26 U.S.C. § 118 — Contributions to the capital of a corporation

(a) General rule. A corporation's gross income does not include any contribution made to its capital. (b) Exceptions. Except as provided in subsection (c), a "contribution to the capital of the taxpayer" does NOT include: (1) a contribution in aid of construction, or any other contribution made by a customer or potential customer; or (2) a contribution from a governmental entity or civic group (unless that contributor is also a shareholder acting as a shareholder). So these kinds of payments count as taxable income, not tax-free capital contributions. (c) Special rules for water and sewerage disposal utilities. (1) General rule. For a regulated public utility that provides water or sewer service, "contribution to the capital of the taxpayer" DOES include money or property received from anyone (shareholder or not) if: (A) the amount is either a contribution in aid of construction, or a contribution from a government entity meant to protect, preserve, or improve drinking water or sewer service; (B) if the contribution is property other than water or sewer facilities, it must meet the spending rule in paragraph (2); and (C) the amount (or property bought with it) is not counted in the utility's rate base for setting customer rates. (2) Expenditure rule. A contribution meets this rule if: (A) an equal amount is spent buying or building tangible property described in section 1231(b) that is either the same property the contribution was for, or the same type, and that is mainly used in the water or sewer business; (B) that spending happens before the end of the second tax year after the year the contribution was received; and (C) accurate records are kept of how much was contributed, how much was spent, what the spending was for, and when the contributions and spending happened. (3) Definitions. "Contribution in aid of construction" is defined by Treasury regulations, but never includes fees charged just for starting or stopping service. "Predominantly" means 80 percent or more. "Regulated public utility" has the meaning in section 7701(a)(33), except it excludes any utility that isn't required to provide water or sewer service to the general public in its service area. (4) Disallowance of deductions and credits; adjusted basis. No deduction or credit is allowed for spending that counts as a contribution in aid of construction under this subsection. Any property bought with such contributions has a tax basis of zero. (d) Statute of limitations. If a taxpayer treats an amount as a capital contribution described in (c)(1)(A)(i) (a contribution in aid of construction), the deadline for the IRS to assess any resulting tax deficiency does not expire until three years after the taxpayer notifies the Secretary - in whatever manner the Secretary requires - of: (1) how much was actually spent under the expenditure rule; (2) that the taxpayer does not intend to make that spending; or (3) that the taxpayer failed to make the required spending within the deadline in (c)(2)(B). The IRS may assess the deficiency any time before that three-year period ends, regardless of any other law. (e) Cross references. (1) For how a corporation calculates the tax basis of property it acquired through a capital contribution, see section 362. (2) For special rules about contributions of debt, see section 108(e)(6).