5.1 C-Corp Formation and Overview

Module Overview

This module introduces the legal and tax implications of corporate formation and capitalization. It begins with the legal steps required to form a corporation under state law, including filing articles of incorporation, adopting bylaws, appointing a registered agent, issuing stock, and satisfying ongoing administrative requirements. These steps establish the corporation as a separate legal entity and are essential for preserving limited liability protection. The module also explains how ownership is structured through the issuance of stock and how corporations obtain the necessary registrations, such as an Employer Identification Number (EIN), to operate and comply with tax and regulatory obligations.

The module then focuses on the tax treatment of capital contributions to corporations, with particular emphasis on Internal Revenue Code §351. It examines when shareholders can transfer property to a corporation in exchange for stock without recognizing gain or loss, the requirements for nonrecognition treatment, and the consequences of receiving boot or transferring liabilities. In addition, the module explains how these transactions affect both shareholder and corporate basis, holding periods, and future depreciation. Special rules and exceptions, including those related to services, non-shareholder contributions, and investment companies, are also discussed.

Legal Steps in Forming a Corporation

A corporation is legally formed when one or more individuals take the necessary steps to incorporate a business under state law. This process creates a corporation as a separate legal entity that is independent from its owners, referred to as shareholders. The legal separation offers protection to shareholders, limiting their personal liability for the corporation’s debts and obligations.

The incorporation process begins by selecting a unique corporate name that adheres to state regulations and does not violate any existing trademarks. Once a suitable name is chosen, the incorporators draft and file articles of incorporation with the appropriate state authority. The articles of incorporation typically consist of the corporation’s legal name, business address, stated business purpose, details regarding the authorized number and types of shares, and information about the initial directors and registered agent.

Following the filing of articles of incorporation, the next step is to draft corporate bylaws. These bylaws are a set of internal rules that govern the corporation’s operations. They typically outline procedures for electing directors and officers, conducting meetings, and managing corporate records. Once the bylaws are adopted, the incorporators or the initial board of directors hold the first organizational meeting. At this meeting, they appoint officers, officially approve the bylaws, issue the initial shares of stock to founding shareholders, and address other essential organizational matters.

An important aspect of maintaining compliance is appointing a registered agent. This individual or business entity is authorized to receive legal notices and official correspondence on behalf of the corporation, ensuring that the corporation is properly notified in the event of lawsuits or actions by regulatory authorities.

Once the corporation’s structure is in place, it issues stock certificates to the initial shareholders. These certificates serve as evidence of each shareholder’s ownership interest in the corporation. The quantity and class of shares issued correspond to each shareholder’s investment and their proportionate ownership stake in the business.

After the corporation is organized, it must apply for an Employer Identification Number (EIN) from the IRS. The EIN is similar to a Social Security Number for the business and is required for opening business bank accounts, hiring employees, and meeting federal and state tax obligations. Depending on the nature and location of the corporation’s activities, additional licenses and permits may also be necessary to operate legally.

See Wisconsin business corporation law

Capital Contributions to a Corporation – Underlying Economic Transaction

Contribution of Capital in Exchange for Stock

Shareholders may contribute services, cash, or other property to a newly formed corporation in exchange for stock. These contributions are fundamental to establishing the corporation’s initial equity and ownership structure. When a shareholder transfers cash or property in exchange for stock, the transaction resembles a property disposition, as assets are exchanged for capital stock. Each shareholder receives shares that correspond to the value of their contribution, laying the financial groundwork for the corporation to begin operations and pursue its objectives. Since transferring property is considered a disposition for tax purposes, every transferor must calculate any realized gain or loss. Services are not considered “property”.  A shareholder receiving stock for services must recognize the stock’s fair market value as ordinary income.

The corporate records and equity accounts reflect each shareholder’s economic interest in the corporation, influencing their rights to dividends, voting power, and future proceeds upon liquidation. Additional contributions can occur over time to support growth or address unexpected financial needs, potentially adjusting ownership percentages and strengthening the corporation’s equity base.

Contributions Not in Exchange for Stock

In some instances, shareholders or other individuals provide resources, such as cash, property, or services, to the corporation without receiving shares of stock in return. These contributions are classified as capital contributions or additional paid-in capital and do not impact the ownership percentages of existing shareholders. For example, a shareholder may make a cash infusion to support the corporation’s operations, but if no new shares are issued, their ownership interest remains unchanged. Similarly, someone may donate property or services to the corporation as a gift or to reinforce its financial position, with no expectation of receiving stock.

Unlike contributions made in exchange for stock, non-stock contributions do not result in the issuance of new shares and have different tax and accounting treatments. Although these contributions increase the corporation’s equity as recorded on its balance sheet, they do not affect the equity accounts that determine voting rights, dividend eligibility, or liquidation preferences.

