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Industry Directive #3 on Section 118 Abuse

                                                                          LMSB-Control No: 04-1007-069
     Impacted IRM 4.51.5

October 5, 2007

                                       DIRECTOR, FIELD SPECIALISTS
                                       DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
                                       DIRECTOR, INTERNATIONAL COMPLIANCE
                                       STRATEGY AND POLICY                                    

From:                             Patricia C. Chaback /s/ Patricia C. Chaback
                                       Industry Director
                                       Communications, Technology and Media

Subject:                         Tier I Issue: IRC Section 118 Abuse Directive # 3

This memorandum is intended to provide the field with direction on a Tier I issue relating to Section 118 abuse.   IDD#1 (issued on December 28, 2006) instructs the field that Internal Revenue Code (Code) Section 118 by its terms has no application to partnerships.  Some taxpayers, however, continue to contend that a common law “contribution to capital” doctrine exists, independent of Code Section 118, and that this alleged common law doctrine permits them to exclude from a partnership or other non-corporate entity (e.g., a limited liability company) income amounts allegedly “contributed to the capital” of the non-corporate entity.  The intent of this IDD is to provide additional guidance to the field.  

Background/Strategic Importance:

Taxpayers operating in both corporate and non-corporate forms have taken the position that amounts are excludable from income as “contributions to capital” under Code Section 118 and/or under an alleged common law contribution to capital doctrine.  Non-corporate entities have made this argument with respect to Universal Service Fund (USF) payments, with respect to federal, state and local subsidies, grants, payments etc., as well as with respect to other miscellaneous Code Section 118 issues.   

Issue Tracking:

Any cases having this issue should use the following UIL and SAIN codes:


  • Non Shareholder Contribution to Capital 118.01-02
  • Basis Adjustment Under Section 362(c) 118.01-03


  • Non Shareholder Contribution to Capital
    • Primary SAIN 401Secondary SAIN 187
  • Basis Adjustment Under Section 362(c)
    • Primary SAIN 110Secondary SAIN 186

Planning and Examination Guidance:

Issue identification:

The return filed is typically a Form 1065, US Return of Partnership Income, or any other type of filing applicable to a non-corporate entity.  The issue may be raised either on the original return or through claims.  Absent the filing of a claim, the issue may not be readily apparent.  Thus an in-depth examination of a taxpayer’s book to tax differences is required, specifically, book-tax differences relating to income and/or depreciation.  

Other means of identifying the issue on a tax return include the following:

  • Key words or phrases used on the tax return (i.e., contribution to capital, inducement, IRC §118)
  • A review of fixed assets for basis reductions

Planning and Examination Risk Analysis

If this Tier I compliance issue is present during an examination, it is subject to a documented risk analysis.  The field should challenge all arguments raised by taxpayers operating in a non-corporate form who take the position that Code Section 118 or any other theory permits the taxpayer to exclude an amount from income as a “contribution to capital.” 

Audit Techniques

A generic Information Document Request should be issued asking the taxpayer for a list of all I.R.C. § 118 exclusions from income.  See attachment for list of information to request.

Audit Evaluation:

Direction and assistance on evaluating information gathered should be coordinated with the Telecommunications Industry or Retail Industry Technical Advisor.

LMSB Position:

The Service’s position is that no common law doctrine for non-corporate taxpayers exists, under the case law preceding the enactment of Code Section 118 in 1954, nor under the Code or case law since enactment of Code Section 118. 

Neither Code Section 118 nor any alleged common law “contribution to capital” doctrine permits the exclusion from income of amounts transferred to a non-corporate entity by a non-owner.  The legislative history to Code Section 118 is clear that the provision codified the preexisting case law, all of which case law addressed the issue of whether amounts transferred to a corporation by a non-shareholder were excludable from income.   Thus, neither the preexisting case law nor the Code supports the argument that amounts transferred to a non-corporate entity by a non-owner are excludable from income.  See, for additional discussion, GCM 38944 (1982 GCM LEXIS 129). 

Effect on Other Guidance:

Section 118 Abuses Tier I Compliance Issue IDDs #1 and #2 supplemented.


Kathleen Follis, Telecommunications Technical Advisor, 484-636-0520
Dave Moser, Retail Technical Advisor, 636-255-1246.

This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.  


cc:  Commissioner, LMSB
       Deputy Commissioner, Operations
       Deputy Commissioner, International Division Counsel, LMSB
       Chief, Appeals
       Directors, Field Operations
       Director, Performance, Quality, Analysis, and Support

Page Last Reviewed or Updated: 2013-01-10