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Donating Property to an S-Corporation

Questions from Readers

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Dear Tax Guide,

I have a little background in taxes and I do try to stay current for the sake of our own business. However, I am completely stumped by this tax years complexities and welcome all the help I can get in properly handling our taxes.

We converted our Sole Proprietorship to a S-Corp. Now I have the task of somehow moving our business assets from one entity to the other and from what I have been able to find, this is not a simple task. I believe that most of our business property was done under Sec. 179. Any advice?

Dear Reader,

I agree that some of this year's new tax laws make little if any sense. I learned a long time ago that tax law is not logical, which of course means my years of rigorous training in logic and critical thinking do little to help me understand the tax code. (Ok, actually logic does help, in fact a great deal, but sometimes I am forced to realize how illogical some of the codes are.) Philosophers who claim that contradictions cannot exist have never filled out a tax return! Heraclitus declared that "everything flows, nothing stands still." He would have made a great tax accountant, because this is certainly true of the tax laws!

Now, returning to your particular question. First, let me say Congratulations on setting up an S-Corp. I think this is one of the smartest things you can do to protect your small business and to maximize your tax benefits. I recently talked about the relative benefits of filing a Schedule C, versus an S-Corp, versus a C-Corp, especially from the perspective of protecting business losses against an IRS examination. Setting up an S-Corporation separates your business finances from your personal finances.

When a new business is started, the shareholders in the business contribute money, equipment, property, and services to the corporation. This is considered the business's starting capital. Everything donated into the corporation becomes the corporation's capital assets. In exchange for donating time, money, and property, the shareholder gets a capital account in his or her name, showing that person's share in the capital assets of the new company. Now, I am telling you all this for a reason, and here it is. The shareholder of a small business can sell his or her share of an S-Corp. So any gain or loss on small business stock is calculated like capital gains on stocks or mutual funds. But in order to calculate the gain or loss, the shareholder has to know his or her basis in the investment.

When property is donated to an S-Corp, the value of that property becomes the corporation's basis in that property. Also, the value of that property is added to the capital account of the shareholder who donated the property. We'll talk about how to calculate the value of the property in a moment. But first, I want to give an example of how the capital contributions work. Let's say I donate my relatively new computer to my newly formed S-Corporation. The "adjusted basis" of the computer (we'll cover that in a minute) is $1,500. In addition to donating my computer, I also contribute $10,000 of cash. Here's how my capital accounts would look:

Owner's Equity (on the company's balance sheet)
William's Capital Account
Cash $10,000
Equipment $1,500
Total Capital $11,500

Thus, my total capital contribution to the S-Corp is $11,500. If I later sell my stake in the company, I would calculate my capital gain or loss based on this amount.

Now, your question is how to properly account for the contributions of property from your Schedule C business to your S-Corporation. According to Pub 551, the company's basis in donated property is the smaller amount of either the Fair Market Value or the shareholder's Adjusted Basis. In order to figure this out, we need to know what the "adjusted basis" of your property is. For reference, you may need to read IRS Publication 551 Basis, especially the sections on Adjusted Basis and Property Changed to Business or Rental Use.

Adjusted basis is the original cost of the property, plus any improvements, plus any purchase costs, plus any selling costs, minus any depreciation.

Or, let's write it another way:

Original Cost
+ Improvements
+ Purchase costs
+ Selling costs
- Depreciation
= Adjusted Basis

Next: Two Adjusted Basis Examples

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