Capital Contribution – Tax Implications for Shareholders

General Rule: Nonrecognition of Gain (loss) under IRC § 351

Internal Revenue Code Section 351(a) provides for the tax-free formation or capitalization of a corporation by treating certain property transfers as changes in ownership form rather than taxable sales. If one or more individuals transfer property to a corporation solely in exchange for its stock, and those individuals retain control of the corporation immediately after the exchange, then no gain or loss is recognized for tax purposes. Instead, the gain or loss is deferred to future years.

There are three key requirements under Section 351(a): transfer of property, stock exchange and control requirements.

• To qualify for nonrecognition of gain or loss under Internal Revenue Code Section 351, contributors must transfer property to the corporation. This property can include cash, tangible assets, or intangible assets.  If stock is issued in exchange for services rendered , the transaction is considered taxable rather than qualifying for nonrecognition.
• Nonrecognition is available only when contributors receive stock in exchange for their property. The term “stock” includes common or preferred shares, whether voting or nonvoting. Other instruments, such as warrants, options, rights, or debt securities, do not qualify for nonrecognition treatment. If a contributor receives property other than stock, referred to as “boot,” the receipt of boot will trigger taxable gain for the contributor.
• Immediately following the exchange, the transferors must collectively own at least 80% of the corporation’s voting stock and at least 80% of all other classes of stock. Shares received for property transferred count toward meeting this threshold, while shares issued in exchange for services are excluded unless the structure of the overall transaction still enables the contributors to meet the 80% control requirement.

Special Provisions under IRC § 351

Receipt of Boot

“Boot” refers to consideration received in the exchange that is not corporate stock, such as cash or notes. Under IRC Section 351(b), if boot is received, the transferor must recognize gain up to the value of the boot. The recognized gain is limited to the lesser of the realized gain or the fair market value of the boot received. This means that receiving boot results in immediate gain recognition to the extent of its value, but any losses are deferred and factored into the basis of the stock received. Boot may be in the form of cash or other property, and when multiple assets are transferred, the recognized gain is allocated among the assets according to their relative fair market values. The nature of the recognized gain depends on the type of asset to which the boot is allocated.

Example: Suppose a transferor contributes property with a $50 basis and a $100 fair market value, receiving stock worth $90 and $10 in cash boot. The realized gain is $50. Under Section 351(b), the transferor recognizes $10 of gain (the value of the boot), and the remaining $40 gain is deferred.

Assumption of Liabilities

When shareholders contribute property, such as equipment, real estate, or other assets, to a corporation in exchange for stock, sometimes the property comes with attached liabilities like a mortgage or a loan. If the corporation agrees to take over these liabilities as part of the transaction, this is called the “assumption of liabilities”. According to IRC Section 357(a), this assumption of liabilities isn’t treated as “boot,” and doesn’t result in immediate gain recognition, as long as it’s part of a standard business transaction.

However, if the transaction is structured to avoid taxes or if the liabilities exceed the basis of the transferred property, exceptions apply. The tax avoidance exception is assessed subjectively, while the excess liabilities exception is based on objective dollar amounts.

If a corporation assumes liabilities from the transferor as part of a Section 351 transaction, and those liabilities are taken on with the intent to avoid taxes or do not serve a legitimate business purpose, then Internal Revenue Code Section 357(b) applies. Under this provision, all such assumed liabilities are treated as “boot.” This means that the entire amount of the liabilities is considered taxable to the transferor, resulting in immediate income recognition equal to the liabilities assumed.

Section 357(c) addresses cases where the total liabilities assumed by the corporation exceed the adjusted basis of the property transferred. In this situation, the transferor must recognize gain equal to the amount by which the assumed liabilities surpass the property’s basis. The recognized gain is taxable to the transferor, ensuring that the transfer of property with excessive liabilities does not escape taxation.

Other Considerations

• Investment Company Exception: IRC Section 351(e) denies nonrecognition treatment for transfers to an “investment company.” This typically applies to corporations whose assets are primarily stocks or securities, and where the transfer leads to diversified ownership, preventing tax-free creation of mutual funds.
• Nonqualified Preferred Stock: Under Section 351(g), certain preferred stock with features similar to debt, such as putable or callable stock, is treated as boot for purposes of gain recognition.

Shareholder’s Basis in Stock (§ 358)

IRC § 358(a) governs the determination of a shareholder’s tax basis in stock received during a § 351 exchange. The code applies a substituted basis rule, meaning the shareholder’s original basis in the transferred property is carried over (“substituted”) to the new stock. The primary objective of this rule is to ensure that any gain or loss that was realized but not recognized at the time of the transfer is merely deferred, rather than permanently forgiven. By preserving the original basis, the tax code ensures the deferred gain or loss will be recognized when the shareholder eventually disposes of the stock.

There are two methods to determine the correct basis amount. Both methods should yield the exact same result.

Method 1: Under the strict statutory definition of § 358(a), the basis of the stock received is calculated by starting with the adjusted basis of the property surrendered. This amount is increased by any gain recognized on the exchange and decreased by the fair market value of any boot received and any liabilities assumed by the corporation.

