IRC Section 118: Capital Contributions, Basis, and TCJA Rules

IRC Section 118 lets a corporation exclude genuine contributions to its capital from gross income, so no federal income tax is owed on the transfer.¹ Since the Tax Cuts and Jobs Act of 2017, that exclusion effectively reaches only shareholder contributions, with a narrow carveout for certain water and sewerage utilities. Whether a transfer is a tax-free capital infusion or taxable income turns on who sent it, why they sent it, and whether the corporation gave anything back.

What Counts as a Contribution to Capital

A contribution to capital is a transfer of money or property to a corporation where the corporation issues no new stock and provides no goods or services in exchange. The transferor’s intent has to be aimed at permanently strengthening the corporation’s financial position, not at buying something from it. A shareholder writing a check to help cover payroll, with no additional shares issued in return, is the textbook case.²

Transfers that look like contributions but actually pay for services, purchase goods, or disguise a distribution don’t qualify. Neither does a loan, since a loan creates a liability instead of permanently increasing equity. The IRS looks at the economic substance rather than the label the parties use, so documenting intent at the time of the transfer matters.

Shareholder Contributions and How Basis Moves

When a shareholder contributes cash or property, the transfer is presumed to reflect their role as an owner investing in the company. The corporation excludes it from income under Section 118(a), and the shareholder increases their stock basis by the cash contributed or the adjusted basis of any property contributed.¹ The basis bump prevents double taxation on the same dollars later. A $50,000 basis plus a $10,000 cash contribution produces a $60,000 new stock basis.

The corporation takes a carryover basis in any contributed property, equal to whatever the shareholder’s adjusted basis was immediately before the transfer.³ If a shareholder contributes equipment carried at $30,000 on their books, the corporation’s basis in the equipment is $30,000 even if the fair market value is $75,000. Fair market value doesn’t drive basis here.

One trap catches closely held corporations. A contribution that is not proportional to ownership shifts value to the other shareholders. Own 30%, contribute $100,000 while the others contribute nothing, and you have effectively enriched their shares. The IRS can treat that shift as a taxable gift to those other shareholders, potentially triggering gift tax above the $19,000 annual exclusion or drawing down your $15,000,000 lifetime exemption.⁴ Matching contributions to ownership percentages sidesteps the problem in family-owned corporations.

When a Shareholder Forgives Corporate Debt

A shareholder who cancels a debt the corporation owes them can treat the cancellation as a capital contribution, but the operative rule is Section 108(e)(6), not Section 118. The corporation is treated as if it paid off the debt with cash equal to the shareholder’s adjusted basis in the debt instrument.⁵ The shareholder has to be acting as an owner strengthening the company, not as a creditor writing off a bad loan.

If the shareholder’s basis in the debt equals its face value, no income results. If the basis is lower, the corporation recognizes cancellation-of-debt (COD) income on the difference.⁵ This shows up when the debt was previously discounted or partially written off.

Say a shareholder holds a $50,000 note from the corporation with an adjusted basis of only $10,000. Forgiveness as a capital contribution is treated as the corporation paying $10,000 to discharge a $50,000 obligation. The remaining $40,000 is COD income. The corporation can exclude that income only under a separate exception, such as insolvency at the time of cancellation or bankruptcy. Even then, the price is reducing tax attributes (net operating losses, credit carryforwards, or asset basis) by the excluded amount.

What the TCJA Changed for Non-Shareholder Contributions

Before 2018, corporations could exclude contributions from governments, civic groups, and even customers when the transfer was designed to permanently strengthen the corporation’s capital. Cities routinely handed over land or cash to attract factories and headquarters, and the corporation paid no federal tax on the inducement. Disputes with the IRS over the inducement test were common, but the framework had been in place for decades.

The Tax Cuts and Jobs Act rewrote Section 118(b). For contributions made after December 22, 2017, the exclusion no longer covers:

Transfers by a governmental entity or civic group, unless the contributor also happens to be a shareholder acting in that capacity.
Contributions in aid of construction, or any other transfer from a customer or potential customer.

