FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member Velazquez, and distinguished Members of the Committee:

I appreciate the opportunity today to discuss with you the cash receipts and disbursements and accrual methods of accounting, and the interaction of these methods with the installment method of accounting. We recognize and understand the importance of these issues to small businesses and look forward to working with Congress to address their concerns.

Items of taxable income and deduction generally are taken into account by a taxpayer in a taxable year based on the taxpayer's method of accounting pursuant to §446(a) of the Internal Revenue Code of 1986. ⁽¹⁾ Under §446(c), permissible methods of accounting include the cash receipts and disbursements method (cash method), an accrual method, or any other method or combination of methods, such as the hybrid method, permitted under Treasury regulations. A taxpayer generally is entitled to adopt any one of these permissible methods for each separate trade or business. However, §446(b) requires that the selected method clearly reflect the taxpayer's income from such trade or business and grants the Secretary of the Treasury broad discretion to determine whether a method of accounting clearly reflects income. See Thor Power Tool, 439 U.S. 522 (1979), Hansen, 360 U.S. 446 (1959), Treas. Reg. §1.446-1(c)(2)(ii). A method of accounting that reflects the consistent application of generally accepted accounting principles ordinarily is considered to clearly reflect income. Once a method of accounting has been adopted, the taxpayer must secure the consent of the Secretary in accordance with §446(e) before changing that method.

The cash method of accounting generally requires an item to be included in income when actually or constructively received and permits a deduction for an expense when paid. Treas. Reg. §1.446-1(c)(1)(i). In contrast, the principles of an accrual method of accounting generally require that an item be included in income when all events have occurred which fix the right to its receipt and its amount can be determined with reasonable accuracy. Similarly, a deduction is allowed to an accrual method taxpayer when all events have occurred which determine the fact of liability for payment, the amount of the liability can be determined with reasonable accuracy, and economic performance with respect to the liability has occurred. Treas. Reg. §1.446-1(c)(1)(ii).

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.

Long-standing Treasury regulations provide that, in order to clearly reflect income, taxpayers (other than farmers) that are required to use inventories for a particular trade or business generally must use an accrual method of accounting for their purchases and sales. Treas. Reg. §1.446-1(c)(2). A taxpayer is required to use inventories in any case in which the production, purchase, or sale of merchandise is an income-producing factor. Treas. Reg. §1.471-1. Any other permissible method (including the cash method) may be used to account for items of income and deduction other than purchases and sales in that trade or business or for other trades or businesses of the taxpayer. A farmer generally may use the cash method of accounting even though the farmer is engaged in the production and sale of merchandise.

In addition to the general requirement that a taxpayer's method of accounting must clearly reflect income, the Code places several specific restrictions on the use of the cash method for income tax purposes. Under §448, certain entities have been specifically prohibited from using the cash method since 1986. Those entities generally include a C corporation (other than a farming business and a qualified personal service corporation ⁽²⁾) with average annual gross receipts over $5 million; a partnership (other than a farming business) which has a C corporation (other than a qualified personal service corporation) as a partner and average annual gross receipts over $5 million; or a tax shelter. Taxpayers that are not specifically prohibited from using the cash method under §448 are not automatically eligible to use the cash method. On the contrary, these taxpayers remain subject to the other requirements that a method of accounting must clearly reflect income and that an accrual method must be used for purchases and sales of inventories. As explained in the legislative history underlying §448 ⁽³⁾:

Present law requires the use of the accrual method in certain situations. First, if the production, purchase or sale of merchandise is an income-producing factor to the taxpayer, the taxpayer is required to use the accrual method of accounting and to keep inventories.

The Committee bill does not change the rules of present law relating to what accounting methods clearly reflect income or the authority of the Secretary of the Treasury to require the use of an accounting method that clearly reflects income.

See also General Explanation of the Tax Reform Act of 1986, Staff of the Joint Committee on Taxation, 100^th Cong., 1^st Sess. (May 4, 1987). ⁽⁴⁾ Consistent with the legislative history underlying §448, temporary Treas. Reg. §1.448-1T(c) provides that "nothing in §448 affects the ... requirement of §1.446-1(c)(2) that an accrual method be used with respect to the purchases and sales of inventory." Thus, for example, if the purchase, production or sale of merchandise is an income-producing factor in a taxpayer's business, the taxpayer generally must use an accrual method for its purchases and sales, regardless of whether the taxpayer has average annual gross receipts of less than $5 million.

Under §447, use of an accrual method also is required for a corporation engaged in the trade or business of farming (or a partnership engaged in the trade or business of farming that has a corporation as a partner) with gross receipts of more than $1 million in any taxable year beginning after December 31, 1975 ($25 million in any taxable year beginning after December 31, 1985 for certain family corporations).

