Incorporating a cash-basis business by transferring accounts receivable and payable to an accrual-basis corporation.

• Author: Ellentuck, Albert B.

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.

Assets Cash $ 29,500 Accounts receivable 500 Supplies 3,000 Equipment 300,000 Accumulated depreciation---equipment (70,000) Total assets $263,000 Liabilities Accounts payable--supplies $ 2,000 Accounts payable---payroll taxes 500 Loan payable--Mary 25,000 Note payable Bank 25,000 Total liabilities $ 52,500 Owner's equity $210,500 Total liabilities and equity $263,000 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...