Of the above balance of $33,300 to the debit of installment sales contracts, two-thirds, or $22,200 (shown as a balance to the credit of unrealized gross profits), is to be accounted for and taxed as profit as, when, and if collected. The remaining one-third is the capital investment representing the cost of goods sold. But let it be assumed that the whole or any part of the balance of the installment sales contracts, amounting to $33,300, was defaulted in 1919 or at any later time; then the question arises: How should the loss occasioned by such defaults be treated for purposes of determining the income and excess profits tax? The answer is that the proper portion (two-thirds in this case) of the amount of the defaulted payments should be charged against the unrealized profits and the balance (in this case one-third), representing the cost of the goods sold, should be allowed to the taxpayer as a deduction for losses actually sustained during the taxable year. This method of treatment should be followed whether the goods are or are not recovered. If the goods are not recovered, it correctly reflects the facts without further entries upon the books. If the goods are recovered, their fair market value at the time of recovery should be credited as realized profits for that year, with a corresponding debit to the account of goods purchased. The difference (debit balance) between the two accounts of goods purchased and goods sold should reflect the value of the physical inventory at any given date. (C. B. 4, 86; O. D. 792.) Some installment houses make arrangements with second-hand dealers to take over all goods returned. The dealer allows a price for these returned goods which allowance is credited by the installment house to the customer as the equivalent of a cash payment. A similar procedure is followed in those states which require recovered goods to be disposed of by public auction. Under this procedure that proportion of the remaining balance in the customer's account (after all receipts have been credited, including the value of the goods returned) which represents cost, or the taxpayer's capital invested therein, is allowed as a deduction in the return for the year the account is ascertained to be worthless. The remainder of the account, representing unrealized gross profit, is charged against the unrealized profits and credited to installment sales accounts. The latter entry has no effect on the taxable net income to be reported for that year. While the law permits the deduction of a "reasonable addition to a reserve for bad debts," it is questionable whether the establishment of the reserve method is advisable in the case of installment houses. The method indicated in O. D. 792 is predicated on the fact that the amount of the bad debt to be charged off represents the unrecovered cost of the goods sold to the particular customer who has defaulted. Under the reserve method which deals with accounts in the aggregate (for explanation of the reserve method, see Chapter 35) it would hardly be practicable to make such an allocation. LOSSES. The Treasury has held that a loss incurred on a sale on the installment basis may not be prorated over the period of sale. (C. B. III-2, 108; I. T. 2063.) The new regulations also so provide. (Art. 42.) NET LOSSES.-Paragraph (a) of section 206 states that "the term 'net loss' means the excess of the deductions allowed by section 214 or 234 over the gross income. "Sections 214 and 234 permit the deduction of "all the ordinary and necessary expenses paid or incurred . . . . in carrying on any trade or business." In the new regulations (see page 538) the Treasury holds that the expenses for any year may not be allocated to the year in which the profits on the sale of the goods are realized but are to be applied to all the realized profits of the year during which the expenses are incurred, including profits returnable in that year on installment sales made in previous years.17 Under these rulings it would appear that the expenses which could not be deferred are deemed to result from the operation of a trade or business and thus constitute a net loss under section 206 which may be carried forward for two years. (See Chapter 34.) In a later ruling the Solicitor held: RULING. (1) Any loss suffered by a taxpayer engaged in a business which is not the result of the sale of capital assets is capable of producing a net loss within the meaning of the Revenue Act of 1918, or, in other words, a net loss 'resulting from the operation of a business' is nothing more or less than a net loss suffered while operating a business and due to any cause other than the sale of capital assets; and (2) that losses and net losses are statutory conceptions-they are the excess of allowable deductions over gross income. (C. B. III-2, 44; S. R. 1509.) This taxpayer was engaged in a business making sales both on the cash and installment basis, and had previously filed returns on the accrual basis but in 1918 changed to the installment sales basis. As a result of this change a taxable net loss resulted for the year of change and the subsequent year, i.e., 1919. Accordingly, it does not appear that a taxpayer will be estopped from claiming the benefits of section 206 merely because he has To the same effect O. D. 844; I. T. 1227 and A. R. R. 1216, cited on page 538. changed to an installment basis and such change has resulted in a net loss due to the fact that the entire expenses of the year during which the change was made exceeded the profits for that year computed on the installment basis, as may very well happen. GAIN OR LOSS ON REPOSSESSION.18. REGULATION. If for any reason the purchaser defaults in any of his payments, and the vendor returning income on the installment basis repossesses the property, the entire amount received on installment payments and retained by the vendor, less the profits previously returned as income, will be income of the vendor for the year in which the property is repossessed, and the property repossessed must be included in the inventory of the vendor at its original cost, less proper allowance for damage and use, if any. . . . . (Art. 