capital ownership by employees to generate general working capital or for other purposes that do not primarily benefit employees. Such a use of the tax benefit is inappropriate. 2. Leveraged ESOPS are also used as a method of protecting a company against a hostile takeover. A sale of stock to an ESOP will not necessarily dilute control of the company to the same degree as a sale to outside parties. The stock purchased by a leveraged ESOP is not immediately credited to employees' individual accounts, but is held in a suspense account and released for allocation to employees' accounts as the acquisition loan is repaid. During this period, the shares may be voted by plan trustees (who are frequently representatives of the management of the company) subject to the fiduciary rules of ERISA. It is not appropriate for the tax benefits accorded to ESOPS to be used by corporate managers who want to protect themselves against the risk of takeover. 3. The existence of special contribution and deduction limits for contributions by an employer to an ESOP creates an incentive to maintain an ESOP as a primary source of retirement income for employees. The tax laws should not create an incentive for an employer to maintain one type of retirement plan to the exclusion of other types. If an employer experiences financial difficulty, employees with retirement savings concentrated primarily in employer stock may be subject to a double risk of loss. Not only would employees lose their jobs (and employer contributions to their retirement plan possibly would be reduced or eliminated), but they also may suffer from decreases in the value of the securities and the amount of dividends paid thereon. Moreover, if a plan is permitted to invest substantially in employer securities, a plan fiduciary could be subject to great pressure to time purchases and sales to improve the market in those securities, whether or not the interests of plan participants were adversely affected. Arguments against the proposals 1. The tax incentives historically afforded ESOPS represent an attempt to balance tax policy goals encouraging employee stock ownership with those encouraging employer-provided retirement benefits. The special tax benefits for ESOPs are designed to encourage the use of a special corporate financing tool (leveraged ESOPs) to expand the ownership of capital in the U.S. Leveraged ESOPs have a legitimate function as corporate financing devices. The corporation is able to obtain low-cost financing for plant expansion and other purposes, enabling it to become more productive, with the corporation's employees, rather than outside investors, receiving the benefits. 2. Employers who incur debt through an ESOP in order to purchase a block of employer securities to be held by the ESOP cannot reasonably be expected to retire the debt on a nondeductible basis. However, absent special deduction limits, an employer could not make deductible payments of interest and principal to retire the debt in many cases. 3. Repeal of the special contribution and deduction limits for ESOPS would restrict investment in employer securities and, therefore, would deny retirees the opportunity to benefit from growth in the value of employer securities. 6. Accounting Provisions a. Accrual accounting requirement for large nonfarm busi nesses Present Law In general, a nonfarm taxpayer must use an accrual method of accounting if the taxpayer's average annual gross receipts for any three-taxable year period preceding the year in question exceed $5 million. Individuals, partnerships (other than partnerships having a C corporation as a partner), S corporations, and "qualified personal service corporations" are exempt from the required use of an accrual method. A qualified personal service corporation is a corporation meeting a function test and an ownership test. The function test is met if substantially all the activities of the corporation are the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. In general, the ownership test is met if substantially all of the value of the outstanding stock of the corporation is owned by present or retired employees. Possible Proposal Under the President's tax reform proposal, use of the cash method of accounting would have been denied to any taxpayer unless the taxpayer (1) had less than 5 million of gross receipts and (2) with respect to a trade or business other than farming, had not regularly used any other method of accounting for the purpose of reports or statements to shareholders, partners, other proprietors, beneficiaries, or for credit purposes. No exception was provided for individuals, partnerships, S corporations, or personal service corporations. (See section II. D. 7. a., below, for a discussion of accrual accounting proposals related to farming businesses.) Arguments for the proposal Pros and Cons 1. An accrual method of accounting more properly reflects the economic income of a taxpayer. 2. Although the simplicity of the cash method may justify its use by smaller, less sophisticated taxpayers, there is no sound policy reason to permit its use by larger businesses which have the capacity to deal with the additional burdens of accrual accounting. 3. By allowing large taxpayers operating in certain business forms or in certain fields to use the cash method, present law permits distortion of income and the deferral of taxes by these taxpayers; it thus provides a subsidy to this group, discriminating against other similarly situated taxpayers, some of whom may be in direct competition with the exempted businesses. Arguments against the proposal 1. Any benefits achieved by requiring these types of taxpayers to use the accrual method of accounting would be outweighed by the burdens of compliance. 2. The cash method of accounting is more consistent with the manner in which professional partnerships and corporations conduct their business and intra-partnership or intra-corporate affairs. b. LIFO method of inventory accounting Inventory methods Present Law Under present law, if the production, purchase, or sale of merchandise is a material income-producing factor to a taxpayer, the taxpayer is required to use an accrual method of accounting and to maintain inventories. Acceptable methods of accounting for inventories include specific identification, first-in first-out ("FIFO"), lastin first-out ("LIFO"), and, in certain limited circumstances, average cost. Under the LIFO method, the costs of the items most recently purchased or produced are matched against sales. When costs are rising, the LIFO method results in a higher measure of cost of goods sold and, consequently, a lower measure of taxable income. Thus, compared to the FIFO method, the LIFO method allows the recognition of taxable income to be deferred. Taxpayers are not required to pay interest on the resultant deferral of tax liability. The extent of the deferral can be measured by the LIFO reserve, which is the excess of the taxpayer's LIFO inventory over the inventory that the taxpayer would be allowed under the FIFO method. The LIFO method is not permitted for purposes of measuring earnings and profits. In addition, recapture (i.e., inclusion in income) of the LIFO reserve is required in certain mergers and acquisitions. Interest charge on certain installment sales Present law (as amended by the 1986 Act) provides an election under which a dealer can avoid the application of the proportionate disallowance rule with respect to installment obligations that arise from certain sales of timeshares and residential lots. A dealer that makes this election with respect to an installment obligation is required to pay interest on any tax that is deferred as a result of payments on the obligation being received in any year following the year of sale. Interest is computed for the period from the date of the sale to the date the payment is received. The interest rate used for this purpose is 100 percent of the applicable Federal rate. Interest charge on long-term contracts A taxpayer using the percentage of completion method with respect to a long-term contract is required to determine upon completion of the contract the amount of tax that would have been paid in each taxable year if the income from the contract had been computed by using the actual gross contract price and total contract costs, rather than the anticipated contract price and costs. Interest must be paid by the taxpayer if, applying this "lookback" method, |