The tax treatment of a capital contribution depends on what you contribute and what kind of entity receives it: cash and property transfers into a partnership, LLC, or corporation can generally move in without triggering immediate gain or loss, but contributing services is taxable, and each pathway carries its own basis, reporting, and recapture rules.
Property Contributions to Partnerships and LLCs
If you contribute property to a partnership, or to an LLC taxed as a partnership, you generally recognize no gain or loss on the transfer.1Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution This applies whether the partnership is brand new or already operating.
There is one important carve-out. If the partnership would qualify as an “investment company” (broadly, a vehicle holding a diversified portfolio of stocks and securities), the nonrecognition rule falls away and gain on the transfer is taxable.
Property Contributions to Corporations
For corporations, tax-free treatment under Section 351 requires that the people transferring property collectively own at least 80 percent of the corporation’s voting stock and at least 80 percent of every other class of stock immediately after the exchange.2Office of the Law Revision Counsel. 26 US Code 351 – Transfer to Corporation Controlled by Transferor3Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations
Miss the 80 percent threshold and the whole transaction becomes taxable. This is where owners commonly slip. Bringing in a new investor who takes more than 20 percent of the stock in a standalone exchange can knock out non-recognition for everyone in that transfer.
Why Contributing Services Is Taxable
Sweat equity is not treated the same as property, and getting this wrong produces a tax bill people don’t expect.
If you receive a partnership interest in exchange for services, the fair market value of that interest is ordinary income to you. The regulation is direct: a partnership interest received as compensation for services is taxable, whether the services have already been performed or will be performed later.4eCFR. 26 CFR 1.721-1 – Nonrecognition of Gain or Loss on Contribution The amount you include equals the value of the capital interest received.
Corporations run on a parallel rule. Stock issued for services is not stock issued “for property” under Section 351.2Office of the Law Revision Counsel. 26 US Code 351 – Transfer to Corporation Controlled by Transferor The person receiving stock for services cannot be counted in the 80 percent control group, and the value of that stock is taxable compensation under Section 83.5Office of the Law Revision Counsel. 26 USC 83 – Property Transferred in Connection With Performance of Services
So if you contribute labor rather than cash or property, you owe income tax on the value of the interest even though no cash changed hands. Accountants call this “phantom income.” Planning around it, such as taking only a profits interest rather than a capital interest in a partnership, has to be structured before the contribution happens.
Your Basis After a Contribution
Nonrecognition doesn’t mean the gain disappears. It means the gain is deferred, held inside your basis, and paid later.
Partnership and LLC Basis
Your basis in a partnership interest equals the cash you contributed plus your adjusted basis in any contributed property.6Office of the Law Revision Counsel. 26 USC 722 – Basis of Contributing Partners Interest Adjusted basis, not fair market value. Contribute equipment you bought for $50,000 that is now worth $120,000, and your outside basis is $50,000.
The partnership takes the same basis in the contributed property that you had.7Office of the Law Revision Counsel. 26 USC 723 – Basis of Property Contributed to Partnership That $70,000 of built-in gain stays with the property and comes out when the partnership sells it.
Basis also caps your losses. You can deduct your share of partnership losses only up to your adjusted basis in your interest.8Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share Losses above basis suspend and carry forward until additional contributions or income allocations lift your basis.
Corporate Basis
In a qualifying Section 351 exchange, your basis in the stock you receive equals your adjusted basis in the property transferred.9Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees The corporation’s basis in the property carries over from you as well.10Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations The deferred gain stays attached and surfaces on the corporation’s later sale of the property, or on your later sale of the stock.
Getting Capital Back Out
How the IRS taxes withdrawals depends on the entity.
Partnerships and LLCs
Cash distributed to a partner triggers gain only to the extent the cash exceeds the partner’s adjusted basis in the interest.11Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution Property distributions other than cash are generally not taxable events. With sufficient basis, pulling capital out of a partnership is relatively tax-efficient.
Corporations
Corporate distributions follow a stricter ordering rule. Distributions are first treated as dividends to the extent the corporation has current or accumulated earnings and profits. Only after those are exhausted does the distribution become a tax-free return of capital, which reduces your stock basis. Once basis hits zero, further distributions are taxed as capital gain.12Internal Revenue Service. Topic No. 404, Dividends and Other Corporate Distributions Getting capital back from a C corporation typically costs more in tax than the same withdrawal from a partnership or LLC.
When the IRS Treats a “Loan” as a Contribution
Owners sometimes prefer lending money to the business over contributing it, since loans can be repaid with deductible interest. The IRS has broad authority to recharacterize what you call a loan as equity if the economic reality looks more like an investment than a debt.
The factors evaluated include whether there is a written promise to repay a fixed sum on a fixed date at a fixed rate of interest, whether the debt is subordinated to other creditors, the company’s overall debt-to-equity ratio, whether the instrument converts to stock, and whether the lender’s share of the debt mirrors their ownership stake.13Office of the Law Revision Counsel. 26 US Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
A shareholder “loan” with no repayment schedule, no stated interest rate, and repayments only when the business has spare cash will likely be called equity on audit. The business then loses its interest deductions, and “repayments” may be recast as taxable distributions. If you plan to lend to your own company, use a written promissory note, charge a market rate, and follow the schedule.
A related trap: if the entity pays you money or assumes a specific debt in exchange for the transfer, the IRS can treat the whole transaction as a sale rather than a contribution, which changes the tax outcome entirely.14eCFR. Contributions to a Partnership
Penalties for Overstating Value
Non-cash contributions have to be valued at fair market value, and overstating that value is one of the fastest ways to draw IRS attention. If the value claimed on a return is 150 percent or more of the correct value, the IRS can impose a penalty equal to 20 percent of the resulting tax underpayment.15Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments At 200 percent or more, the penalty doubles to 40 percent.
The penalty runs against the underpayment caused by the misstatement, so the dollar impact scales with the tax bracket and the size of the overstatement. A qualified, independent appraisal completed before the contribution is the best defense.
Reporting the Contribution
Partnerships and multi-member LLCs report each partner’s capital activity on Schedule K-1 (Form 1065), which tracks the beginning capital balance, contributions during the year, share of income or loss, and any withdrawals or distributions.16Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) If a partner contributed property carrying built-in gain or loss, the partnership must attach a statement identifying the property, the contribution date, and the amount of built-in gain or loss.
S corporations report contributions on the balance sheet section of Form 1120-S, with additional paid-in capital appearing on Schedule L, Line 23.17Internal Revenue Service. US Income Tax Return for an S Corporation (Form 1120-S) Contributions are not income to the corporation, so they do not appear on the income or deduction schedules.
Keep the underlying records permanently: the contribution agreement, the appraisal for any non-cash asset, the board resolution or operating agreement amendment, and the entries showing basis on both sides. These establish your basis, support the valuation, and provide the audit trail if the IRS later questions the transaction. Rebuilding this file years later, if it can be done at all, costs more than getting it right at the start.