Basic Principles
What does the term “gross income” mean to you? For most folks, it refers to the amount of money that is paid to someone in exchange for their services or property, or for the use of their property.
The Code describes the gross income of a taxpayer more expansively to mean all of the taxpayer’s income from whatever source derived, and in whatever form realized.[i] In other words, any accretion in wealth realized[ii] by a taxpayer is included in gross income.
That being said, the Courts have long recognized that Congress has the authority to provide exceptions to the general rule that all income is subject to tax. Thus, Congress may specifically exclude from the gross income of a taxpayer certain items of value that are actually realized by the taxpayer.
Over the years, Congress has excluded various items in order to further certain economic or social policies.[iii]
For example, the amount of gain realized by a taxpayer from the sale of property (an exchange of the property for cash), is included in gross income. Likewise, the gain realized by a taxpayer from the exchange of a property for other property (other than money) differing materially in kind from the exchanged property, is treated as income.[iv]
In each of these transactions, the nature of the taxpayer’s interest or investment in a property has changed sufficiently to conclude that the taxpayer has terminated such interest or investment and, so, should include in gross income the gain arising from the transaction.
There are other transactions, however, with respect to which Congress has determined that a taxpayer’s disposition of their investment in a property in exchange for other property has not materially changed the nature of such investment to warrant the inclusion of the gain realized in gross income.[v]
In Exchange for Stock
The Code identifies several exchanges involving shareholders and corporations that it has determined should be excepted from the general rule that gain must be accounted for upon the exchange of property.
The purpose of the so-called “reorganization” provisions of the Code is to except from the general rule certain specifically described exchanges that are incident to such reorganizations of corporate structures and are made in one of the particular ways specified in the Code, provided the reorganization is motivated by business exigencies and it effects only a readjustment of its shareholders’ continuing interest in the corporation’s business or property under modified corporate forms.[vi]
Requisite to a reorganization under the Code are a continuity of the business enterprise through the issuing corporation under the modified corporate form[vii] and a continuity of interest.[viii]
Controlled Corporation
In addition, the Code provides for the nonrecognition of gain upon: (a) the transfer of property[ix] by one or more persons, (b) to a corporation, (c) solely in exchange for stock of such corporation, (d) if, immediately after the exchange, such person or persons are in “control”[x] of the corporation.[xi]
It should be noted that those transferring property to the corporation may already be in control of the corporation. There is no requirement that control be acquired in connection with the transfer.
Indeed, there is no requirement that additional stock of the corporation be issued to its shareholders – who are, by definition, already in control of the corporation – in exchange for their transfer of property to the corporation where the issuance of such additional stock would be a so-called “meaningless gesture”; as where the amount contributed by each shareholder is proportionate to their pre-contribution interest in the corporation.[xii]
No gain is recognized to a corporation on its receipt of money or other property in exchange for the issuance of its stock (including treasury stock) to the transferor of such money or property.[xiii] The basis of such property in the hands of the corporation is the same as it was in the hands of the transferor.[xiv]
Taxable Exchange
If the transferors of property to a corporation, in exchange for shares of the corporation’s stock, are not in control of the corporation immediately after the exchange, the transferors must recognize – i.e., include in gross income – the gain realized in the exchange.
Still, as stated earlier, no gain is recognized to the issuing corporation on the receipt of money or other property in exchange for its stock, notwithstanding the transferors of such property must include the gain from the exchange in gross income.
Contribution But No Exchange
However, what if there is no exchange between the transferor of property and the corporation to which the property is transferred? Specifically, what if the transferee corporation does not issue shares of its stock to the transferor in consideration for the property?
You may wonder how realistic a scenario this question contemplates. I assure you that it’s not all that unusual.
For example, how many times have you encountered a struggling business, of which one of the owners – probably the one with the most to lose – “voluntarily” contributes additional capital to the business without any expectation of increasing his ownership interest relative to the other owners, and certainly without intending to bestow an economic benefit on the other owners beyond one that is incidental to the contribution? In that case, isn’t the contributing owner merely protecting his investment in the business by effectively agreeing to pay more for his interest?[xv]
What if the transferor is not already a shareholder of the transferee corporation, in which case application of the meaningless gesture rationale is precluded?
