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I should appreciate very much your consideration of this matter and your submission of it to Mr. Stam for study, if you believe it has merit. I shall, of course, be glad to submit any additional information that might be helpful or otherwise be of any assistance possible. Very truly yours,
ADRIAN W. DEWIND.
PROPOSED AMENDMENT TO SECTION 353 (c) TO ELIMINATE ITS APPLICATION TO
BANKS, LIFE-INSURANCE COMPANIES, SURETY COMPANIES, AND OTHER FINANCIAL CORPORATIONS
Subparagraph (3) of section 353 (c) (relating to inactive corporations) is hereby amended to read as follows:
“(3) 90 pjercent or more of the gross income of such business for each year of such 5-year period was other than personal holding company income as defined in section 543 or such business is held by a corporation defined in section 542 (c), (2), (3), (4), (6), (7), (8), and (9).”
PAUL WEISS, RIFKIND, WHARTON & GARRISON,
New York 22, N. Y., April 14, 1954. Hon. EUGENE D. MILLIKIN, Chairman, Committee on Finance,
United States Senate, Washington 25, D. C. My dear SENATOR MILLIKIN: I am writing to suggest the desirability of eliminating from the proposed Internal Revenue Code of 1954 the provision in section 453 (c) and a related provision in section 481 (d). A detailed memorandum relating to this proposal is enclosed.
Under existing law, an accrual basis taxpayer who makes sales of merchandise on the installment plan and who desires to change to the installment method of accounting is subject to a severe tax penalty in the form of a double inclusion of gross income from installment accounts receivable outstanding at the time of the change in the method of accounting.
Briefly stated, this penalty arises from the fact that installment accounts previously accrued under the accrual method of accounting are again required to be included in computing gross income when they are collected after the change to the installment method of reporting. Since the deductible expenses of the previously accrued sales are not available a second time as deductions, the second reporting of the installment receivables results in a tax on gross income which may be easily several times the net profit on the sales involved. While as long as sales are maintained at the same or higher levels, the contemporaneous deduction of the expenses of later sales will tend to defer the effect of the penalty tax on earlier sales, the time will inevitably come when a decline in sales and a consequent decline in expenses will bring the full impact of the penalty tax. The effect is that taxpayers are effectively prevented from making a desirable and wise change in accounting method.
One of our clients, Field Enterprises, Inc., whose educational division publishes and sells the children's encyclopedias known as World Book and Childcraft, is an example of a taxpayer adversely affected by the existing law. Encyclopedias are largely sold on the installment plan and, accordingly, Field Enterprises is heavily involved in installment accounts receivable. At present these receivables total between $12 million and $15 million at any given time. A change of accounting method under existing law would present the company with an ultimate tax penalty substantially in excess of $4 million, under existing tax rates. This, of course, absolutely prevents any change in accounting method. The result is that as the sales of the encyclopedias increase the cash position of the company steadily worsens, because of the fact that income taxes must be paid upon the added sales long prior to the collection of the installment payments.
Under section 453 (c) of the proposed 1954 code, a provision has been inserted which is apparently designed to give relief to taxpayers from the penalty tax under existing law. However, the relief offered is at best partial and in some cases will amount to no relief at all. The reason for this is that under the proposed section 453 (c) the double inclusion in gross income would be continued, as under existing law, but with a credit against the second tax. This credit, however, it limited to the tax on the installment items paid in the earlier
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year of accrual. The difficulty with this credit is that the tax in the earlier year was only a tax on net income, whereas the second time the installment items are included, the gross amount is taken into income unreduced by deductible expenses. Accordingly, the tax credit will be much less than the penalty tax, and the relief provision is entirely inadequate.
There is no apparent reason for continuing to exact this penalty. Under section 481 of the proposed code, it is expressly provided that in the case of every other change in accounting method, the Secretary is to establish rules to prevent double inclusion of items in gross income and the allowance of double deductions. Thus, a change from the accrual basis to the cash basis of accounting would not be subject to any penalty tax; yet this change in method is very similar to a change to the installment method. Such other changes in accounting method as the adoption of the LIFO inventory method, the declining balance method of depreciation or any other accounting method which results in the deferment of income, would be free of penalty. The only apparent reason for continuing any part of the penalty is that in a continuing business the expenses of future sales may result in deferring the impact of the penalty, thus making it less apparent. Since, however, the full impact will ultimately be felt, this appears to be no ground upon which to single out this particular change of accounting method for imposition of a penalty. Moreover, since the penalty tax will tend to have its effect in a period in which sales and related expenses decline, the timing of the imposition of the penalty could hardly be worse.
In view of the foregoing, I most respectfully urge that most serious consideration be given to eliminating section 453 (c) and the related section 481 (d). This change would apply to taxpayers shifting to the installment method of accounting precisely the same treatment that is accorded to every other change in accounting method under section 481. Moreover, any taxpayer making such a change would not become entitled to any deferment of income that is not enjoyed by a taxpayer who has been on the installment method of accounting from the beginning. There is, therefore, no special privilege granted to a taxpayer who now makes the change.
