The Taxation of Corporations and their Shareholders
Our modern Internal Revenue Code anticipates two kinds of taxpayers: individuals (i.e., natural persons, the men and women making up the majority of the U.S. tax base), who are subjected to federal income tax under IRC § 1, and corporations (i.e., artificially created “bodies corporate” formed by leave of, and under rules promulgated by, the state), which are subjected to federal income tax under IRC § 11. Everything other than § 1 individuals and § 11 corporations—including partnerships, limited liability companies, S corporations, regulated investment companies, trusts and estates, and so on—are, in essence, variations of one of those two basic kinds of taxpayer.
Corporations are an artificial form of taxpayer and have an equally artificial (and not always intuitive) set of rules governing their taxation. Generally, they can be formed tax-free, which is to say that individual (or even other corporate) taxpayers can cause the springing into existence of a new corporation without having to recognize an income event as a result. Thereafter, however, the income resulting from that corporation’s operations will be subject, generally, to income taxation twice: first upon the corporation’s recognition of the income, and then again when that income is distributed to the shareholders (usually as dividends). This “double taxation” is at the heart of federal income taxation of corporations and persists throughout its life and even unto its death (its dissolution).
The Tax Effect of Forming a Corporation: Inside-Outside Parity and Setting the Stage for Double Taxation
As mentioned above, one or more taxpayers can generally form a corporation without recognizing income as a result. This might seem obvious - after all, why would there be income just by starting a new business? - but the Code actually does have to specifically exclude the gain that would otherwise result from capitalizing a new corporation. This is because of the general sale or exchange rule of section 1001 of the Code. That rule provides that when a taxpayer sells or otherwise disposes of property, the taxpayer must recognize gain equal to the excess of the fair market value of the property received over the adjusted basis of the property given up. When a taxpayer forms a new corporation the taxpayer typically contributes cash or other property to the corporation and in exchange receives stock in that corporation. If, say, a taxpayer contributed $1,000,000 in cash to a newly formed corporation in exchange for all of the corporation’s stock, the taxpayer would receive, logically, $1,000,000 worth of stock. Because the adjusted basis of the cash was also $1,000,000 there is no excess—no gain—for the taxpayer to recognize. But what if instead of cash the taxpayer contributed property—say a building—that had a fair market value of $1,000,000 but an adjusted basis in the taxpayer’s hands of just $100,000? Under section 1001, the taxpayer has received $1,000,000 worth of stock in exchange for a building with a $100,000 adjusted basis, thus the taxpayer has realized, and will have to recognize, $900,000 in gain.
This is where the Code must intervene and offer an exclusion from income. It does this through section 351 of the Code, which provides that so long as the taxpayer (or group of taxpayers) forming the new corporation controls at least 80% of the stock immediately after the contribution, then the gain realized on the exchange is not recognized. It is important to understand, however, that these shareholders have still realized a gain; it is only by reason of the specific exclusion afforded by section 351 that the shareholders have not also had to recognize that gain. In the case of the $900,000 in gain built-into the building, the Code preserves that gain for future recognition through a device called inside-outside basis parity. Moreover, because of the double-taxation scheme of corporate taxation, that $900,000 of built-in gain is actually doubled.
First, let’s discuss parity. When the shareholder exchanged the building for the new corporation’s stock, he was able to avoid having to recognize that gain by reason of section 351. He is not forever exempt from recognizing it, however. Instead, as with all nonrecognition rules in the Code, the built-in gain is preserved by the exchanger taking an “exchanged basis.” That is, although the shareholder in effect contributed $1,000,000 of capital to the corporation (the fair market value of the building), the shareholder’s adjusted basis in his stock will be just $100,000. Notice how this preserves the built-in gain: If the shareholder were to soon after the contribution sell the stock he would, presumably, get $1,000,000 for it. Without a nonrecognition rule to apply, section 1001 would control and the shareholder would recognize $900,000 in gain ($1,000,000 amount realized less $100,000 adjusted basis).
What is perhaps surprising is that the corporation will also take a $100,000 adjusted basis (a “carryover basis”) in the building. This has the effect of preserving that same $900,000 in built-in gain, but now at the corporate, rather than the shareholder, level. This is sometimes called “inside-outside basis parity” as the inside basis (the corporation’s basis in the building) is fixed at the same amount as the outside basis (the shareholder’s basis in his stock). By preserving the gain both inside the corporation and outside through the mechanism of parity, the potential for recognizing the gain has essentially doubled.
 That is, the Internal Revenue Code of 1986, as amended (the “Code” or “IRC”).
 Most of the rules governing the taxation of corporations are found in Subchapter C of the Code. Hence, corporations that have not made an election to be governed instead by Subchapter S are called “C corporations” (and are the subject of this article), while corporations that have made the S election are called “S corporations.”
 IRC § 1001(a)-(c).
 Note that this exclusion only functions to exclude the gain realized on the exchange of stock for property. If the contributing shareholder or shareholders receive anything else in the exchange from the corporation, then section 351 to that extent does not apply. The “anything else” is called “boot” and may trigger the recognition of taxable gain on the part of the organizing shareholders.
 For example, the contribution rule for partnerships (IRC § 721) operates much in the same way, as do the nonrecognition rules for like-kind exchanges (IRC § 1031) and involuntary conversions (IRC § 1033).
 IRC § 358(a).
 IRC § 362(a).