The tax treatment of a shareholder contribution is generally favorable: neither the corporation nor the contributing shareholder recognizes income when cash or property is put into the business, provided the transfer meets the rules under Internal Revenue Code Sections 118 and 351.1Office of the Law Revision Counsel. 26 USC 118 – Contributions to the Capital of a Corporation What changes is basis. The shareholder’s basis in their stock goes up, the corporation takes the contributed property with a carryover basis, and those numbers control the tax bill on later sales, distributions, and pass-through losses. A few situations knock the transaction out of tax-free treatment entirely, and those are the ones worth understanding before you move any money or property.
When the Contribution Is Tax-Free
Two provisions do the work. Section 118 keeps the contribution off the corporation’s income statement. Section 351 tells the shareholder that transferring property to a corporation in exchange for stock triggers no gain or loss, so long as the transferor (or a group of transferors acting together) controls at least 80 percent of the corporation immediately after the exchange.2Office of the Law Revision Counsel. 26 US Code 351 – Transfer to Corporation Controlled by Transferor “Control” comes from Section 368(c): at least 80 percent of total combined voting power and at least 80 percent of all other classes of stock.3Office of the Law Revision Counsel. 26 US Code 368 – Definitions Relating to Corporate Reorganizations
An existing owner adding capital to their own corporation clears the control test almost automatically. The test bites at formation. If several people are starting a company and one contributes cash or property while others contribute services, the service contributors’ shares don’t count toward the 80-percent group, because services aren’t “property” under Section 351. Drop below 80 percent and the property transferors owe tax on the full appreciation in what they contributed.
The other common breaker is boot. If the shareholder receives cash, notes, or other property along with stock, gain is recognized up to the value of that boot. The rest of the exchange still qualifies. This shows up when the corporation assumes a shareholder’s personal debt as part of the deal, and the shareholder doesn’t realize the debt assumption is treated like receiving cash.
How Basis Changes on Both Sides
The contribution itself may be tax-free, but two basis figures shift, and they drive every downstream tax consequence.
The Shareholder’s Stock Basis
Under Section 358, the shareholder’s basis in the stock received equals the basis of what they handed over, reduced by cash or the value of other property received, and increased by any gain recognized on the exchange.4Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees Contribute $100,000 in cash, your stock basis goes up by $100,000. Contribute property, and the stock basis increase equals your adjusted basis in that property, not its fair market value.
That difference matters when the property has appreciated. A shareholder who contributes equipment worth $200,000 but with an adjusted basis of $60,000 gets only a $60,000 stock basis increase. Assuming market value is a common and expensive mistake.
The Corporation’s Basis in Contributed Property
Under Section 362(a), the corporation’s basis in property received through a Section 351 exchange equals the transferor’s adjusted basis immediately before the transfer, plus any gain the transferor recognized on the exchange.5Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations The corporation uses that carryover basis to calculate depreciation and to figure gain or loss on a future sale. The company’s financial books record the asset at fair market value; the tax basis is a separate figure that has to be tracked in parallel.
When Contributed Property Carries Debt
Section 357(c) creates the trap that catches shareholders who thought their transfer was tax-free. If you contribute property to a corporation and the corporation assumes liabilities attached to it, and those liabilities exceed your adjusted basis in the property, the excess is taxable gain.6Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability
Take a building with an adjusted basis of $200,000 and a mortgage of $300,000. You transfer both to the corporation. The $300,000 liability exceeds your $200,000 basis by $100,000, so you recognize $100,000 of gain even though no cash changed hands. The character of the gain — capital or ordinary — follows the underlying property.
Some liabilities are excluded from the calculation, including accrued trade payables whose payment would produce a deduction. But any property contribution involving debt deserves a basis check before the transfer, not after.
What the Contribution Means for a C Corporation
A C corporation reports nothing on Form 1120 for the contribution. Section 118 keeps it out of income, and Section 351 spares the shareholder any gain when the requirements are met.7Office of the Law Revision Counsel. 26 US Code 118 – Contributions to the Capital of a Corporation The shareholder’s payoff is a higher stock basis, which affects two later events.
Selling shares later produces less capital gain. An initial investment of $100,000 plus a later $150,000 contribution gives you $250,000 of basis; a sale at $400,000 becomes a $150,000 gain rather than $300,000.
Distributions also feel the effect. Under Section 301, a C corporation distribution is a dividend to the extent of earnings and profits, then a tax-free return of capital that reduces stock basis, then capital gain once basis is exhausted.8Office of the Law Revision Counsel. 26 USC 301 – Distributions of Property More basis means more room for tax-free returns of capital.
What the Contribution Means for an S Corporation
S corporations pass income, losses, deductions, and credits through to shareholders on Schedule K-1 (Form 1120-S).9Internal Revenue Service. Instructions for Schedule K-1 (Form 1120-S) Basis is doing much heavier work here, because it acts as the ceiling on how many losses a shareholder can deduct in the current year.
Annual Basis Adjustments
Section 1367 requires an S corporation shareholder’s stock basis to be adjusted each year: up for the shareholder’s share of income (including tax-exempt income), down for distributions, losses, deductions, and non-deductible expenses.10Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders Contributions add directly. Cash increases basis dollar for dollar; contributed property increases basis by the property’s adjusted basis in the shareholder’s hands.
