Recent Tax Changes Affecting Installment Sales
CRS Report for Congress
Received through the CRS Web
Tax Changes Affecting Installment Sales
Gregg A. Esenwein
Specialist in Public Finance
Government and Finance Division
Summary
On December 17, 1999, President Clinton signed the Work Incentives Improvement
Act of 1999 (H.R. 1180; P.L. 106-170). This Act included a modification and limitation
on the use of the installment method of reporting asset sales for taxpayers who normally
use the accrual method of accounting. This change produced a great deal of concern in
the small business community.
In response to this controversy, Congress acted to repeal these restrictions on
installment method sales. Congressional action on this issue culminated in the passage
of the Installment Tax Correction Act of 2000 (P.L. 106-573, H.R. 3594) which was
signed into law on December 28, 2000. This Act repealed the restrictions on the
installment sale method imposed by the 1999 Act. The repeal was made retroactive to
the date of enactment of the 1999 change.
This report will not be updated unless new legislative action is undertaken.
Under pre-December 1999 tax law, some accrual basis taxpayers were allowed to
use the installment method of accounting for certain non-dealer asset sales. However, if
the cumulative total of outstanding installment sale obligations was greater than
$5,000,000 at the end of the year, the taxpayer was required to pay an interest penalty on
the deferred tax associated with the installment obligations in excess of the $5,000,000.
Installment sales where the asset price was less than $150,000 did not count towards the
$5,000,000 limit.
The Work Incentives Improvement Act of 1999 (P.L. 106-170) repealed these
provisions by prohibiting the use of the installment method of accounting for accrual basis
taxpayers whose sales would otherwise be reported using an accrual method of
accounting. The Act also modified the installment sale “pledge” rules so that any
arrangement that gave the taxpayer the right to satisfy an outstanding debt obligation with
an installment note would be treated as a direct pledge of the installment note and trigger
a recognition of gain.
The 1999 Act did not change the availability of the installment method of accounting
for the sale of farm property or the sale of timeshare or residential lots. In addition, the
Congressional Research Service ˜ The Library of Congress
Act did not affect the ability of cash basis taxpayers to continue to use the installment
method of accounting.
This change in the tax treatment of installment sales caused a great deal of concern
in the small business community. In the past, some small business owners were able to
combine the use of seller financing as means of selling their businesses and business assets
with the installment method of accounting to calculate their federal income tax on the sale.
Many in the small business community argued that it was unfair to tax the full gain from
an installment sale at the time of the transaction because in many cases the cash flow
generated in the first period of the sale was insufficient to pay the full amount of taxes due.
The 1999 Act, however, closed down this tax strategy for any asset sales after the date of
enactment, December 17, 1999.
How Installment Sales Work
Under federal tax law, a sale of an asset is considered an installment sale if the sales
contract specifies that at least one payment is made in a tax year later than the tax year in
which the sale took place. Under these circumstances, certain accrual basis1 taxpayers are
allowed to use what is basically a cash method of accounting and prorate the gross profit
from the sale over the years in which payments are made.
In effect, an installment sale is the exchange of the seller’s property for the buyer’s
promise to pay at a later date. The promise to pay is usually evidenced by a note,
mortgage, or other written debt instrument. It is important to recognize that this sale is
simply the exchange of one type of asset (the house, small business, or whatever was sold)
for another type of asset (the debt instrument).
In general, the normal income tax treatment of exchanges of property is to calculate
profit or loss just as if the seller had sold the property for cash, based on the fair market
value of the property received in exchange. This rule is to prevent taxpayers’ escaping
federal income tax through barter arrangements.
However, the installment sales rules are the exception to the general rule. Receipt
of the debt instrument alone is not considered as receiving the full amount of income from
the sale. Rather, under the installment sales rules, the income is not considered received
for income tax purposes until the cash is actually received by the seller in payment of the
debt.
The tax advantage of installment sales is the time value of the deferred taxes on the
profit. The following simplified two period example of installment sales reporting
illustrates this income tax advantage. Consider the case where a property whose basis
1 There are two basic accounting methods for federal income tax purposes, a cash basis and an
accrual basis. The cash basis is the method used by most individuals; income is reported in the
year it is received and deductions are taken in the year in which the related expenditures were
actually paid. Accrual basis is the method used by most businesses and individuals engaged in
operating businesses. Under this method of accounting, income is recognized when the right to
receive it has occurred and expenses are deductible when the liability is incurred.
(original value) was $5,000 is sold for $15,000 by a taxpayer in the highest marginal
income tax bracket of 39.6%. We will assume that the market interest rate is 10%.