Shareholder’s Stock Basis = Adj. Basis of Property Transferred + Gain Recognized – Boot Received – Liabilities Assumed

Example: If assets with a $100 basis are transferred and the corporation assumes a $30 liability, with no gain recognized, the stock basis is $70 ($100 – $0 boot – $30 liability + $0 gain).

Method 2:  This method calculates basis by subtracting the deferred gain and or adding back the deferred loss from the stock’s current fair market value.

Shareholder’s Stock Basis = FMV of Stock Received – Deferred Gain + Deferred Loss

Example: If assets with a $100 basis are transferred and the corporation assumes a $30 liability, with no gain recognized, the stock basis is $70 (FMV of the stock received).

Capital Contribution – Tax Implications for Corporations

Shareholder contributions (IRC § 118(a),§ 362(a))

Under Section 118(a) of the Internal Revenue Code, a corporation does not include shareholder contributions of money or property in its gross income. This rule applies to contributions made by shareholders, whether in the form of cash, property, or even debt forgiveness. The rationale behind this provision is that such contributions represent investments in the corporation’s ownership, not income, and therefore should not generate immediate tax liability for the corporation.

When a corporation receives property from a shareholder in exchange for its stock, the corporation’s basis in the property is determined under § 362 (a). In most cases, the corporation takes a carryover basis, meaning the corporation’s basis is the same as the transferor’s original basis in the property. However, if the transferor recognizes any gain during the exchange, such as gain arising from the receipt of boot or the assumption of liabilities exceeding the property’s basis, the corporation’s basis in the property is increased by the amount of gain recognized. This adjustment ensures that any built-in gain is taxed only once, at the shareholder level, and prevents double taxation on the same appreciation in value.

Example: If a transferor contributes property with a basis of $100 and a fair market value of $150, and receives $10 of boot, the transferor recognizes $10 of gain. As a result, the corporation’s basis in the property becomes $110, the original $100 basis plus the $10 recognized gain.

Internal Revenue Code § 362(e)(2) provides a specific limitation to prevent the duplication of losses when property with a built-in loss is transferred to a corporation in a § 351 transaction. This provision addresses situations where a shareholder could otherwise transfer property with a basis higher than its fair market value, which would allow both the shareholder (in their stock basis) and the corporation (in its asset basis) to hold a basis reflecting the same economic loss. To prevent this outcome, § 362(e)(2) mandates that if the aggregate adjusted basis of all property transferred by a shareholder exceeds the aggregate fair market value of that property, the corporation’s total basis in the assets must be reduced to their total fair market value. This step-down in basis ensures that the built-in loss is not duplicated and preserved in both the stock and the assets.

The aggregate basis reduction required under § 362(e)(2) is allocated among the transferred properties that have a built-in loss, in proportion to the size of their respective losses. As an alternative, the transferor and the corporation can jointly elect under § 362(e)(2)(C) to have the basis reduction apply to the transferor’s stock received in the exchange, rather than to the corporation’s basis in the transferred assets. This election preserves the corporation’s higher carryover basis in the assets but reduces the shareholder’s stock basis to its fair market value, effectively shifting the location of the loss limitation from the corporate level to the shareholder level.

Example: Suppose a transferor contributes property with a $120 basis and a $100 fair market value. The corporation’s basis in the property would be limited to $100. However, if the parties elect, the corporation can retain the $120 basis in the property, but the transferor’s basis in the stock received will be limited to $100.

For capital assets or Section 1231 assets contributed to a corporation, the corporation’s holding periods include the period during which the transferor held the asset. The corporation assumes the shareholder’s depreciation schedule for the carryover basis portion of the property (§ 168(i)(7)). Any increase in tax basis from gain recognition due to boot is treated as a separate asset, subject to its own depreciation.

Non-shareholder contributions (IRC § 118(b),§ 362(c))

Unlike shareholder contributions, capital provided to corporations by non-shareholders, such as government grants, incentives from community organizations, or other third-party contributions, is included in corporation’s gross income under § 61. Under section 362(c), property received in such a contribution usually takes a zero basis, and cash received in such a contribution generally requires the corporation to reduce the tax basis of other property it acquires during the relevant period, rather than creating new depreciable or amortizable basis.

Example: A city wants to induce X Corp. to build a factory in a blighted area and, as an incentive, the city makes a $500,000 non‑shareholder capital contribution to X Corp. that is excluded from X Corp.’s income under section 118; under section 362(c), if X Corp. uses the $500,000 within 12 months to buy factory equipment costing $500,000, X Corp.’s tax basis in that equipment is reduced from $500,000 to zero, so it cannot claim depreciation on that equipment, and if instead X Corp. acquired only $300,000 of assets in that period, it would reduce the basis of those assets by $300,000 and then reduce the basis of its other property (down to, but not below, zero) by the remaining $200,000.