To raise the revenue needed to extend the research and development credit and other tax breaks, Congress repealed installment-sale reporting for accrual-method taxpayers in section 536(a) of the Ticket to Work and Work Incentives Improvement Act of 1999. As a result, IRC section 453(a)(2) now says accrual-method taxpayers must include in income currently all gain realized (and to be realized) from the disposition of property, even though the taxpayer will receive some (or all) of the sales proceeds in a future tax year. The repeal was effective for sales and other dispositions entered into after December 16, 1999. But the hue and cry over this legislation means the issue is far from dead. In fact, as will be discussed, bills have been introduced in Congress to repeal section 536(a) of the act. However, CPAs should be aware of the change in the law and advise clients accordingly in structuring transactions.
Generally, taxpayers are free to choose a method of accounting under IRC section 446(c) by which to compute taxable income. However, sections 448(a) and (b)(3) require (1) C corporations and (2) partnerships with a C corporation partner to use the accrual method of accounting if their average annual gross receipts exceeded $5 million for the past three years. Tax shelters of any size also must use accrual-method accounting. Under section 448(b), certain farming businesses and qualified personal service corporations are exempt from the accrual-method requirement.
Use of the accrual method generally means that the right to receive income, rather than actual receipt, determines when an amount is included in gross income. A taxpayer includes income, under regulations sections 1.446-1(c)(1)(ii) and 1.451-1(a), when all events have occurred that fix the taxpayer’s right to receive the income and the amount can be determined with reasonable accuracy.
Normally, when a taxpayer sells property and some (or all) of the purchase price will be deferred until a later tax year, the profit on the sale can be reported over time as payments are received. This prevents a taxpayer from having to recognize all the gain on the sale before receiving all the payments. However, after the 1999 legislation, an accrual-method taxpayer cannot use the installment method for income recognized from an installment sale.
Accrual-method taxpayers who sell property in exchange for an installment obligation must treat as part of the amount realized the gross value of all payments to be received on the obligation (less stated and unstated interest, as well as original issue discount, according to regulations section 15a.453-1(d)(2)(ii)). If the installment obligation includes a contingent payment, its fair market value (FMV) is also treated as part of the amount realized. Regulations section 15a.453-1(d)(2)(iii) provides that transferability restrictions are ignored in computing the contingent payment’s FMV.
While this change in the law may not present a problem for large C corporations, it might for small businesses with low cash flow. For example, several individuals might collectively own the stock of an accrual-method S corporation. Although the shareholders may want to sell some of the corporation’s assets for an installment note, IRC section 453(a)(2) bars installment reporting of the asset sale by the corporation. The shareholders have to report currently the entire gain realized on the transaction, even though neither they nor their corporation have the cash to pay the tax.
If the shareholders wish to sell the entire business, they can sell their shares—this would permit installment reporting (the sellers are the cash-method individuals, not the accrual-method corporation). However, purchase of the shares by a corporation will prevent a step-up in asset basis, unless a section 338(h)(10) election is made to treat the share sale as an asset sale. But such treatment would bar installment reporting by the selling shareholders. Thus, owners of accrual-method S corporations may want to consider converting to the cash method, so a future sale of the company can be reported on the installment method if a section 338(h)(10) election is filed.
A partnership with both individual and corporate partners must use the accrual method of accounting. The partnership cannot sell all its assets for a note and use installment reporting. However, if all partners simultaneously sell their partnership interests, the cash-method partners can use installment reporting. The buyer’s tax consequences are the same in either case: He or she is treated as purchasing the partnership’s assets. However, taxation of the selling partners can differ.
IRS notice 2000-26 offers guidance, in question-and-answer format, on some of the corporation and partnership issues.
Fixing the problem
In testimony in February, the House Ways and Means Oversight Committee heard many complaints on how the new provision burdens taxpayers. The American Bar Association taxation section testified that the repeal will hinder employee buyouts of family businesses. Further, it will negatively affect the price and liquidity of accrual-basis S corporation businesses, adversely affect family succession planning of such corporations and require shareholders to pay tax immediately on a complete liquidation. Moreover, as was discussed, the installment sale prohibition will cause problems for accrual-method partnerships.
A Joint Committee on Taxation summary (JCX-15-00, 2/28/00) affirmed that an accrual-method S corporation cannot sell its assets using the installment method, regardless of whether it is the actual seller or is deemed to have sold its assets via a section 338 election. The study also indicated it might not be appropriate to bar a cash-method taxpayer from using installment reporting for the sale of an accrual-basis sole proprietorship.
Treasury’s tax legislative counsel told the Ways and Means Oversight Committee that the law, as it now stands, needs to be fixed. Treasury’s solution is to allow sellers of small businesses with gross receipts of less than, say, $5 million to use the installment method (perhaps with an interest charge), regardless of the seller’s method of accounting.
Lawmakers and business groups agree that Treasury’s proposed remedy will not suffice. HRs 3594 and 3568 have been introduced to repeal the installment method change, retroactively effective for post-December 16, 1999, sales and other dispositions. The Small Business Tax Fairness Act of 2000 also contains such a provision. Further developments are expected.
—Lesli S. Laffie, JD, LLM.