FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member Coyne, and distinguished Members of the Subcommittee:

I appreciate the opportunity today to discuss with you the repeal of the installment method of accounting for accrual method taxpayers, which was originally proposed in the Administration's Fiscal Year 2000 budget and was enacted by section 536 of the Ticket to Work and Work Incentives Improvement Act of 1999, effective for sales or other dispositions occurring on or after December 17, 1999.

Items of income and loss generally are taken into account by a taxpayer in a taxable year based on the taxpayer's method of accounting. The cash receipts and disbursements method of accounting (cash method) generally requires an item to be included in income when actually or constructively received. In contrast, an accrual method of accounting items generally requires an item to be included in income when all events have occurred that fix the right to its receipt and its amount can be determined with reasonable accuracy. Accrual methods of accounting, when compared to the cash method, generally are acknowledged to better reflect economic income and comport to generally accepted accounting principles. Present law places several restrictions on the use of the cash method for income tax purposes.

The installment method of accounting provides an exception to these general recognition principles by allowing a taxpayer to defer recognition of income from the disposition of certain property until payment is received. Under the installment method, a taxpayer recognizes the gain resulting from the disposition of property proportionately as payments are received on the installment note. Payments taken into account for this purpose generally include cash, marketable securities, and evidences of indebtedness that are payable upon demand or are readily tradable.

The use of installment reporting was originally permitted by Treasury regulations in 1918 for dealers and subsequently sanctioned by Congress in 1926 for dealers and nondealers, subject to certain conditions. As explained by the Supreme Court in South Texas Lumber Co, 333 U.S. 496 (1948), the installment method of reporting was enacted to relieve taxpayers who adopted it from having to pay income tax in the year of sale based on the full amount of anticipated profits when in fact they had received in cash only a small portion of the sales price. However, beginning with the Tax Reform Act of 1986 (1986 Act), the availability of the installment method has been restricted and the benefits derived from its use have been substantially reduced. For example, use of the installment method was denied for revolving credit sales and sales of certain publicly traded property by the 1986 Act and for dealer dispositions of real or personal property, with exceptions for farming property, timeshares and residential lots, by the Revenue Act of 1987 (1987 Act). In addition, the 1987 Act significantly limited the benefits of using the installment method by imposing interest charges on the deferred tax liability attributable to certain installment obligations and by treating pledges of certain installment obligations as payment, thereby triggering the recognition of income.

The Administration's Fiscal Year 2000 budget proposed to prohibit the use of the installment method to report income from an installment sale that would otherwise be reported on an accrual method of accounting (installment sales provision). The proposal did not change the use of the installment method by cash method taxpayers or the present-law exceptions regarding the availability of the installment method for sales of farming property, timeshares or residential lots. The Administration also proposed to eliminate certain inadequacies in the pledging rules by clarifying that put rights or other similar arrangements will receive the same treatment as pledges. The installment sales provision was proposed to be effective for sales or other dispositions occurring on or after the date of enactment.

As indicated in the General Explanations of the Administrations Fiscal Year 2000 Revenue Proposals, the installment sales provision was proposed because the use of the installment method is inconsistent with an accrual method of accounting and effectively allows an accrual method taxpayer to recognize income from the sale of certain property using the cash method. Consequently, the installment method fails to reflect the economic results of a taxpayer's business during the taxable year.

The policy reason underlying the installment method of accounting is to impose tax when the taxpayer has the wherewithal to pay the tax (i.e., when the taxpayer has received the cash). It was difficult to reconcile this policy reason, however, with an accrual method, which requires the payment of tax on trade or business receivables prior to the receipt of the related cash. Moreover, as a result of the repeal of the installment method for revolving credit sales, certain publicly traded property and dealer dispositions, the law already required taxpayers to include in income amounts that had not been collected. Allowing an exception for accrual method taxpayers for the disposition of certain property, but not for other property, created additional inconsistencies in the application of accounting methods.

The installment sales provision and the pledge rule clarification were enacted as part of the Ticket to Work and Work Incentives Improvement Act of 1999 (1999 Act), effective for sales or other dispositions occurring on or after December 17, 1999.

After the 1999 Act was passed by Congress, small businesses began to express concerns that the repeal of the installment method for accrual method taxpayers negatively impacted the sales of small businesses. In particular, small business groups have asserted that the use of the installment method to report the gain on the sale of the business enabled a seller to get a higher price for its business and a buyer to purchase a business for which bank financing was not readily available. As a result of the enactment of the installment sales provision, these small business groups have estimated that the sales price of some closely held businesses may be reduced by 8 percent or more.

