FAQ: How Do You Covert Property into an S-Corporation?
Donating or Converting Property into Your S-Corporation
I recently received this question from a reader:
“We have converted our sole proprietorship to an S Corporation. Now I have the task of somehow moving our business assets from one entity to the other. From what I have been able to find out, this is not a simple task. I believe that depreciation on most of our business property was taken under Section 179. Any advice?”
First, let me say congratulations on setting up an S-corp. I think this is one of the smartest things anyone can do to protect his small business and maximize tax benefits. It separates your business finances from your personal finances.
Property Donated to an S-Corporation
When a new business is started, its shareholders contribute money, equipment, property and services to the corporation. This is 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 name showing his share of the capital assets in the new company. A shareholder can sell his share of an S-corp so any gain or loss on small business stock is calculated like capital gains on stocks or mutual funds. The shareholder has to know his tax basis in the investment in order to calculate the gain or loss.
The value of the property becomes the corporation's basis in it when it is donated or transferred to an S-corp. The value of that property is also added to the capital account of the shareholder who donated it. Let's say I donate my relatively new computer to my newly formed S-corporation. The "adjusted basis" of the computer is $1,500. In addition to donating my computer, I also contribute $10,000 in cash. Here's how my capital account would look:
Owner's Equity (as it will appear on the company's balance sheet)
William's Capital Account
Total Capital $11,500
My total capital contribution to the S-corp is $11,500. I would calculate my capital gain or loss based on this amount if I later sell my stake in the company.
How to Account for the Contributions
My reader’s question was how to properly account for the contributions of property from his Schedule C sole proprietorship to his S-corporation. According to IRS Publication 551, the company's basis in the donated property is the smaller amount of either its fair market value or the shareholder's adjusted basis. Adjusted basis is the original cost of the property plus any improvements, plus any purchase costs, plus any selling costs, minus any depreciation.
In the scenario above, I donated my relatively new computer, only six months old, to a newly-formed S-corp. I must calculate two numbers to figure out the value of my capital contribution and to calculate the company's basis for depreciation: the fair market value of the computer and the computer's adjusted basis. Here are two examples.
The computer was my personal property. I did not use it as business property and did not claim any depreciation on it. I bought the computer for $2,000, which included costs for shipping and tax. My adjusted basis in the computer would be as follows:
$2,000 original cost + $0 improvements + $0 purchase costs because shipping and tax were already included in the purchase price + $0 selling costs - $0 depreciation = $2,000 adjusted basis.
Next I have to find out the fair market value of my computer. I’d check various websites such as eBay and craigslist. I might find out that my computer model is selling for around $1,500 in good condition. If I were to sell my computer this way, I could expect to get about $1,500 for it. So this is the FMV of my computer.
When I donate my computer to my S-corp, the computer is valued at the lesser of its adjusted basis or its fair market value. The value of the computer is $1,500 because that is the lesser of these two figures. My capital account is increased by $1,500 and the corporation can use $1,500 as its basis for depreciating the computer.
The computer was my business property. I used the computer as an independent contractor and I depreciated its cost on my Schedule C. I bought it for $2,000, which included shipping and tax. I bought the computer in June 2015 and took Section 179 depreciation on my 2015 Schedule C, opting to claim the full cost of my computer in the first year. My adjusted basis in the computer is as follows:
$2,000 original cost + $0 improvements + $0 purchase costs because shipping and tax were included + $0 selling costs - $2,000 Section 179 depreciation taken in 2015 = $0 adjusted basis.
Just as in Example #1, the fair market value of the computer is $1,500. The lesser of these two figures is $0, so my computer is unfortunately valued at $0. My capital account is increased by $0 and the corporation cannot depreciate the computer because the corporation's basis in the computer is also $0.
If the S-Corp were to go out and buy a similar computer for $1,500, the company could depreciate it. The company would have a verifiable basis in it, namely the purchase price. The business could elect to buy the computer from you, but that would impact on your personal taxes in two ways:
- Your capital account would not increase or decrease because you have not donated the property to the company.
- You would have to report ordinary gain on the sale of business property on Form 4797. You would have a gain because you already reduced your adjusted basis in the property to zero by using Section 179. If the company pays you $1,500 for your computer, you would have $1,500 of ordinary gain taxed at your ordinary tax rates, not capital gains tax rates.
So the short answer to the reader's question is this: If you have expensed the full cost of your business property using Section 179, your adjusted basis in the property is zero. When you convert your business property to an S-corp, the S-corp inherits your adjusted basis, which is still zero.
NOTE: Tax laws change periodically, and you should consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and is not a substitute for tax advice.