Well, you may ask, under what circumstances would a transferor not expect anything in return from the corporation? Assuming we are not looking at a scenario in which the transferor of capital is the parent of the corporation’s shareholders and intends to make a gift to his kids, is there some other relationship that explains the corporation’s failure to issue any stock in exchange for the contribution to capital?
Moreover, can the corporation exclude the value of the contribution from its gross income notwithstanding the corporation has experienced an accretion in value as a direct result of the contribution?
Contribution to Capital
In general, the Code provides an exclusion from the gross income of a corporation with respect to any contribution of money or property to the capital of the corporation.[xvi]
Shareholders
Thus, if a corporation requires additional funds for conducting its business and obtains such funds through voluntary pro rata payments by its shareholders, the amounts so received being credited to its surplus account or to a special account, such amounts do not constitute income, although there is no increase in the outstanding shares of stock of the corporation.[xvii]
In such a case the payments are in the nature of assessments upon, and represent an additional price paid for, the shares of stock held by the individual shareholders, and will be treated as an addition to, and as a part of, the operating capital of the company.
Non-Shareholders
Prior to the Tax Cuts and Jobs Act,[xviii] this exclusionary rule also applied to specific contributions to the capital of a corporation made by persons other than shareholders; for example, the exclusion applied to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities in that community.
TCJA[xix]
However, for contributions made after December 22, 2017,[xx] the Act redefined the term “contribution to the capital of the taxpayer” to exclude: (1) any contribution in aid of construction or any other contribution of money or property as a customer or potential customer, and (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).[xxi]
Thus, after the Act, a corporation will generally be required to include in its gross income the amount of money and the fair market value of other property that is contributed to its capital by someone other than a shareholder of the corporation acting it their capacity as such.[xxii]
A recent decision of the U.S. Tax Court considered the application of this rule taxable years that straddled the effective date of the Act.[xxiii]
“Help” for a Growing Business
Taxpayer was a C corporation that designed, engineered, and manufactured Product at a facility it leased indirectly from its sole shareholder.
Customer, acting through a wholly owned subsidiary (“Customer-Sub”), engaged Taxpayer to produce Product; however, Customer-Sub sought nearly 20 times Taxpayer’s then-current production, and at the same per-unit cost.
Taxpayer attempted to meet this demand by running its production lines for additional hours each day, but labor overtime costs raised the price per unit. At its then-current size, Taxpayer could not meet Customer-Sub’s demand for Product while maintaining a lower per-unit cost.
As Customer-Sub’s demand for Product began to outstrip Taxpayer’s production capacity, Customer, Customer-Sub, and Taxpayer explored ways to increase Taxpayer’s throughput without increasing Product’s unit cost.
The parties determined that the demand required Taxpayer to expand its facility and manufacturing space, equipment, and personnel. They eventually settled on an addition to Taxpayer’s leased manufacturing facility that would be funded primarily by Customer-Sub, though Lessor also intended to use its own funds to make capital improvements to the facility that would aid in meeting Customer-Sub’s demand.
Contemporaneously with the construction of the improvements to the facility, Taxpayer and Customer-Sub negotiated the terms of the arrangement pursuant to which Taxpayer would use its “equipment, materials and facilities” to manufacture Product for Customer-Sub. In addition to funding the construction, Customer-Sub agreed to provide funds for Taxpayer to purchase additional machinery and equipment to be used for the manufacture of Product. Interestingly, the parties also specified that ownership of, and title to, any machinery and equipment purchased by Taxpayer using the funds provided by Customer-Sub would “remain vested in [Customer-Sub]” and Taxpayer would have “no right, title or interest in or to any part of” such property other than the right to use it to manufacture and supply Product to Customer-Sub.
Taxpayer’s Return
Taxpayer did not report any of the almost $4.3 million provided by Sub for the leasehold improvements as income on its federal corporate tax returns[xxiv] for the two years in which Sub paid for the improvements.
The IRS issued Taxpayer a Notice of Deficiency for both these tax years. Taxpayer timely filed its Petition with the Tax Court.
By late 2017 much of the additional manufacturing facility was complete and Taxpayer bought the tools and machinery necessary to populate the leasehold addition, for which it charged Sub on a cost-plus basis. The remainder of the leasehold addition was completed in late 2018. Since the completion of the leasehold addition, Taxpayer paid the insurance and property taxes for the entire premises, including the resultant leasehold improvements, and has borne any attendant risks.