42.) Installment basis may be used if books contain "adequate information." REGULATION. Any dealer in personal property on the installment plan whose books of account contain adequate information and were kept so that income can be accurately computed on the installment basis in accordance with the provisions of this article may file amended returns accordingly, and the excess of the amount of any tax previously paid over the tax as computed on the installment basis as herein provided shall, subject to the statutory period of limitations properly applicable thereto, be credited or refunded. . . . . (Art. 42.) The big tax problem for most installment dealers has been to convince revenue agents that their books were kept so that income could be computed on an installment basis. In Franc Furniture Co.'s Appeal (1 B. T. A. 420) the taxpayer reported income on the installment basis and expenses on the accrual basis. (See page 538.) As this method was a departure from Mim. 3170 the Treasury actually changed over the entire accounts to an accrual basis and imposed an additional tax. The Tax Board very properly disallowed the Commissioner's contention and permitted the taxpayer to use the installment basis. Accrual or cash basis may be used instead of installment basis. REGULATION. . . . . If the vendor chooses as a matter of consistent practice to return the income from installment sales on the straight accrual or cash receipts and disbursements basis, such a course is permissible. . . . . (Art. 42.) 18 For gain or loss on repossession of real estate sold on the installment basis, see Art. 46, page 547. Change may be made from installment to accrual or cash basis. RULING. A corporation engaged in selling furniture on the installment plan which for the taxable years prior to 1922 computed income and filed returns on the installment plan will be permitted to adopt the strict accrual basis in computing its taxable net income for 1922 and subsequent years provided it includes in gross income for the taxable year all sales made during such year and sets up in its books of account, as completed transactions, all balances due on installment contracts as of the close of the preceding taxable year, the unrealized profits pertaining to such balances being reflected in the balance sheet taken from its books as at the end of the taxable year as earned income. (C. B. II-2, 72; I. T. 1805.) "Casual" Sales of Personal Property for More Than $1,000 Since sales of personal property on the installment plan, strictly so-called, were limited to dealers (see page 529) it became necessary to take care of the "isolated" or "casual" sale of property. This has been done in section 212 (d), quoted on page 530, and in the following: REGULATION. . . . In the case of a casual sale or other casual disposition of personal property for a price exceeding $1,000, income may be returned on the installment basis provided the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable year in which the sale or other disposition is made do not exceed one-fourth of the purchase price. ... (Art. 42.) The foregoing applies to sales made under all laws since 1916. First payment limited to 25 per cent.-This includes all payments received during the year in cash and other property (except the purchaser's obligations). For example, suppose A sells an oil painting for $5,000, and takes from B the following: Cash.... City lot worth. Notes of B.. $ 800.00 I, 200.00 $5,000.00 Here the other property (city lot) plus cash is $2,000. Thus the "initial payments" are more than one-fourth of the purchase price, so it would not be a "casual" sale on which the profit could be deferred. Obligations of purchaser excluded.-This eliminates most of the controversy heretofore prevailing as to whether the "evidence of indebtedness" of the purchaser had or had not a market value. To illustrate: In Kelly's Appeal [3 B. T. A. 257 (A)] the taxpayer sold stock in a company he owned for $250,000. He received $55,700 in cash, the balance in notes (presumably of the purchaser). The Board held under the 1918 law, that this was not an installment sale because: DECISION. . . . . It was not shown that the notes received for the property sold were not worth their full face value or that there was not a market therefor. In the absence of such showing the transaction amounted to the receipt of cash and notes which were the equivalent of cash, and as such the transaction was a single closed transaction in the year 1919. The taxpayer received cash and the equivalent of cash for the stock. Under the 1926 law the above transaction would be a "casual" sale and the profit reported only as the notes were collected. Even under laws prior to the 1926 law, if the notes of the purchaser had no readily realizable market value, the vendor in the above illustration would have received less than one-fourth of the sales price. Installment Sales of Real Property REGULATION. In transactions included in class (1) in article 44 the vendor may return as income from such transactions in any taxable year that proportion of the installment payments actually received in that year which the total profit realized or to be realized when the property is paid for bears to the total contract price. (Art. 45.) First payment limited to 25 per cent. REGULATION. Under section 212 (d) deferred-payment sales of real property fall into two classes when considered with respect to the terms of sale, as follows: (1) Sales of property on the installment plan, that is, sales in which the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable year in which the sale is made do not exceed one-fourth of the purchase price. (2) Deferred-payment sales not on the installment plan, that is, sales in which the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable year in which the sale is made exceed one-fourth of the purchase price. Sales falling within class (1) and class (2) alike include (a) agreements of purchase and sale which contemplate that a conveyance is not to be made at the outset, but only after all or a substantial portion of the purchase price has been paid, and (b) sales where there is an im |