The difference between selling for $15,000 cash and selling for a promissory note to
pay $15,000 in the following year is illustrated in the table below:
One-Year Value of Deferred Taxes on Hypothetical Installment Sale
Cash SaleInstallment Sale
Sales Price$15,000$15,000
(Less : Basis of Property)(5,000)(5,000)
Profit on Sale$10,000$10,000
Profit taxable in year of sale$10,0000
Federal income taxes @ 39.6%$3,9600
First year after tax profits$6,040$10,000
Interest on 1st year after tax profits @10 %$604$1,000
Additional profit attributable to installment sales reporting: $396 ($1,000 - $604)
As can be seen from this simplified example, the tax benefits of installment reporting
is that interest can be earned on the deferred taxes. In this example, the benefits amounted
to $396 , which is exactly a year’s interest (at 10%) on the $3,960 in deferred taxes.
Initially it might appear that installment sales also involve a disadvantage because the
seller ends up with an IOU instead of cash. However, in economic terms, the installment
debt instrument is an asset that the seller can use as leverage to borrow the desired cash.
The seller’s net worth remains the same, but now he has both the tax advantages of
installment accounting and the cash.
The ability of a seller to acquire cash by borrowing against their installment debt
obligations has long been recognized by Congress. In an effort to curtail this practice, the
federal tax code contains what are referred to as pledge rules. These pledge rules are
based on the proposition that anyone who has outstanding both an installment debt owed
to them and debt they owe someone else has, in effect, collected part of the installment
debt by borrowing against it.
Initially, these pledge rules prohibited just those transactions where there was a direct
legal linkage between the installment obligation and a taxpayer’s outstanding debt. In
other words, the pledge rules prohibited a taxpayer from using his outstanding installment
obligations as a direct pledge (collateral) against other borrowing. However, since money
is fungible, taxpayers readily found ways around these direct pledge limitations. As a
result of these taxpayer maneuvers , the pledge rule restrictions have had to become much
more extensive and complicated over time.
Recent Legislative Changes
Rules governing installment sales have been part of the tax code since the early 1920's
and the enactment of the Revenue Act of 1921. In the more recent past, the Installment
Sales Revision Act of 1980 broadened the availability of installment sales by allowing the
installment method to be used as long as at least one payment was made a year after the
date of sale.
Congress revisited installment sales in the Tax Reform Act of 1986, curtailing the tax
advantages of these transactions for most taxpayers. In addition, it added the
“proportionate disallowance rule” which tried to link the outstanding debt of the seller to
outstanding installment obligations owed to the seller. The “proportionate disallowance
rule” proved unworkable in practice. Within a year Congress, in the Omnibus Budget
Reconciliation Act of 1987, repealed these provisions. In their place, Congress adopted
more restrictions on the use of installment sales, repealing the method for dealers and
applying interest charges on large non-dealer sales.
More recently, both the Senate’s Taxpayer Refund Act of 1999 and the House’s
Financial Freedom Act of 1999 included provisions that would have repealed the
installment method of reporting for most accrual basis taxpayers. These provisions were
included in the conference agreement for the Taxpayer Relief and Refund Act of 1999,
that passed both chambers but was vetoed by President Clinton.
The Work Incentives Improvement Act of 1999 (H.R. 1180; P.L. 106-170) which
was signed by the President on December 17, 1999 included provisions that would prohibit
most accrual basis taxpayers from using the installment method of accounting. The Act did
not change present law with respect to the availability of the installment method of
accounting for sales of assets used or produced in the business of farming or for sales of
timeshare or residential lots. In addition, the Act did not change the ability of a cash basis
taxpayer to use the installment method of accounting.
The Act also amended the pledge rules 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.”2 This includes situations
where the taxpayer had the ability or right to repay a loan by transferring the installment
note to his creditor.
The beginning of the second session of the 106th Congress saw an increase in
Congressional concern over the possible negative ramifications of these new restrictions.
On January 26, 2000, Senator Conrad Burns introduced legislation (S. 2005) that would
repeal the new restrictions on the use of the installment method of reporting. On February
2 U.S. Congress. Joint Committee on Taxation. Summary of Conference Agreement on H.R.
November 17, 1999.
The Treasury Department indicated at hearings held by the Ways and Means
Committee in February 2000 that they would be issuing new guide lines that would allow
certain taxpayers to continue to use the installment method of reporting. IRS Revenue
Procedure 2000-22 was subsequently issued on April 28, 2000 and allowed qualified
taxpayers with annual average gross receipts of under $1 million to continue to use the
installment method of reporting.
Provisions to repeal the restrictions on installment sales were included in several
pieces of legislation offered in both the House and Senate during the remainder of the
second session of the 106th Congress. Ultimately, Congressional action on this issue
culminated in the passage of the Installment Tax Correction Act of 2000 (P.L. 106-573,
H.R. 3594) which was signed into law on December 28, 2000. This Act repealed the
restrictions on the installment sale method imposed by the 1999 Act. The repeal was made
retroactive to the date of enactment of the 1999 change.