The Agreement imposed limitations on Taxpayer’s use of the Equipment funded by Customer-Sub “Dedicated Equipment” such that it could only be used to manufacture Product for Customer-Sub.
Pursuant to the terms of the Agreement, Taxpayer used the portion of the leasehold addition (and the Dedicated Equipment therein) funded by Customer-Sub only to make Product for Customer-Sub. This remained true the parties terminated their relationship.
Tax Returns
Taxpayer did not report on its return as gross income any of the approximately $4.3 million received from Customer-Sub.[xxv]
However, Taxpayer disclosed that it had received funds in the nature of non-shareholder contributions to its capital, and relied on the pre-Act version of the Code’s exclusion rule for capital contributions as the bases for not reporting these amounts as taxable income on its returns.
The IRS issued Taxpayer a Notice of Deficiency in which it determined that Taxpayer owed additional income tax attributable to the funds provided by Customer-Sub.
In its timely-filed Petition to the Tax Court, Taxpayer disagreed with the IRS’s determination.
Tax Court’s Analysis[xxvi]
It was undisputed, the Court began, that Taxpayer contracted with Customer-Sub to receive about $4.3 million to expand its manufacturing capacity for Product, and that Customer-Sub paid that amount for that purpose. It was likewise undisputed, the Court continued, that those funds were ultimately used to build the leasehold addition.
Ownership
The parties disagreed, however, on who owned the resultant leasehold addition. Taxpayer contended that it belonged to Customer-Sub, whereas the IRS asserted that Taxpayer was the owner of the leasehold addition.
Taxpayer argued that Customer-Sub wanted Taxpayer to hold legal title to the leasehold addition, while Customer-Sub held an equitable interest therein. However, this point was never specifically memorialized, and there was no other concrete evidence that proved Customer-Sub to be the true owner of the leasehold addition.
On the other hand, there was direct evidence showing Taxpayer’s ownership: Taxpayer paid the insurance and the taxes for the entire facility, including the addition; Taxpayer bore the risks relating to the leasehold addition while Taxpayer possessed it; and the certificate of occupancy was issued in Taxpayer’s name.
After determining that Taxpayer failed to carry its burden of proving that Customer-Sub owned the leasehold addition, the Court next considered the income tax treatment of the funds provided by Customer-Sub to Taxpayer.
Accession to Wealth
The Court explained that the Code defined gross income as “all income from whatever source derived.” The meaning of gross income, it stated, is construed broadly to include all “accessions to wealth, clearly realized, and over which [a taxpayer has] complete dominion.”
Accordingly, the Court added, exclusions from gross income are to be narrowly construed.
Because the leasehold addition belonged to Taxpayer, it followed that Taxpayer must have had income – as a result of its business arrangement with Customer-Sub, Taxpayer received ownership and possession of a leasehold addition worth about $4.3 million.
The Court stated that this was the sort of accession to wealth expressly contemplated by the Code. Moreover, Customer-Sub could not realistically have prevented Taxpayer from keeping the portion of the leasehold improvement attributable to Customer-Sub’s funds. Thus, Taxpayer had “complete dominion” over this accession to wealth.
Capital Contribution?
Next, the Court considered Taxpayer’s argument that the $4.3 million paid by Customer-Sub was excludable from income under pre-Act version of the capital contribution rule, which provided that, “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”[xxvii]
The IRS argued that the exceptions to this rule precluded a capital contribution determination. According to the IRS, Taxpayer had the burden of showing that the funds from Customer-Sub fell “squarely within the requirements for the exclusion.”
The Court explained that, to determine whether a transfer qualified as a contribution to capital for purposes of the exclusion rule, it was necessary to look to the transferor’s intent in making the transfer. When this intent was not explicit, the Court continued, it would consider the requirements for a transfer to be recognized as a contribution to capital, as “distilled by” the courts; specifically, whether (1) the contribution became part of the transferee’s permanent working capital structure; (2) the contribution was not compensation for specific, quantifiable services; (3) the contribution was bargained for; (4) the contribution must foreseeably result in a benefit to the transferee in an amount commensurate with its value; and (5) the contribution would be employed in, or contribute to, the production of additional income.
The Court observed that the parties did not contest that three of the above requirements were satisfied: the payment was bargained for, it benefited Taxpayer in an amount commensurate with its value, and it contributed to the production of additional income. With that, the Court considered the remaining requirements.
