Accounts Receivable Transferred to a Corporation
If you have an unincorporated business and use the cash method of accounting, your adjusted basis in unrealized (uncollected) accounts receivable (if you had any) when you transfer them to a corporation in a Section 351 exchange is zero.
Since your basis in the receivables is zero, the corporation's basis in the receivables it receives from you is also zero. In addition, the basis in the stock you receive from the corporation that is attributable to the accounts receivable transferred to it is also zero.
If the corporation is on the cash basis of accounting it pays income taxes on the receivables when it collects them; you do not recognize any gain.
What Does it Mean to Have a Zero Basis in Accounts Receivable and in Stock?
A zero basis in accounts receivable simply means, for tax purposes, that the entire amount of the proceeds collected by the corporation is recognized as income and is subject to income taxes. A zero basis in the stock you receive in exchange for the receivables means you have no equity in the stock.
This means, if you sell your stock, the amount of the proceeds you receive that exceeds your basis is recognized as a taxable gain. Since your basis (your equity in the stock) is zero, the entire amount of the proceeds is a taxable gain.
For example, if all you transfer to the corporation is $5,000 of accounts receivable and you receive one share of stock in exchange, your one share of stock has a zero basis.
Now, if you sell your one share, the entire proceeds in excess of your basis (which is zero in this case) would be a taxable gain.
In contrast, say you contributed $5,000 in cash to the corporation instead of accounts receivable and you received one share of stock in an exchange In this case, your one share of stock would have basis (equity) of $5,000. If you sell your one share of stock for $6,000 you would report a taxable gain of $1,000 ($6,000 minus $5,000).
Of the $6,000, $5,000 is considered a return of capital (equity); what you contributed to the corporation. Any amount that represents a return of capital is not taxable.
Basis is the equity in your stock. Therefore, a zero basis means you have no equity in your stock. Capital gain is the difference between you cost basis and the amount realized. If you have no cost basis, the entire amount realized is a capital gain (minus any selling expenses).
The Assignment of Income Doctrine
Don't run afoul of the assignment of income doctrine which states:
- Whoever earned the income pays the taxes.
The IRS says, if you don't have a valid reason for transferring accounts receivable, the assignment of income doctrine will apply and you, not the corporation, will be taxed on the receivables when they are collected by the corporation if the corporation is on the cash basis.
So, if you plan on transferring accounts receivable into your corporation, you should have a valid business reason for doing so and that you're not just trying to avoid taxes.
Tax avoidance may be construed by the IRS where there is no valid business purpose for transferring accounts receivable to the corporation. An example of evidence that no valid business purpose exists is where the corporation receiving the receivables is not actually conducting an ongoing business. In other words, it's a sham corporation.
- Return to the Tax Basics for Startups Table of Contents to find related links.