FEDERAL TAXATION

May 2000

INSTALLMENT METHOD:NOT FOR ACCRUAL-BASIS TAXPAYERS ANYMORE

By Walter G. Antognini

The Ticket to Work and Work Incentives Improvement Act of 1999 (P.L. 106-170) made two substantive changes to the installment method of accounting for tax purposes. First, the act generally precludes accrual method taxpayers from using the installment method of accounting for tax purposes. Second, if a taxpayer enters into an arrangement that allows the taxpayer to satisfy all or part of an indebtedness with an installment obligation, the act generally treats that indebtedness as secured by the installment obligation and, hence, as though the taxpayer received payment from the installment obligation. Both provisions are effective for sales or other dispositions occurring on or after December 17, 1999, the day the law was enacted.

Background

Under prior law, all taxpayers, cash and accrual basis, were to use the installment method of accounting unless they elected otherwise. With limited exceptions, the installment method applied to any disposition of property where at least one payment was to be received after the close of the taxable year of the disposition. One such exception is for a "dealer disposition"--generally, a disposition of personal property by a person who regularly disposes of personal property on the installment plan or a disposition of real property held by a taxpayer for sale to customers in the ordinary course of business. The definition of a dealer disposition itself has exceptions for farm property and for timeshares and residential lots.

Prior and current law provides that income is recognized from a disposition as payments are received. Payments currently received include the proceeds from indebtedness secured by an installment obligation. Thus, a payment does not have to actually be received from the obligation itself as long as the taxpayer is able to derive proceeds by using the installment obligation as collateral.

The rules provided for the installment method of accounting are creatures of the tax law. Financial accounting has its own rules for the treatment of property dispositions. These rules do not consider the same factors as the installment method does for tax purposes. Barring unusual circumstances, revenues are reported at the time of sale. Thus, financial statements typically report deferred taxes when a taxpayer uses the installment method for tax purposes.

The Changes

The act made two substantive changes and several conforming amendments. The first substantive change indicates that the installment method does not apply if a taxpayer would otherwise report income on the accrual method. The second substantive change treats a debt as secured by an installment obligation to the extent an arrangement allows the taxpayer to satisfy the debt with the installment obligation.

For sales and dispositions on or after December 17, 1999, accrual-basis taxpayers must generally use the accrual basis of accounting to report sales on the installment method [IRC section 453(a)(2), as modified by P.L. 106-170]. Accrual-basis taxpayers may, subject to an interest charge, continue to use the installment method for dispositions of farm property and timeshares and residential lots. Because large corporations are generally precluded from using the cash method of accounting, use of the installment method is generally limited to noncorporate taxpayers and small corporations. Accrual-basis taxpayers will find that their taxable income more closely matches financial accounting income, thereby eliminating or at least reducing the need for deferred taxes on any differences.

Example: Blue Corporation has had annual gross receipts of $20 million and, because no exception applies, is required to use the accrual method of overall accounting for tax purposes. In 1998, Blue sold undeveloped land with an adjusted basis (cost) of $100,000 for an installment obligation that would pay $150,000 in 1998 and $150,000 in 1999. In 2000, Blue sold another parcel of undeveloped land, again with an adjusted basis (cost) of $100,000, and again for an installment obligation requiring a payment of $150,000 in each of 2 years (2000 and 2001). In both instances, Blue's gross profit is $200,000 ($300,000 total contract price less adjusted basis of $100,000).

Blue recognizes the gain from the first sale over a period of two years. Prior law applies to the first sale, and unless Blue elects out, the installment method applies. Hence, Blue will recognize the gain of $200,000 as the installment obligation is paid ($150,000 x $200,000 / $300,000 = $100,000 gain recognized in 1998 and, likewise, $100,000 gain recognized in 1999). Barring some unusual circumstance, Blue reports the entire gain of $200,000 in the 1998 financial statements along with a deferred tax liability on the $100,000 gain to be reported in the 1999 tax return.

Blue recognizes the gain of $200,000 from the second sale entirely in the year of sale, 2000. The act precludes Blue from using the installment method on this sale because the sale occurred after December 17, 1999. Again barring some unusual circumstance, Blue will report the entire gain of $200,000 in the financial statements for 2000. Because there is no mismatch between tax and financial accounting, Blue will not have deferred taxes from this sale.

Where a taxpayer has otherwise qualified to use the installment sale (e.g., a cash-basis taxpayer sells property for an installment obligation), entering into an arrangement where the taxpayer has the right to "put" or repay debt using the installment obligation results in the taxpayer being treated as having received payment from the installment obligation, thereby triggering recognition of gain [IRC section 453A(d)(4), as modified by P.L. 106-170]. This change is also effective for sales or other dispositions on or after December 17, 1999. Because the right to pay off debt with an installment obligation is presumably not itself a sale or disposition, but rather a deemed receipt of payment from the obligation, the change made by the act presumably does not apply where an installment sale occurs before December 17, 1999, even if an arrangement to pay off debt with the obligation is entered into after December 17, 1999.

Example: Lola, a cash-basis taxpayer, sells undeveloped land in 2000 with a basis of $100,000 for an installment note paying $150,000 in 2000 and $150,000 in 2005. Lola borrows $1 million in 2001. While the installment obligation is not used as collateral for the loan, the terms of the loan give Lola the right to repay $150,000 principal on the loan by transferring the installment obligation.

As a cash-basis taxpayer, Lola would continue to use the installment method of accounting on or after December 17, 1999, unless she elects out. Under the installment method, she recognizes gain as payments from the installment obligation are received. The first payment is actually received in 2000, resulting in gain recognition of $100,000. The second payment is deemed received in 2001, resulting in gain recognition of $100,000 in 2001. Because Lola has entered into an arrangement where she can partially repay a debt with the remainder of the installment obligation, she is treated as having directly secured that indebtedness to the extent the arrangement allows her to repay the debt (i.e., $150,000) and she is therefore treated as having received payment from the installment obligation to that extent.

Will the Installment Method Be Reinstated?

The elimination of the installment method, in the opinion of many, has placed a severe burden on small-business owners seeking to sell their businesses. In many cases the net assets of the business are sold rather than stock, with payment for those assets received by the corporation on an installment basis. Under the act, the corporation selling the assets could be subject to tax on the gain in the year of sale well in advance of receiving payment for those assets.

The AICPA, along with many small-business trade organizations, believes that Congress should reinstate the ability of accrual-basis businesses to utilize the installment method of accounting. Bills have been introduced in both houses of Congress to permit accrual-basis businesses to once again use the installment method of accounting. *