For Texas franchise tax, at what value does a corporation report property an owner contributed tax-free in exchange for stock — federal tax basis or fair market value?

Plain-English summary

This letter is about the Texas franchise tax, not sales tax. (The STAR system lists it in the "Letters" bucket, but the ruling itself decides a franchise-tax question under Chapter 171 of the Tax Code.)

An individual planned to form an S corporation and contribute property to it solely in exchange for stock. Under IRC § 351, the individual recognizes no gain or loss on that contribution, and under IRC § 362(a) the corporation takes the individual's basis in the property. So the property — worth about $1,300,000 at fair market value — would be carried on the corporation's federal income tax books at its roughly $71,000 carryover basis. The taxpayer asked which figure controls for computing Texas franchise tax.

The Comptroller answered by reference to the two methods a corporation could use to compute its surplus (the base of the then-current franchise tax):

• If surplus is less than $1 million: Under Tex. Tax Code § 171.109(c), a corporation may report its surplus using the same method it uses to compute its federal income tax return. Because the contributed assets were recognized at $71,000 on the federal return, that $71,000 amount is what goes into the surplus calculation — provided the corporation is eligible to use the income-tax method.

• If surplus exceeds $1 million: The corporation must compute franchise tax using the method required by Generally Accepted Accounting Principles (GAAP). To the extent GAAP would require the contributed assets to be recognized at their fair market value, the corporation would have to report them at that higher value.

A note on currency: this 1988 letter interprets the franchise tax as it existed then, which was based on a corporation's taxable capital and surplus. Texas has since restructured its franchise tax, so — consistent with the STAR caveat above — the specific surplus-method rules discussed here may no longer reflect current Texas franchise-tax law.

What this means for you

Corporations formed with contributed property

When an owner contributes appreciated property to a corporation tax-free for stock, there can be a large gap between the property's federal tax basis and its fair market value. Which figure a Texas corporation used for the old surplus-based franchise tax depended on which computation method it was on — and the $1 million surplus threshold in § 171.109(c) was the switch between the federal-income-tax method and the GAAP method.

Check eligibility before assuming the income-tax method

The letter conditions the favorable (lower-basis) result on the corporation actually being eligible to use the income-tax method. Crossing the $1 million surplus line forces the GAAP method, which can pull contributed assets up to fair market value.

Confirm the current rules

Because the Texas franchise tax has since been restructured, treat this letter as historical guidance on the surplus-based regime and confirm the current franchise-tax treatment with up-to-date sources or a tax professional.

Common questions

Q: Is this a sales-tax ruling?
A: No. Despite appearing in the STAR "Letters" bucket, it decides a Texas franchise-tax question under Tax Code Chapter 171.

Q: At what value is § 351-contributed property reported for franchise tax?
A: For a corporation with surplus under $1 million eligible for the income-tax method, at its federal tax basis (here about $71,000). For a corporation with surplus over $1 million, under GAAP — at fair market value to the extent GAAP requires.

Q: What is the $1 million figure?
A: It is the surplus threshold in Tex. Tax Code § 171.109(c). Below it, a corporation may use its federal income tax method; above it, it must use GAAP.

Q: Does this still reflect current Texas franchise-tax law?
A: Not necessarily. It interprets the older surplus-based franchise tax, which Texas has since restructured, so verify current rules.

Q: Can I rely on this letter?
A: Treat it as guidance only. It is based on the specific facts presented and can change with different facts; on the STAR system it binds the Comptroller only as to the taxpayer it was issued to and may no longer reflect current policy.

Citations and references

Statutes:

• Tex. Tax Code § 171.109(c) (a corporation with surplus under $1 million may compute surplus by the method used on its federal income tax return)
• IRC § 351 (no gain or loss on a transfer of property to a corporation solely in exchange for stock)
• IRC § 362(a) (corporation takes a carryover basis in property contributed under § 351)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/8810L0899G01

Original ruling text

COMPTROLLER OF PUBLIC ACCOUNTS
STATE OF TEXAS
AUSTIN, 78774

BOB BULLOCK
Comptroller October 25, 1988

Dear ***:

In your letter of October 6, 1988, you described the circumstances
surrounding an individual's transfer of property to an S Corpora-
tion. The property was transferred in exchange for stock in the
corporation. Under federal income tax guidelines, the property
will be recognized at $71,000 on the corporation's federal income
tax return. Its fair market value is approximately $1,300,000.

Under Section 171.109(c) of the Texas Tax Code, a corporation
whose surplus is less than $1 million as determined by the method
used to compute its federal income tax return may report its
surplus according to the method used on the tax return. Because
the assets in question were recognized at $71,000 on the corpora-
tion's income tax return, that amount would be used in calculating
its surplus provided the corporation is eligible to use the income
tax method.

Should the corporation's surplus exceed $1 million, it would be
required to report its franchise tax using the method mandated by
Generally Accepted Accounting Principles (GAAP). To the extent
that GAAP would require the contributed assets to be recognized at
their fair market value, the corporation would have to report the
assets at that value if it had to use the GAAP method.

This opinion is based on the facts presented. If there are
different or additional facts, the opinion may change.

If you have any questions, please call me at (512) 463-4496.

Sincerely,
Jerry Bobbitt
Legal Services Division, Taxability Section

HAND-DELIVERED

October 6, 1988

Comptroller of Public Accounts
Policy Section
111 West 6th Street
Austin, Texas 78701

Attn: Debbie Angus

Re: Request for Written Opinion

Dear Ms. Angus:

Taxpayer requests your written opinion regarding the franchise
tax consequences of the following facts:

1. An individual desires to form an S Corporation. The individual
   will transfer property to the Corporation solely in exchange for
   stock in the Corporation under Internal Revenue Code ("IRC") Sec. 351.
   Under such section, the individual will not recognize any gain or
   loss on the contribution of such property.

2. The property to be contributed to the corporation has an federal
   income tax basis to the individual transferor of approximately
   $71,000. The fair market value of the property is approximately
   $1,300,000.

3. Under IRC Sec. 362(a) the corporation will have a basis of the
   property contributed equal to the basis as it was in the hands of
   the individual transferor. Therefore, the property will be carried
   on the corporation's federal income tax basis books at $71,000.

QUESTIONS:

1. May the corporation use the federal income tax method to compute
   its franchise tax?

2. Under the federal income tax method, will the surplus of the cor-
   poration be calculated based on the corporation's federal income tax
   basis in the assets contributed (i.e., $80,000)?

Your expedited response to these questions will be greatly appreciated.
If you need any additional facts to make a determination, please give
me a call.

Sincerely,