Effect of installment-method repeal on accrual-method S corporations.

Under new Sec. 453(a)(2), the installment method can no longer be used by accrual-method sellers of property for sales after Dec. 16, 1999, except for sales of farm property and timeshares or residential lots, if a taxpayer elects to pay interest on the deferred tax.

Affected sellers should attempt to finance the buyer's installment note to obtain cash at least equal to the tax on the total gain, which no longer will be deferred.

This new provision will have a particular effect on accrual-method S corporations owned by cash-method shareholders; see Tax Clinic, "Congress Repeals Installment Reporting for Accrual Taxpayers," TTA, March 2000, p. 142. The full gain on asset sales by S corporations, not subject to the corporate built-in gains (BIG) tax, will be currently taxable to the shareholders. The full gain on asset sales subject to the BIG tax will be currently taxable to the corporation. This gain, less the BIG tax (under Sec. 1366(f)(2)), also will be currently taxable to the shareholders.

On the other hand, the installment method will be available to the shareholders if they sell their S stock. If the purchasing corporation alone elects deemed asset sale treatment under Sec. 338(g), the full gain on this deemed asset sale also will be taxable to the old S target on a one-day C return (Temp. Regs. Sec. 1.338-10T(a)(3)). If, instead, both the purchasing corporation and all of the S shareholders (including those who are not selling their S stock), elect deemed asset sale and deemed liquidation treatment under Sec. 338(h)(10), the results described below may apply.

Caution: Under Prop. Regs. Sec. 1.338(h)(10)-1, a new target is deemed the obligor on installment obligations that a purchasing corporation actually issued, and the old target is deemed to receive these obligations from the new target, which were actually received by the old target's shareholders in exchange for their stock. In the deemed liquidation, a selling shareholder who actually received an installment obligation in the stock sale is deemed to receive that obligation as part of his liquidating distribution. The other shareholders are deemed to receive none of the installment obligation.

Effective Jan. 6, 2000, temporary regulations replaced final and Prop. Regs. Sec. 1.338(h)(10)-1. These temporary regulations, generally, are substantively the same as the proposed regulations. However, the regulations do not reflect new Sec. 453(a)(2). Therefore, future IRS guidance could change the following treatment.

If Sec. 338(h)(10) is elected, and the old S target is not subject to the BIG tax, the full gain on the deemed asset sale will be currently taxable to the shareholders. Additional gain (if any) on the deemed liquidation proceeds--less the stock's basis after reflecting the deemed sale gain--may be reportable by the shareholders on the installment method, under Sec. 453(h). No other gain or loss is recognized on the stock sale.

When Sec. 338(h)(10) is elected, and the old S target is subject to the BIG tax, the full gain will be currently taxable to that corporation. The full gain, less the BIG tax, also will be currently taxable to the shareholders; any additional gain on the deemed liquidation proceeds--less the stock's basis after reflecting the deemed sale gain--may be reportable by the shareholders on the installment method, under Sec. 453(h). No other gain or loss is recognized on the stock sale.

In addition, on March 9, 2000, the House of Representatives approved the Small Business Tax Fairness Act of 2000 (H.R. 3832), by a vote of 257 to 169. This proposed legislation has a provision that would retroactively reverse the installment-method repeal. The Senate previously passed small-business tax relief provisions as part of the bankruptcy reform bill (H.R. 833) that did not contain any reversal of the installment-method repeal. House/Senate differences in these measures will have to be reconciled by a Congressional conference committee. In any event, on March 9 and 10, 2000, President Clinton reiterated his threat to veto the House bill, if it is ultimately passed by Congress in its present form.

FROM STUART R. JOSEPHS, CPA, TAX ASSISTANCE PRACTICE (TAP), SAN DIEGO, CA