Congress repeals installment reporting for accrual taxpayers.

Without remorse or repentance, Congress repealed installment-sale reporting for accrual taxpayers. Sweeping aside 70 years of history, the President signed into law the Ticket to Work and Work Incentive Improvement Act (HR 1180). Now, almost all C corporations (and many other taxpayers) must include in current income all gain realized (and to be realized) from the disposition of property, even though some or all of the sales proceeds will be received in a future tax year. This repeal is effective for sales and other dispositions entered into after Dec. 16, 1999.

Under the new law, accrual-method taxpayers who sell property for an installment obligation must treat as part of the amount realized the gross value of all payments to be received on the obligation (excluding stated and unstated interest, as well as original issue discount) (Regs. Sec. 15a.453-1(d)(2)(ii)). If the installment obligation includes a contingent payment, the fair market value (FMV) of the contingent payment must also be treated as part of the amount realized. Restrictions on transferability are ignored in computing the FMV of the contingent payment (Regs. Sec. 15a.453-1(d)(2)(iii)).

For large corporations, this change in the law is unlikely to work a substantial hardship. To be sure, most C corporations must report their income on the accrual method (Sec. 448(a)(1)). But even with installment reporting available, taxpayers have had to pay an interest charge on installment tax deferral if the taxpayer's total installment obligations exceed $5 million (Sec. 453A). For small businesses that survive on their cashflow, though, repeal of installment reporting may present an impassable hurdle.

Consider a group of individuals who together own all the stock of a successful S corporation, and assume the corporation is an accrual-method taxpayer. If the shareholders wish to dispose of some corporate assets in exchange for an installment note, an asset sale by the corporation will preclude installment reporting. As a result, a sale of appreciated assets will force the shareholders to report the entire gain realized on the transaction, even though neither they nor their corporation currently have the cash with which to pay the resulting tax liability.

If the shareholders intend to sell the entire business venture, an alternative is for them to sell their shares, a route that will permit installment reporting, because the sellers now would be the cash-method individuals rather than the accrual-method corporation. But this route also presents difficulties.

If the purchaser is a corporation, purchase of the shares will prevent an asset basis step-up, unless an election is filed under Sec. 338(h)(10). However, if such an election is filed, the transaction is recast as an asset sale, which eliminates installment reporting by the selling shareholders. Temp. Regs. Sec. 1.338(h)(10)-1T(d)(9) (promulgated in January 2000) leaves no doubt that the tax consequences of a Sec. 338(h)(10) election must be determined precisely, as if the assets of the corporation were in fact sold. As a result, owners of accrual-method S corporations may want to consider the possibility of converting to the cash method, despite the burdens imposed by Sec, 481 (see also Rev. Proc. 99-49), so that a future sale of the company can be reported on the installment method if a Sec. 338(h)(10) election is filed.

Another situation to consider is a partnership with both individual and corporate partners; such a partnership must use the accrual method of accounting (Sec. 448(a)(2)). If such a partnership sells all its assets for a note, installment reporting is unavailable. If, however, the partners all simultaneously sell their partnership interests, installment reporting is possible for those partners who use the cash method of accounting. The buyer's tax consequences will be identical under either scenario; in both cases, the buyer is treated as purchasing the partnership's assets. Taxation of the selling partners can differ, though, because a sale of assets will trigger ordinary income recognition under Sec. 751(b), while a sale of partnership interests is taxed under Sec. 751(a). If the partnership owns inventory that is not "substantially appreciated" within the meaning of Sec. 751(b)(3), these two sections operate very differently. Of course, a purchaser may have substantial nontax reasons for preferring an asset purchase to an acquisition of a partnership interest, particularly the avoidance of undisclosed liabilities.

An accrual-method taxpayer who sells property for a note can avoid the harsh results indicated above by qualifying for open-transaction treatment. If the value of an installment obligation cannot be determined, it will be treated as having no FMV and the taxpayer will report gain only as payment when the note is received and after basis is recovered. Regs. Sec. 1.1001-1(a) has long maintained that open-transaction treatment will be limited to "rare and extraordinary cases. However, this regulation was promulgated against a background of generally permissible installment-method reporting. With the elimination of installment-method reporting for accrual-basis taxpayers, perhaps the Service or the courts will be willing to take a more expansive reading of "rare and extraordinary" circumstances sufficient to justify the open-transaction approach.

FROM HOWARD ABRAMS, J.D., WASHINGTON, DC