Section of Taxation Publications

VOL. 63
NO. 2

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Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.

Tax Risk to Noncontributing Shareholders from Disproportionate Capital Contributions: Red Herring or Elephant in the Room?

Harvey Braverman*

I. Introduction

When a shareholder makes a disproportionate contribution to the capital of a corporation, other shareholders may experience an economic benefit in the form of an enhancement to the value, and other attributes, of their shares. Such enhancements may occur not only where there is an actual or deemed transaction between a shareholder and a corporation but also where there is an actual or deemed transaction between two shareholders that is judicially or statutorily recast as, at least in part, a disproportionate contribution to capital. These enhancements may result from transactions involving stock, debt, or other property, and they most often and clearly accrue with respect to stakeholders that are pari passu or junior to the contributor.

Whether and when these indirect, but very real, economic benefits are taxable is open to question. In practice, this question is often ignored. But there are several statutory provisions and judicial doctrines that, at the very least, create lingering doubt about whether these transactions present a real tax risk for noncontributors. Further complicating matters with respect to tax (and financial) reporting, a stakeholder may not even know—or at least not have timely notice—of receiving such a benefit.

At first it might seem that a disproportionate capital contribution, at least the actual variety, would be a rare event because, on its face, it does not make economic sense for the contributor. But it is not rare. In fact, there is a whole line of cases that addresses the tax consequences to taxpayers who make such contributions. Paramount among them is Commissioner v. Fink, where the taxpayers tried to salvage their investment in a corporation they controlled by voluntarily relinquishing some of their shares, thereby reducing their claim on the assets and earnings of the corporation, purportedly in an effort to attract investors.

While Fink and earlier cases did not directly address the tax effect of such contributions on noncontributors, they indicate what is, in fact, the case: such transactions are not uncommon, especially in the context of distressed companies where certain stakeholders might be more motivated than others to make a go of it and thus willing to contribute disproportionately to the enterprise.

Beyond that, such transactions are prevalent wherever financially troubled companies are reorganizing in a manner that includes stakeholders contributing stock, debt, or other property in exchange for relatively little or no consideration. Moreover, they may occur when distressed companies take on new investors, especially where they do so outside of an orderly bankruptcy proceeding, and especially where the new investor has noneconomic or macroeconomic motives, like in the case of a federal government bailout where existing stakeholders may benefit disproportionately relative to what, if anything, they surrender. These transactions may, on their face or upon later Service scrutiny, give rise to the question of whether a particular shareholder has “overcontributed,” thereby indirectly enhancing the value of the investments of other stakeholders.

No doubt, we are, and will be, seeing more and more of these types of transactions. This Article discusses whether, when, and how, in certain circumstances, the economic enhancements resulting from disproportionate capital contributions are, or might be, taxable to noncontributing stakeholders.

*Harvey Braverman, J.D., LL.M., practices in Seattle, WA and is an adjunct faculty member in the Graduate Tax Program at the University of Washington School of Law, and at Seattle University School of Law. He was formerly a member of KPMG LLP’s National Mergers and Acquisitions and Washington National Tax practices and Vice President of Tax at Intrawest, Corp.


Published by the
American Bar Association Section of Taxation
in Collaboration with the
Georgetown University Law Center


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