The Loss Ceiling
Section 1366(d) caps the losses and deductions a shareholder can claim in a year at the sum of their adjusted stock basis plus their basis in direct loans to the corporation.11Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders Suppose your stock basis is $40,000, you’ve loaned the corporation $10,000, and your share of losses is $75,000. You can deduct $50,000 this year. The remaining $25,000 is suspended and carries forward until basis is restored, either through additional contributions or through future income.
This is why shareholders make contributions to loss-year S corporations. A $25,000 contribution before the corporation’s year-end unlocks $25,000 of suspended losses on the current return. Timing is strict: the contribution must land before the S corporation’s tax year closes.
Two More Loss Hurdles Beyond Basis
Clearing the basis ceiling doesn’t guarantee a deduction. Section 465 limits deductible losses to the amount the shareholder actually stands to lose, which generally includes cash and the adjusted basis of contributed property plus amounts borrowed for which the shareholder is personally liable.12Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk Guarantees, stop-loss agreements, and most nonrecourse borrowing don’t count.
Section 469 applies a final filter. A shareholder who doesn’t materially participate in the business is a passive investor, and passive losses can only offset passive income, not wages or portfolio income.13Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited Adding capital doesn’t change participation status. Shareholders who contribute money hoping to deduct large losses against W-2 income are often caught here.
Basis calculations and loss limitations are reported on Form 7203, filed with the individual return.14Internal Revenue Service. About Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations
Contribution or Loan?
Money going into a corporation can be structured as equity or as debt, and the choice has real consequences. The IRS looks hard at these transactions.
Why the Label Matters
A loan creates a repayment obligation. The corporation deducts interest paid; the shareholder reports it as ordinary income. Repayment of principal returns cash to the shareholder without triggering tax. A contribution is permanent: pulling the money out later runs through the distribution rules, with their own tax consequences.
For S corporation shareholders, direct loans also count toward the loss deduction ceiling under Section 1366(d).11Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders Lending gets you both loss-deduction room and tax-free repayment.
What Makes a Loan Hold Up
Section 385(b) lists factors the IRS uses to test whether a transfer is real debt or equity wearing a debt label.15Office of the Law Revision Counsel. 26 USC 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness The ones that matter most:
- A written promissory note with a fixed repayment date and a stated interest rate. Informal arrangements don’t survive audit.
- An interest rate at or above the Applicable Federal Rate.
- A debt-to-equity ratio that isn’t absurd. A corporation stacked with shareholder debt and almost no equity looks like disguised equity.
- Loans that aren’t automatically subordinated to all outside creditors.
- Loan amounts that don’t perfectly track ownership percentages. Proportionality suggests additional equity investment.
Below-Market Loans
Section 7872 targets loans between a corporation and its shareholders that carry a rate below the AFR. The IRS imputes interest as if it had been paid: the shareholder-lender reports interest income never actually received, and the corporation may be treated as having paid a constructive dividend (C corporation) or distribution (S corporation) equal to the forgone interest.16Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
When the IRS Reclassifies
If a shareholder loan fails the debt-vs.-equity test, the IRS treats it as a capital contribution. Every interest payment the corporation made becomes a distribution. A C corporation loses its interest deduction and the shareholder picks up dividend income, a double hit. An S corporation shareholder loses the debt basis that was supporting loss deductions, which can disallow prior-year losses and generate back taxes, interest, and penalties.
Forgiving a Shareholder Loan
When a shareholder cancels a debt the corporation owes them, Section 108(e)(6) treats the cancellation as a capital contribution. The corporation is treated as having repaid the debt in an amount equal to the shareholder’s adjusted basis in the debt.17Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness If the shareholder’s basis in the note is below the face amount, which happens when prior S corporation losses have already reduced debt basis, the corporation recognizes cancellation-of-debt income on the difference. Forgiveness looks generous and can still produce a tax bill.
Documentation and Reporting
Paperwork doesn’t change the tax result, but it decides how easily you can prove your position if questioned.
Each contribution should be backed by a board resolution or written contribution agreement identifying the asset, the transfer date, its fair market value, and the shareholder’s adjusted basis. The document should state that the transfer is intended as equity, not a loan. On the corporation’s books, the entry debits the asset account and credits an equity account such as Additional Paid-in Capital. Book value and tax basis will differ for property contributions, and both need to be tracked.
Treasury Regulation 1.351-3 requires every “significant transferor” to attach a disclosure statement to their return for the year of the exchange. A significant transferor owns at least 5 percent of publicly traded stock, or at least 1 percent of non-publicly-traded stock, immediately after the transfer.18GovInfo. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed The statement identifies the transferee corporation, the transfer date, and the fair market value and basis of the property. The corporation files its own version.
S corporation shareholders use Form 7203 each year to report stock and debt basis and any resulting loss limitations. The form walks through additions for contributions and income, reductions for distributions and losses, and the deductible loss ceiling that results.14Internal Revenue Service. About Form 7203 – S Corporation Shareholder Stock and Debt Basis Limitations A missing or wrong Form 7203 can cost the deduction and draw accuracy-related penalties.