This provision repeals the installment method of accounting for most accrual basis taxpayers and adjusts "pledge rules" for installment obligations. This provision potentially increases the tax burden to thousands of small businesses, especially small business owners that are selling their businesses in an asset-sale transaction. This change also impacts seller financing of real estate if the seller is an accrual basis taxpayer. Be aware that there is already movement in Congress to reverse this change.

This article is designed to give you a brief summary of the new law's major provisions so that you can begin to consider how your personal, investment and business plans and goals should be changed in the coming weeks and months.

Tax Background An accrual method taxpayer is generally required to recognize income when all the events have occurred that fix the right to the receipt of the income and the amount of the income can be determined with reasonable accuracy. The installment method of accounting, however, provided an exception to this general principle of income recognition by allowing an accrual basis taxpayer to defer recognition of income from the disposition of certain property until payment is received. Sales to customers in the ordinary course of business are not eligible for the installment method, except for sales of property that is used or produced in the trade or business of farming, and sales of timeshares and residential lots where the taxpayer elects to pay interest under IRC Section 453(1)(2)(B).

The "pledge" rule provided that if an installment obligation is pledged as security for any indebtedness, the net proceeds of such indebtedness are treated as a payment on the obligation, triggering the recognition of income. Actual payments received on the installment obligation subsequent to the receipt of the loan proceeds are not taken into account until such subsequent payments exceed the loan proceeds that were treated as payments. The pledge rule does not apply to sales of property used or produced in the trade or business of farming, to sales of timeshares and residential lots where the taxpayer elects to pay interests under IRC Section 453(1)(2)(B), or to dispositions where the sales price does not exceed $150,000.

New Law The new law generally prohibits the use of the installment method of accounting for dispositions of property that would otherwise be reported for Federal income tax purposes using an accrual method of accounting. Included in the term "property" are business assets of an accrual method taxpayer that are sold with the buyer paying a portion of the purchase price in cash installments. This disallowance of the installment method could cause the payment of federal and state taxes in excess of the installment payment received in the initial year of the transaction.

For example, assume an accrual basis asset seller agrees to be paid $100,000 over a term of 10 years at $10,000 per year and that the combined Federal and state tax rate is 30 %. The combined Federal and state tax in the initial year of sale would be $30,000, $20,000 more than the taxpayer would receive from the first installment. Obviously, this change in the tax law can have a chilling effect on asset sale transactions of accrual basis taxpayers, as many asset sales are dependent on seller financing.

It should be noted that the new provision does not change present law regarding the availability of the installment method for dispositions of property used or produced in the trade or business of farming, does not change present law regarding the availability of the installment method for dispositions of timeshares or residential lots if the taxpayer elects to pay interest under IRC Section(453(l), and does not apply to cash basis taxpayers, such as individuals.

The new law modifies the installment "pledge rule" so that entering into any arrangement that gives the taxpayer the right to satisfy an obligation with an installment note will be treated in the same manner as the direct pledge of the installment note. For example, a taxpayer now will be treated as if he in fact received loan proceeds to the extent the taxpayer has the right to "put" or repay the loan by transferring the installment note to the taxpayer's creditor. Other arrangements that have a similar effect would be treated in the same manner.

Planning Opportunities One way to avoid the new law is to arrange a stock sale, not an asset sale. However, if the buyer purchases capital stock, he inherits the seller's liabilities, both disclosed and undisclosed. Also, an asset sale potentially permits higher depreciation deductions resulting from an increase in tax basis to fair market value and amortization of "purchased" good will. These additional deductions may not be available in a stock transaction.

The loss of installment reporting may create a greater market for the sale of secured installment notes. Taxpayers who will now owe a full tax liability may wish to cash out their notes completely. The buyer would pay some of the purchase price in cash installments, which would be received by the holder of the securitized note. Be careful about the terms of recourse in the event of default by the maker of the note.

There are other possibilities, all of which are likely to be scrutinized by the IRS. For example, some sellers could accept deferred payments for "personal goodwill" instead of taking installments as part of the purchase price. Payments for "personal goodwill" would be taxed upon receipt. However, this method works only if the purchased company's growth is directly tied to the seller - an unusual fact pattern and one that is difficult to prove.

Conclusion The vast majority of closely held business sales are conducted using installment sales obligations. As such, it has been estimated that the new tax treatment of installments sales could reduce the sale price of such businesses by 5, 10, 20 percent or more, and that over one-half of the approximately 200,000 closely held business sales that occur each year could be adversely affected. Consequently, several bills have been introduced into Congress to repeal this provision as it applies to asset sale transactions of accrual basis taxpayers. The effective date of the new provision is December 17, 1999 and applies to all sales after that date. It is possible that new legislation, if any, may be retroactive.

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