These changes are permanent, with no scheduled sunset.¹ A city that gives a corporation $5 million in cash or land to open a facility has delivered a pre-tax benefit; the corporation now includes the transfer in gross income and pays the flat 21% corporate rate.⁶ Some states haven’t conformed to the federal amendment and may still allow an exclusion on the state return, but the federal tax applies regardless.

The Water and Sewerage Utility Exception

Section 118(c) preserves a narrow exception for regulated public utilities providing water or sewerage disposal services. These utilities can still exclude contributions in aid of construction and certain government contributions tied to protecting drinking water or sewerage services.¹ Three conditions apply:

The utility cannot include the contributed amount, or any property acquired with it, in its rate base for ratemaking purposes.
For contributed property other than the water or sewerage facilities themselves, the utility must spend an equivalent amount on qualifying tangible property before the end of the second taxable year after receiving the contribution.
The utility must keep accurate records tracking contributions received, expenditures made, how the two are matched, and the year each occurred.

Property acquired through this exception takes a basis of zero, so no depreciation or loss deductions are available on it.

How the Corporation Calculates Basis in Contributed Property

Section 362 governs the corporation’s tax basis in contributed property, and the rule splits by contributor.

For shareholder contributions, the corporation takes a carryover basis equal to the shareholder’s adjusted basis in the property immediately before the transfer.³ The corporation steps into the shareholder’s tax position on the asset.

For non-shareholder contributions that still qualify for the Section 118 exclusion (essentially the water utility exception), Section 362(c) sets different rules. Non-cash property comes in at a basis of zero. Cash contributions require the corporation to reduce the basis of whatever property it buys during the 12 months after receiving the contribution. Any excess beyond the cost of property acquired in that window is applied against the corporation’s other existing assets as of the last day of the 12-month period.³ Treasury regulations set the order in which specific assets take the hit.⁷ These mechanics prevent a double benefit: a corporation that received money tax-free should not also carry full basis in what it bought with that money.

Section 118 Compared to Section 351

Both provisions produce nontaxable results for the corporation, but they cover fundamentally different transactions, and mischaracterizing one as the other creates real basis and reporting problems.

Section 351 applies where one or more people transfer property to a corporation in exchange for stock, and those transferors control at least 80% of the corporation immediately after the exchange. Shares are issued; the contributor becomes or remains a shareholder; neither side recognizes gain or loss.⁸

Section 118 covers the opposite pattern: the corporation issues no stock. The contributor puts in cash or property to strengthen the company and receives no equity back. The corporation simply excludes the transfer from income.¹

The 80% control test and the boot rules of Section 351 have no equivalent in Section 118, and a transfer that fails Section 351 does not automatically fall into Section 118. A shareholder who wires cash to the company with no stock issuance agreement is making a Section 118 contribution, not a Section 351 exchange. The characterization drives basis calculations and gain recognition for both sides.

Partnerships and LLCs Are Outside Section 118

Section 118 applies only to corporations. A partnership or an LLC taxed as a partnership cannot use it. The TCJA conference report confirmed that the modified Section 118 continues to reach only corporations.

Partner-to-partnership transfers run through Section 721, which provides that neither the partnership nor its partners recognizes gain or loss on a partner’s contribution of property in exchange for a partnership interest.⁹ The gap is transfers from non-partners. Section 721 only reaches partner contributions for partnership interests. A government grant or third-party payment to a partnership has no equivalent to the old Section 118 exclusion. In Uniquest Delaware LLC v. United States, a federal court held that government grant funds received by an LLC taxed as a partnership were ordinary income under Section 61 and could not be excluded under Section 118.¹ For anyone weighing entity structure around expected grants or third-party funding, the difference in treatment is a real factor.

1
Office of the Law Revision Counsel. 26 USC 118 – Contributions to the Capital of a Corporation
2
eCFR. 26 CFR 1.118-1 – Contributions to the Capital of a Corporation
3
Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations
4
Internal Revenue Service. What’s New – Estate and Gift Tax
5
Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness
6
GovInfo. 26 USC 11 – Tax Imposed
7
eCFR. 26 CFR 1.362-2 – Certain Contributions to Capital
8
Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor
9
Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution