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Contributing Zero-Basis Accounts Receivable to a Cash-Basis Partnership
Editor:
Editor’s note: This case study has been adapted from PPC Tax Planning Guide—Partnerships, 16th Edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex. ((800) 323-8724; www.ppcnet.com).
Facts: For several years, Mason Peary has operated his law practice as a sole proprietorship and used the cash method of accounting. He recently agreed to bring in Marshall Owen, currently an employee, as a partner. Peary is seeking advice from his tax adviser as to the partnership’s formation. His concern is whether he should contribute his practice’s accounts receivable to the new partnership, which will also use cash accounting. These accounts receivable generally total $60,000 at any given point. Based on Peary’s collection history, he could probably sell the receivables to a third party for 95% of their face value ($57,000), based on the average amount of receivables. Issue: How will income from Peary’s receivables be taxed if he contributes them to the new partnership?
Analysis An account receivable is a contractual right to receive money; thus, it is property. Because receivables are property, the contribution of zero-basis accounts receivable to a partnership is taxed under the general nonrecognition rule applicable to property contributions, unless there is a significant reason for a different treatment. Congress has indicated that, when such contributions do not have a tax-avoidance motive and have a valid business purpose (at least when the contribution is to a cash-basis partnership), the nonrecognition rule applies. In such circumstances, the partnership assumes the contributor's zero basis in the receivables; under Sec. 704(c), the income the partnership realizes from collection of the receivables is taxed to the contributor to the extent such income reflects the difference between the receivables' zero basis and their fair market value ( FMV ) at the time of contribution. (While each receivable is a separate item of property subject to the test, it may be appropriate to aggregate them for these calculations.) If collections exceed the receivables' FMV at the time of contribution, some of this income will be allocated to other partners. Contributions of zero-basis receivables are not taxed as contributions in all cases. While it sanctioned some such contributions, Congress clearly indicated that assignment-of-income principles are still applicable to such transactions. If the contributor were taxed under such principles, he or she would be taxed directly on all income from the receivables as collected and then treated as contributing the cash to the partnership. In the analogous corporate situation, nonrecognition treatment for a contribution of zero-basis receivables may be conditioned on a business purpose for the transaction (such as a change in the form of conducting a business), a requirement that payables be transferred along with the receivables and no other evidence of tax avoidance (such as an accumulation of receivables or prepayment of payables). In the partnership setting, the requirement that income from property be taxed to the contributor to the extent that it reflects the difference between the property's basis and FMV at contribution, serves to limit tax-avoidance possibilities. Nevertheless, in the absence of controlling precedent or regulations, a prudent adviser might suggest that a contribution of zero-basis receivables be made only for valid business reasons, that it be accompanied by the partnership's assumption-related payables, and that there be no accumulation of receivables or prepayment of payables. (In such cases, the cash-basis payables are not deemed partnership liabilities and the expenses are deductible by the transferor as paid, under Sec. 704(c).) Although Congress addressed nonrecognition treatment only for contributions of zero-basis receivables by cash-method taxpayers to partnerships using the cash method, the same result should apply if the partnership used the accrual basis. The collection of the receivables would produce income, as each collection would involve realizing an amount greater than the partnership's basis in the receivable. Nevertheless, the legislative history makes this result less certain than when a cash-method partnership is involved. In this fact pattern, the transferee partnership will be a cash-method partnership. The tax adviser should suggest that Peary contribute his $60,000 of zero-basis accounts receivable from his practice, but, to avoid assignment-of-income issues, the partnership should also assume the payables of Peary's practice. Peary would still be taxed on the first $57,000 of the income to be realized from the receivables (the amount by which their FMV exceeds their zero basis on the contribution date).
Conclusion A contribution of zero-basis receivables to a cash-method partnership generally is taxed as a contribution of property under partnership rules. Assignment-of-income principles do not apply when the contribution is not motivated by tax avoidance, but by a valid business purpose.
Variation If, instead of a law practice, Peary had operated a business with a working-capital loan secured by receivables, contributing the zero-basis receivables subject to the loan could create problems. Unlike cash-method payables, the working-capital loan constitutes a "liability." The partnership's assumption of this liability results in a deemed cash distribution to Peary. Depending on a number of factors, this deemed distribution could produce taxable gain to Peary in addition to the income taxable to him from collection of the receivables. In this situation, Peary may be better off retaining both the receivables and the loan and paying off the loan as the receivables are collected, or selling the receivables to the partnership and using the proceeds to pay the loan. |