Permanent Working Capital
The Court explained that a contribution to capital must become a permanent part of the transferee’s working capital structure. Conditions attached to a transfer, such as a requirement that the funds be spent on capital assets, tend to show that a contribution has become a part of the permanent working capital. Similarly, funds “committed for investment and use in the business” become a permanent part of a corporation’s working capital structure.
The Court found that Customer-Sub had provided the funds for the sole purpose of building the leasehold addition on land leased by Taxpayer and that the leasehold addition was used by Taxpayer in its manufacturing operations.
Thus, the Court held that the $4.3 million contributed by Customer-Sub became a permanent part of Taxpayer’s working capital structure, which meant there was only one more factor to examine.
Compensation
A contribution to capital cannot be linked to compensation.[xxviii]
As its demand for Product outstripped Taxpayer’s production capacity, Customer-Sub was “at a crossroads.” With its then-current premises, Taxpayer could increase output only by running its production lines for more hours each day. However, overtime costs would increase the cost per unit.
Alternatively, if Taxpayer had more manufacturing space, it would be able to produce more Product at the prevailing cost per unit. Adding to Taxpayer’s leasehold premises would require significant upfront investment of approximately $4.3 million but would ultimately result in greater production capacity at a sustained cost per unit.
According to the Court, Customer-Sub performed a cost-benefit analysis and concluded that it would recoup its cash outlay for Taxpayer’s leasehold addition by the purchase of a specific amount of Product. Customer-Sub’s objective was to obtain as much Product as possible for the most economical price. These and other actions, the Court explained, were consistent with Customer-Sub’s viewing its investment in the leasehold addition as an advance payment on the purchase of future Product.
Viewed in this light, the Court stated, the funds were intended to be compensation for a service – i.e., future production volume at a higher output and a lower price per unit.
Because Customer-Sub sought to obtain more Product at a lower price, the Court held that the $4.3 million it paid was compensation to Taxpayer.
Consequently, Customer-Sub did not have the requisite intent to make a contribution to capital excludable under the Code. Instead, the payments to Taxpayer were intended to facilitate the provision of manufacturing services to its customer; they were the price of such services rather than a capital contribution by the Customer-Sub.
Even assuming arguendo that Customer-Sub had the requisite intent to make a non-shareholder capital contribution, Taxpayer failed to navigate the requirement that the contribution not be “in aid of construction” or made by “a customer or potential customer.”
The parties did not dispute that Customer-Sub’s funds were used to construct the leasehold addition or that, at the time Customer-Sub provided the $4.3 million, Customer-Sub bought Product in significant quantities from Taxpayer and intended to continue doing so. Thus, the payment from Customer-Sub was both “in aid of construction” and made by a “customer or potential customer” of Taxpayer.
Accordingly, the funds did not qualify for the exclusion from income for non-shareholder contributions to capital, and Taxpayer was required to include the entire $4.3 million in its gross income.
Observations
The Court’s decision was spot on. Customer-Sub’s “contributions” to Taxpayer’s capital were made for the purpose of enabling Taxpayer, as the supplier of Product to Customer-Sub, to meet the latter’s demand for Product. The funds were provided with the expectation that Customer-Sub would directly profit from the “investment” made in Taxpayer’s manufacturing facility.
Was it reasonable for Taxpayer to think that Customer-Sub owned the properties that Taxpayer acquired with Customer-Sub’s funds? On the basis of that belief,[xxix] Taxpayer did not claim depreciation deductions with respect to such newly acquired properties, though the properties were titled in Taxpayer’s name and it paid other expenses associated with the ownership of those properties.
Query whether Taxpayer was able to recover some of these deductions following the Court’s decision.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Whether in money, property, or services
The Code and the applicable Regulations list the more common items of gross income for purposes of illustration; gross income is not limited to the items so enumerated. IRC Sec. 61(a); Reg. Sec. 1.61-1. See also the Sixteenth Amendment to the Constitution, which provides that “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, . . .”
[ii] Do you recall Moore vs. U.S.? https://www.taxslaw.com/2024/07/the-supreme-courts-non-opinion-on-the-realization-of-income-a-lost-opportunity/.
[iii] For the same reasons, Congress has permitted taxpayers to claim deductions in respect of certain expenditures.
[iv] Reg. Sec. 1.1001-1(a).
