Contributing zero-basis accounts receivable to a cash-basis partnership.

• Author: Ellentuck, Albert B.

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 non-recognition 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...