Incorporating a Cash-Basis Business by Transferring Accounts Receivable and Payable to an Accrual-Basis Corporation

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Arlington, VA

Editor's note: This case study has been adapted from PPC Tax Planning Guide—Closely Held Corporations, 13th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter-Craig, Lewis A. Siegel, Joan Wilson Gray, James A. Keller and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 2000.

Facts: Mary operates a computer consulting business as a sole proprietorship. Her business is growing rapidly. She has been told the corporate form of doing business will shield her from the increased liability associated with employing more workers and expanding her customer base. Her books and records have been maintained on the cash method, and she has filed her Schedule C using the cash method. Mary wants the new corporation to use the accrual method. Because all but a few hundred dollars of her receivables are collected before year-end, she does not anticipate this will accelerate taxation of income. Below is Mary's accrual-basis balance sheet as of Dec. 31, 2000.

Issue: How are the accounts receivable and payable to be treated on transfer to the corporation?

Analysis

Because the proprietorship uses the cash method and the corporation will use the accrual method, the transfer of accounts receivable and accounts payable could create problems.

The sales that produced the accounts receivable have been made (but not taxed) to the cash-basis proprietorship. Thus, the transfer of the cash-basis receivables could give rise to some tax savings if the corporation's effective tax rate is lower than the shareholder's. The IRS has long been aware of this potential tax saving opportunity and has taken the position that this type of transfer does not effectively transfer the tax burden incident to those receivables to the corporation. The courts have not always agreed with the Service's position. Fortunately, the IRS has acquiesced in some of these cases, indicating that this type of transfer is relatively risk-free. Thus, the receivables can be transferred to the corporation, which will include them in income as they are received.

The transfer of the cash-basis accounts payable is a different matter. There is some uncertainty about the deductibility of a payable when it is paid later by an accrual-basis corporation. The Service has successfully defended its position that the deductibility of the underlying expenses by the transferee corporation is not allowed, because the corporation was not the taxpayer that incurred the expenses. This position would result in a complete disallowance of the expenses' deductibility, because the transferor (who incurred but did not pay the expenses) would also not be allowed a deduction.

One solution is to have the transferor retain enough of the cash-basis receivables to pay the cash-basis payables, rather than transferring the payables to the corporation, thereby assuring deductibility. However, from a practical standpoint, this solution might not always work. Sometimes, not all liabilities have been identified by the time of the transfer.

In Rev. Rul. 80-198, the IRS ruled that if the incorporation is bona fide and the new corporation carries on an active business, it can take a deduction when it pays the payable. However, the ruling did not address the issue of a transferee on the accrual basis. If the amount of payables to be transferred is significant, this uncertainty as to future deductibility might warrant a ruling request. The Service will generally grant a favorable ruling if the parties enter into a closing agreement, with the IRS stating that the expenses will be deducted only by the transferee/corporation.

Conclusion

Some uncertainty exists as to the tax treatment of accounts receivable and accounts payable when a cash-basis taxpayer transfers substantially all assets used in a business to an accrual-basis corporation in a Sec. 351 exchange. Thus, the tax adviser should recommend that the transferor reduce the receivables and payables before making the transfer. If this is not possible and the receivables or payables are significant, the tax adviser might request a ruling to ensure that the Service does not challenge the transaction.

Variation

Mary has decided the new corporation should use the cash method. In Rev. Rul. 80-198, the IRS stated that an effective transfer of accounts receivable and payable by a cash-basis transferor to a cash-basis corporation is deemed to occur under Sec. 351 if they are transferred in connection with substantially all the assets and liabilities of a going concern. As long as there is no evidence that the payables were prepaid or the receivables were accumulated just prior to incorporation, the corporation will recognize income as the receivables are collected. It will also receive a deduction when the payables are paid.

Although the Service will generally uphold its position in Rev. Rul. 80-198, the possibility exists that the IRS can take a contrary stance if it determines that the assignment-of-income or the clear-reflection-of-income doctrine applies, or that the transfer was motivated by tax avoidance.

Due to the uncertainty surrounding the transfer of the receivables and payables, it is advisable to enter into a closing agreement with the Service if accounts receivable and payable balances transferred to a corporation are significant. Alternatively, a letter ruling could be requested or the accounts could be held outside the corporation.