The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property received. The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value.
The gain realized by a taxpayer from a sale or exchange of property is equal to the amount by which the amount realized exceeds the taxpayer’s adjusted basis in the property, as prescribed by IRC Sec. 1011 and the regulations thereunder. A taxpayer’s adjusted basis in a property may be described as the taxpayer’s unrecovered investment in the property.
[v] For example, a like kind exchange of real property. IRC Sec. 1031.
[vi] IRC Sec. 368; Reg. Sec. 1.368-1.
[vii] Reg. Sec. 1.368-1(d).
[viii] Reg. Sec. 1.368-1(e).
[ix] Stock will not be treated as issued for property if it is issued for services rendered or to be rendered to or for the benefit of the issuing corporation.
[x] The term “control” means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. IRC Sec. 368(c).
[xi] IRC Sec. 351(a); Reg. Sec. 1.351-1.
It should be noted that stock will not be treated as issued for property if it is issued for property which is of relatively small value in comparison to the value of the stock already owned by the person who transferred such property and the primary purpose of the transfer is . o qualify the exchanges of property by other persons for nonrecognition of gain under IRC Sec. 351.
[xii] For example, as in the case of a capital call. When the amount of property transferred to a corporation by its shareholders is disproportionate to their stock holdings, one must question what was intended.
Likewise, where two or more persons contribute property to the corporation in exchange for stock, and the stock received is disproportionate to a transferor’s prior interest in such property, the entire transaction will be given tax effect in accordance with its true nature; thus, the transaction may be treated as if the stock had first been received in proportion and then some of such stock had been used to make gifts, to pay compensation, or for some other reason.
[xiii] IRC Sec. 1032.
[xiv] Thereby preserving the unrealized gain. IRC Sec. 362(a). Similarly, the transferor’s basis for the stock issued by the corporation in the exchange will be the same as the transferor’s adjusted basis for the property transferred to the corporation, thus preserving the gain in the hands of the transferor-shareholder.
[xv] Comm’r v. Fink, 483 U.S. 89 (1987).
[xvi] IRC Sec. 118; Reg. Sec. 1.118-1.
[xvii] You’ll recall the “meaningless gesture” doctrine, described earlier, which applies to contributions by existing shareholders. See, e.g., Lessinger v. Comm’r, 872 F.2d 519 (2d. Cir. 1989); Rev. Rul. 64-155. Thus, whether incremental shares of stock are issued when the existing shareholder or shareholders of a corporation make a pro-rata contribution to the capital of the corporation is not determinative of whether the contribution is included in the income of the corporation.
[xviii] The “Act.”; P.L. 115-97.
[xix] Sec. 13312 of the Act.
[xx] The date of enactment.
[xxi] In explaining the reason for the change, the House Ways and Means Committee Report (H. Rept. 115-409) stated that a contribution to a corporation’s capital is properly treated as income to the corporation unless the contributor receives in exchange an ownership interest of commensurate value to the contribution. According to the Report, the treatment of contributions to capital by non-shareholders as income to the corporation would remove a Federal tax subsidy for State and local governments to offer incentives to businesses as a way of encouraging them to locate operations in a particular jurisdiction.
[xxii] IRC Sec. 118(a).
For example, a contribution of municipal land by a municipality that is not in exchange for stock of equivalent value would be considered a contribution to capital that is includable in the corporation’s gross income.
The only exception to this new rule concerns contributions to a regulated public utility that provides water or sewerage disposal services, provided certain conditions are satisfied.
[xxiii] T.C. Memo. 2026-29 Thermal Circuits, Inc. v. Comm’r Docket Nos. 33027-21, 33035-21.
[xxiv] IRS Form 1120, U.S. Corporation Income Tax Return.
[xxv] Taxpayer did not deduct any depreciation on its returns for the portion of the leasehold improvements funded by Customer-Sub.
[xxvi] The Court acknowledged that IRC Sec. 118 was amended as part of the Act, but noted that the amendment did not affect its analysis.
[xxvii] IRC Sec. 118(a).
[xxviii] See Reg. Sec. 1.118-1 (providing that “money or property transferred to the corporation in consideration for goods or services rendered” is not excluded from gross income).
[xxix] Taxpayer also relied upon the requirement that the properties acquired with Customer-Sub’s funds be used only to satisfy the latter’s orders for Product.
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