Accrual methods of accounting, when compared to the cash method, are acknowledged to better reflect economic income and comport to generally accepted accounting principles. As explained in the Treasury Department's "Tax Reform for Fairness, Simplicity, and Economic Growth" (Treasury I), Vol. 2, p. 215-216 (1984):

The cash method of accounting frequently fails to reflect the economic results of a taxpayer's business over a taxable year. The cash method simply reflects actual cash receipts and disbursements, which need not be related to economic income. Obligations to pay and rights to receive payment are disregarded under the cash method, even though they directly bear on whether the business has generated an economic profit or loss. Because of its inadequacies, the cash method of accounting is not considered to be in accord with generally accepted accounting principles and, therefore, is not permissible for financial accounting purposes.

The cash method also produces mismatching of income and deductions where the taxpayer engages in transactions with parties that employ a different method of accounting. For example, an accrual method taxpayer may deduct certain liabilities as incurred, such as liabilities for certain services rendered, even though the service provider on the cash method may defer reporting income until cash payment is made.

These shortcomings of the cash method were specifically cited by Congress as the reasons for change in the legislative history to §448. ⁽⁵⁾

In order to clearly reflect income, Treasury regulations since 1918 have required the use of inventories and an accrual method to properly match gross receipts from merchandise sales with the related cost of goods sold when the purchase, production or sale of merchandise is an income-producing factor. The rationale for these regulations has been recognized by Congress and the courts. For example, as explained by the court in Knight-Ridder Newspapers, 743 F.2d 781, 789-90 (11^th Cir. 1984):

The reasoning behind this regulatory scheme is straightforward. According to accounting wisdom, the income realized from the sale of merchandise is most clearly measured by matching the costs of that merchandise with the revenue derived from its sale. In order to achieve such a matching of revenue and cost, it is necessary to keep an inventory account reflecting the costs of merchandise, raw materials and manufacturing expenses. The costs are not deducted immediately when paid but are deferred until the year when the resulting merchandise is sold. To make the matching complete, the taxpayer must report income on the accrual method. That method helps to ensure that income from the sale (like the inventory costs) is reflected in the year of the sale.

Not only does the cash method fail to reflect economic income, the cash method is subject to manipulation that distorts taxable income. For example, cash method taxpayers may attempt to postpone the collection of income that they are otherwise entitled to receive or to prepay certain expenditures in order to yield a targeted taxable income. ⁽⁶⁾ Because of this concern, Congress denied the use of the cash method to tax shelters in §448. General Explanation of the Tax Reform Act of 1986, Staff of the Joint Committee on Taxation, 100^th Cong., 1^st Sess. (May 4, 1987).

Despite these defects, as noted in Treasury I and the legislative history to §448, the relative simplicity of the cash method justifies its use for tax purposes by smaller, less sophisticated businesses for which accrual accounting may be burdensome. In addition, the cash method is ingrained with certainty as to the actual realization of items of income and deduction. Finally, the cash method addresses liquidity concerns in that it provides for payment of tax at the time the taxpayer is most likely to have the ability to pay the tax.

Although long-standing Treasury regulations provide that inventories and, generally, an accrual method of accounting are required in order to clearly reflect income when merchandise is an income-producing factor in the taxpayer's business, uncertainty exists as to when a taxpayer, in particular a service provider, is selling merchandise and when the sale of merchandise is an income-producing factor. In addition, small, unsophisticated taxpayers that do not use an accrual method for any other purpose have complained that the requirement to account for inventories and to use an accrual method is burdensome. We intend to publish administrative guidance that would address these concerns.

For example, in recognition that inventory and accrual accounting may be burdensome to some taxpayers, we plan to issue guidance providing an administrative exception for small taxpayers. This small taxpayer exception would allow qualified taxpayers with average annual gross receipts of less than $1 million (with appropriate aggregation rules) to not keep inventories and to use the cash method. This exception will provide simplicity to small, unsophisticated taxpayers by exempting them from the complex inventory accounting rules and by not requiring them to compute their books and records on an accrual method. We believe this $1 million threshold should cover a majority of small businesses. In 1997 (the most recent year for which data is available), approximately 78 percent of all C corporations, 85 percent of all S corporations, 95 percent of all partnerships and 94 percent of all sole proprietorships had gross receipts of under $1 million (not considering aggregation rules). We are also considering additional exceptions and safe harbors that will allow the use of the cash method.

As part of the Ticket to Work and Work Incentives Improvement Act of 1999 (1999 Act), Congress repealed the use of the installment method of accounting for accrual method taxpayers effective for sales on or after December 17, 1999 (the installment sales provision). The installment sales provision was made applicable to all accrual method taxpayers, not just to small businesses. The provision applies to both casual sales of property and sales of businesses that would otherwise be reported on an accrual method.

After the 1999 Act was passed by Congress, small business groups 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.

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 sales by cash method individuals of interests in accrual method businesses and the sales by such businesses of their assets.

We intend to issue guidance in the near future that will address the availability of the installment method for many common disposition transactions. In addition, we believe that the broader accounting method guidance described above (relating to the availability of the cash method) will alleviate the effect of the legislation on small businesses, regardless of the entity's form. However, providing the complete relief requested by small businesses will require legislation.

Overall, we believe the policy underlying the installment sales provision enacted in 1999 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, 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. We now understand that the legislation has imposed financial burdens on small businesses that override the 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 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 seller's 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 the Congress 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.

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