Could an S corporation using the federal-income-tax method value a management contract at zero for taxable-capital surplus when its balance sheet showed $2 million?

Plain-English summary

A management contract shown at $2 million could use a zero value in surplus only if the corporation documented zero federal-tax value when the asset was recognized.

The S corporation elected under Section 171.113 to report assets and surplus using its federal income-tax method. Its balance sheet valued the management contract at $2 million, while the taxpayer said its federal basis was zero.

The Comptroller said $2 million appeared to be the asset's cost unless proven otherwise. If documentation established zero federal-income-tax value at recognition, zero would be used for surplus. Stated capital would not be adjusted to the extent the contract was used as the basis for issuing stock.

The letter did not make a specific surplus determination because it lacked a more detailed explanation of why and how the contract was recognized.

What this means for you

S corporations using the federal method

A claimed zero value needed contemporaneous support tied to the asset's recognition, not merely a later assertion of zero basis.

Tax professionals

Keep surplus valuation separate from stated capital when an asset supports stock issuance.

Common questions

Q: Did the Comptroller accept zero automatically?
A: No.

Q: Could documentation establish zero for surplus?
A: Yes, if it proved zero federal value when recognized.

Q: Did the letter give a final valuation?
A: No.

Citations and references

• Texas Tax Code Sec. 171.113
• 34 Tex. Admin. Code Sec. 3.547(c)(1)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9712381L

Original ruling text

December 15, 1997

Dear Mr. **:

In your letter of December 2, you requested a determination regarding the
computation of taxable capital for a corporation using the federal income tax
(FIT) method.

You state that your client (Taxpayer) is a Delaware corporation that is
qualified to conduct business in Texas. Taxpayer has elected to be treated as
an S corporation for federal income tax purposes. Taxpayer collects nominal
fees for providing management services to a Texas limited partnership (in which
Taxpayer is the general partner). The corporation has no other income. You
indicate that Taxpayer's GAAP basis balance sheet in the federal income tax
return sheet shows assets of cash, investment in the partnership, and a
management contract. The remaining items in the balance sheet are current
liabilities, common stock, additional paid-in capital, and retained earnings.
For GAAP purposes, the management contract is valued at $2,000,000. For
federal income tax purposes, the contract has a zero basis. The amount of
additional paid-in capital corresponds directly to the value reflected for the
management contract.

Under Texas Tax Code Sec. 171.113, an S corporation may elect to report assets
and surplus according to the method used to report its federal income tax.
Rule 3.547(c)(1) defines accounting method as the method of allocating the
cost, benefit, or expense of an asset or liability to accounting periods.

Since the management contract is valued at $2,000,000 in the balance sheet, it
appears that the cost of the asset would be that amount unless proven
otherwise. However, if Taxpayer can provide documentation establishing that
the management contract value was zero for FIT purposes at the time the asset
was recognized, then that would be the value in computing surplus. However,
there would be no adjustment to stated capital to the extent the contract was
used as a basis for issuing stock.

I am unable to provide you with a specific determination regarding the
computation of surplus with regard to the contract without a more detailed
explanation of the basis for recognition of the contract.

This response is based on the facts presented and current law. If there are
different or additional facts, the response may change.

If you have any questions, contact Tax Policy Division. You may call toll free
1-800-531-5441, or our regular number is 512/463-4600. My extension is 3-4662.
You may write me at Tax Policy Division, Comptroller of Public Accounts.

Sincerely,

Bob Jeffcoat
Tax Policy Division