Treatment of grants as nonshareholder contributions to capital.

• Author: Holets, David J.

Corporations are generally exempt from tax on contributions made to corporate capital. The general rule regarding contributions to capital is stated in Sec. 118(a): "In the case of a corporation, gross income does not include any contribution to the capital of the taxpayer."

Application of this rule is generally clear in transactions with shareholders: A corporation recognizes no gain or loss on a shareholder's contribution to the corporation's capital. The corporation receives basis for the contribution equivalent to the basis of the transferor at the time of the transaction under Sec. 362. This allows shareholders to make tax-flee investments in corporations without the threat of double taxation.

However, Sec. 118 does not limit the exclusion to shareholders. If a nonshare holder makes a contribution to the corporation's capital, Sec. 118 may apply. In a series of court decisions and IRS rulings, this treatment has been upheld. However, the IRS and the courts have taken a strict interpretation of when this exclusion applies. The strict interpretation of the rules under Sec. 118 has resulted in significant controversy in this area. The IRS has made nonshareholder contributions to capital a Tier 1 examination issue, releasing several directives and rulings in the last several years. This item identifies some of the key legislation and judicial decisions establishing the law in this area and analyzes several of the most recent rulings and guidance.

Pre-Sec. 118 Case Law

Sec. 118 was enacted following the issuance of two Supreme Court opinions: Detroit Edison Co., 319 U.S. 98 (1943), and Brown Shoe Co., 339 U.S. 583 (1950). In Detroit Edison, the taxpayer was an electric utility that provided electrical service to commercial and residential customers. Because some of these customers were located outside the taxpayer's existing range of service, they were required to make a one-time payment for connection to the utility. The taxpayer used these payments to supplement the construction of fixed assets used in energy transmission.

The taxpayer argued that these funds were gifts or nontaxable contributions to capital, not payment for services. The taxpayer claimed a carryover basis in any property received and/or constructed using the payments. The IRS argued that the payments were not gifts or nontaxable contributions to capital, but payments for services rendered by the taxpayer. The Court did not specifically address the issue of whether the payments qualified as nonshareholder contributions to capital in this case. It agreed with the IRS that the fees paid by the customers did not in form or substance equate to contributions but were payments for services. Therefore, assets acquired using the customer payments received a basis of zero for purposes of depreciation. The Court was not asked to rule on the issue of whether the payments were excludible as contributions to capital.

The decision in Brown Shoe reached a different result from Detroit Edison. In Brown Shoe, the taxpayer received funds and property from several different community groups to provide incentives for the construction and/or expansion of its manufacturing facilities. Generally, the taxpayer would receive property and/or funding if it constructed and operated a factory in a specific location for a minimum period of time. The taxpayer argued that the funds and property received from these community groups were...