholder is contributing property (real estate) in exchange for stock.
• After the contribution, the shareholder owns at least 80% of the S corporation’s stock, meeting the control requirement.

Since no boot is involved and no liabilities are assumed, the shareholder recognizes no gain on the contribution, even though there is a $100,000 realized gain ($300,000 FMV – $200,000 adjusted basis). This gain is deferred, meaning the shareholder will not be taxed until the stock received is sold or disposed of in a taxable transaction.

Tax Consequences:

• Shareholder: No gain is recognized in the current tax year, and the shareholder takes a basis in the stock received equal to the adjusted basis of the property contributed ($200,000).
• S Corporation: The corporation takes a carryover basis in the real estate, which is $200,000 (the same as the shareholder’s adjusted basis).

Scenario 2: Contribution with Boot Received (Partial Gain Recognized)

Facts:
A shareholder contributes machinery with an FMV of $150,000 and an adjusted basis of $100,000 to an S corporation. In return, the shareholder receives stock worth $120,000 and $30,000 in cash (boot).

Analysis:
This transaction is partially tax-deferred under IRC Section 351, but the shareholder must recognize gain to the extent of the boot received. The realized gain is $50,000 ($150,000 FMV – $100,000 adjusted basis), but only $30,000 of this gain is recognized, as the recognized gain is limited to the amount of cash (boot) received.

Tax Consequences:

• Shareholder: The shareholder must recognize a gain of $30,000 (the amount of boot received) and will report this gain as taxable income. The remaining $20,000 of realized gain is deferred. The shareholder’s basis in the stock received is calculated as follows:
  Basis in Stock = Adjusted Basis of Contributed Property – Boot Received + Recognized Gain
  Basis in Stock = 100,000 – 30,000 + 30,000 = 100,000
  Thus, the shareholder’s basis in the stock is $100,000.
• S Corporation: The corporation’s basis in the machinery is $100,000, the carryover basis from the shareholder, since the gain recognized by the shareholder does not increase the corporation’s basis.

Scenario 3: Contribution of Property with Liabilities (Gain Recognized and Basis Adjustment)

Facts:
A shareholder contributes a building with an FMV of $400,000 and an adjusted basis of $250,000 to an S corporation. The building is subject to a $300,000 mortgage, which is assumed by the S corporation.

Analysis:
In this scenario, the assumption of the liability ($300,000) by the S corporation exceeds the shareholder’s adjusted basis in the property ($250,000). As a result, the excess liability of $50,000 ($300,000 – $250,000) is treated as recognized gain, even though the contribution otherwise qualifies for tax deferral under IRC Section 351.

The total realized gain is $150,000 ($400,000 FMV – $250,000 adjusted basis), but only $50,000 of that gain is recognized due to the excess liability.

Tax Consequences:

• Shareholder: The shareholder must recognize $50,000 of gain as taxable income because the liability exceeds the adjusted basis in the property. The shareholder’s basis in the stock received is calculated as:
  Basis in Stock = Adjusted Basis of Contributed Property – Liability Assumed + Recognized Gain
  Basis in Stock = 250,000 – 300,000 + 50,000 = 0
  Therefore, the shareholder has a zero basis in the stock received.
• S Corporation: The S corporation’s basis in the building is adjusted to account for the recognized gain. The corporation’s basis is calculated as the shareholder’s adjusted basis plus the gain recognized by the shareholder:
  S Corporation’s Basis = Adjusted Basis of Property + Recognized Gain
  S Corporation’s Basis = 250,000 + 50,000 = 300,000
  Thus, the S corporation’s basis in the building is $300,000, which reflects the liability assumed and the recognized gain.

These scenarios illustrate how the presence of boot or liabilities can affect the recognition of gain for the shareholder and the corresponding adjustments to the S corporation’s basis in the contributed property. Proper planning and understanding of these tax consequences can help avoid unexpected tax liabilities.

Conclusion

Recap of Key Points

Contributing noncash property to an S corporation can have significant tax implications for both the shareholder and the corporation. Key points covered in this article include:

• The realized gain or loss is the difference between the fair market value of the property and the shareholder’s adjusted basis in the property.
• Under IRC Section 351, shareholders can defer recognizing gain or loss on property contributions, provided they meet the control and property requirements. However, certain conditions, such as receiving boot or contributing property with liabilities, can trigger recognized gain.
• The S corporation’s basis in the contributed property is generally the same as the shareholder’s adjusted basis, with adjustments for recognized gain or assumed liabilities. This basis affects the corporation’s future depreciation deductions and the gain or loss on future sales of the property.
• Special considerations apply when contributing depreciable property, including potential depreciation recapture, which may lead to recognized ordinary income for the shareholder.

Importance of Understanding the Tax Treatment of Property Contributions to Avoid Unexpected Tax Consequences

Understanding the tax treatment of property contributions is crucial to avoid surprises. While many contributions can qualify for tax deferral, the presence of liabilities, boot, or specific types of property (like depreciable assets) can lead to immediate tax consequences. Careful attention to the rules, especially the application of IRC Section 351 and the impact of liabilities, is essential to ensure proper tax reporting and compliance.

Final Thoughts on Proper Planning When Contributing Property to an S Corporation

Proper tax planning is key when contributing property to an S corporation. Shareholders should work with tax professionals to structure contributions in a way that maximizes the tax deferral benefits and minimizes the risk of recognized gain. This includes evaluating the nature of the property, the presence of any liabilities, and the potential for depreciation recapture. With careful planning, shareholders can contribute property to an S corporation while avoiding unintended tax consequences, ensuring that both the shareholder and the corporation benefit from the transaction in the long term.