The installment sales provision was made applicable to all accrual method taxpayers, not just to small businesses. The ability for an accrual method taxpayer to defer a realized gain until the related cash was received is inconsistent with an accrual method, regardless of the size of the taxpayers business. The provision applies to both casual sales of property and sales of businesses that would otherwise be reported on an accrual method. However, the extent of the impact of the provision on the sales of small businesses apparently was unforeseen by policymakers and potentially affected taxpayers and their advisors during the legislative process.

The repeal of the installment method for accrual method taxpayers decreases the flexibility of structuring certain business dispositions, but does not totally eliminate the use of the installment method in such transactions. As indicated in the legislative history to the provision, the sale of stock of an accrual method business by a cash method taxpayer will continue to qualify for the installment method. Similarly, the sale of an interest in an accrual method partnership by a cash method taxpayer generally should continue to be eligible for installment reporting. On the other hand, sales of assets of an accrual method corporation or partnership will no longer qualify for installment reporting. These different tax results add to the tension that already exists between buyers and sellers with respect to the decision to sell assets or stock. Buyers generally want to purchase assets in order to avoid contingent liabilities associated with the stock and to obtain an asset basis step-up to fair market value. On the other hand, sellers typically want to sell stock in order to avoid two levels of tax, to obtain favorable capital gain treatment, and to transfer contingent liabilities associated with the stock.

Treasury's Office of Tax Policy has met several times with interested industry groups, including the National Federation of Independent Businesses, National Association of Manufacturers, American Institute of Certified Public Accountants, Small Business Legislative Council, and U.S. Chamber of Commerce, and listened to their concerns about the effect of this recent legislation on sales of small businesses. These groups also requested clarification of the effect of the installment sales provision on particular transactions. For example, they requested that we address the sale by a cash method individual of an accrual method business conducted as a sole proprietorship; the continued viability of section 453(h), which allows a shareholder of a liquidating corporation to use the installment method to report the gain on the exchange of its stock for an installment obligation of the purchaser of the corporations assets; and the effect of a section 338 election, under which a stock sale is deemed an asset sale for tax purposes, on a stock sale of an accrual method corporation by a cash method seller.

We intend to issue guidance in the near future that will address the availability of the installment method for most common disposition transactions. In addition, we will issue broader guidance that should alleviate the effect of the legislation on small businesses, regardless of the entitys form, as well as provide additional tax accounting relief. As the installment sales legislation applies to accrual method taxpayers, a threshold issue arises as to which taxpayers are required to use an accrual method, an issue that we have been aggressively studying in other contexts. As indicated on the most recent Treasury and IRS Priority Guidance Plan, we intend to issue guidance addressing the requirements to account for inventories and, as a result, to use an accrual method. Part of this planned guidance generally will allow a qualified taxpayer with average annual gross receipts of $1 million or less to use the cash method and, thus, the installment method. The details for qualifying for this exception and the procedures to automatically change to the cash method will be provided in guidance that should be published in the near future.

While we believe it is important to provide clear and timely guidance to clarify the effect of the installment sales provision on particular transactions and certain small businesses, we believe the law is clear that where an accrual method entity sells assets, or is deemed to sell assets, the installment method will no longer be available because the method of accounting of the entity controls the transaction. Consequently, providing relief for such transactions will require legislation.

Overall, we believe the policy underlying the legislation is appropriate. The installment method is inconsistent with an accrual method of accounting, which generally requires a taxpayer to pay tax on a realized gain, regardless of whether the taxpayer has received the related cash. However, we now understand that the legislation has imposed financial burdens on small businesses that override this basic tax policy concern. As such, we are eager to work with Congress to provide a legislative solution to alleviate this unforeseen impact of the installment sales provision.

Any legislative response should be targeted to address the legitimate concerns of affected taxpayers. To address the liquidity problems facing sellers of small businesses (e.g., businesses with less than $5 million in gross receipts), use of the installment method could be allowed (perhaps with an interest charge), regardless of the sellers method of accounting. If there is concern that different types of flow-through entities are treated differently (because sales of partnerships may be structured to allow the buyer to obtain a stepped-up basis and the seller to use the installment method while sales of S corporations allow either the buyer to obtain a stepped-up basis or the seller to use the installment method), special rules could be provided to level the playing field. In addition, legislation also could clarify the treatment of sole proprietorships and address other issues related to the use of deferred payments. Finally, any legislative solution should promote simplification and administrability.

This concludes my prepared remarks. We look forward to working with you, Mr. Chairman, Mr. Coyne, and members of the Subcommittee and full Committee in developing any legislative proposals deemed appropriate, and we will keep you informed of our proposed administrative actions. I would be pleased to respond to your questions.