It may be observed that this change would not cost the Government any revenue, since it is to be very much doubted that any taxpayer would over subject himself to the existing penalty tax. In fact, most taxpayers are : ble to get around the penalty provisions simply by selling their accounts receivable prior to making the change to the installment method. This has precisely the same effect as the change in the law here proposed. It is only in those cases in which a taxpayer is so heavily involved in installment sales that a sale of installment receivables could only be made at a sizable loss, that the penalty provision can have any effect. In such instances, of course, no change in accounting method is made and so the Government never collects the penalty tax anyhow. This simply results in continuing an unwarranted and discriminatory burden upon taxpayers who should be allowed the benefits of the installment method of reporting that are available to other taxpayers similarly situated.
I should appreciate very much your consideration of this matter. I shall, of course, be glad to submit any additional information that might be helpful or otherwise be of any assistance possible. Very truly yours,
ADRIAN W. DEWIND.
CHANGES FROM THE ACCRUAL TO THE INSTALLMENT METHOD OF REPORTING
INCOME—INADEQUACY OF RELIEF PROPOSED IN INTERNAL REVENUE CODE OF 1954
The Internal Revenue Code of 1954, as passed by the House of Representatives, contains a relief provision 1 for taxpayers who wish to change from the accrual method of accounting to the installment method.
Dealers often wish to change from the accrual to the installment method when their installment sales are increasing rapidly. Continued use of the accrual methods, which requires the payment of income tax upon profits from the increasing sales before the sales proceeds are received, tends to burden and restrict ihe growth of the business. Since this burden is not shared by competitors using the installment method of reporting income, the taxpayer using the accrual method can obtain equality of treatment only by changing to the installment method.
1 Sec. 453 (c).
However, existing law exacts a double or penalty tax for the privilege of making the change, which is frequently so severe that it prohibits the change entirely. Present law requires the taxpayer who changes from the accrual to the installment method to include, in computing taxable income, all installment payments subsequently received on account of sales made before the change, even though the income from those sales had previously been fully included in the taxpayer's income under the accrual method.
As an example, assume that a taxpayer using the accrual method has accrued and reported $1 million of gross profit from installment sales, payment for which has not yet been received from its customers. If the taxpayer changes to the installment method of reporting, it must again include the $1 million of gross profit in income as payments are received. If the taxpayer is a corporation, and a 52 percent tax rate is assumed, the taxpayer must pay a penalty tax of $520,000 for the privilege of changing accounting method. If the business is being conducted as a partnership or sole proprietorship, the penalty tax may be even higher.
The excess amount subject to tax under this penalty provision is not merely the net profit inhering in the installment accounts on the books at the time of the change. The effect of the penalty provision is to include the gross profit from these accounts in income twice even though the selling and administrative expenses attributable to those accounts are deducted only once. This means that the original tax plus the penalty tax can amount to several times the entire net profit from the installment sales involved. As tax rates have increased over the years, this has become more and more often the case. The penalty causes a permanent overstatement of the taxpayer's net income by an amount equal to the gross profit attributable to the accounts receivable at the time of the change. In the example given in the preceding paragraph, the taxpayer must, in one year or another, overstate its net income permanently by $1 million.
The penalty is particularly severe in those types of businesses which have a high gross profit ratio, and heavy selling and administrative expenses. Assume, for example, that a taxpayer whose income statement (expressed as a percentage of net sales) is as shown below, desires to change from the accrual to the installment method :
Percent Net sales -
100 Cost of goods sold--
15 Assume also that there are $1,250,000 of installment receivables at the time of the change. These receivables represent a gross profit of $1 million, but a net profit of only $187,500. The original tax, assuming the taxpayer to be a corporation and the rate of tax to be 52 percent, on the net profit of $187,500 would be $97,500. The penalty tax on the gross profit of $1 million would be $520,000. The combined taxes of $617,500 would be over 3 times the $187,500 net profit before taxes.
The Internal Revenue Code of 1954 as passed by the House purports to eliminate the penalty or double tax. Under the House bill the gross profit inhering in the receivables on the books at the time of the change from the accrual to the installment method will continue to be included in income twice first in the year of accrual and secondly in the year of collection. But the House bill provides that the tax imposed for the year of collection shall be adjusted downward by an amount which equals the lesser of the following:
(1) The proportionate part of the tax in the year of accrual which is attributable to the doubly taxed gross profit, and
(2) The proportionate part of the tax in the year of collection which is attributable to the doubly taxed gross profit.
By its very nature, the provision in the House bill will fail to eliminate the inequity at which it is aimed. As stated above, the nature of the penalty is a permanent overstatement of taxable income in an amount equal to the gross profit represented by the receivables on the books at the time of the change. But the House bill would alleviate this penalty only by the amount of tax on the net profit from those receivables. For instance, in the above example in which the original and penalty taxes on a net profit of $187,500 amount to $617,500, the relief provided by the House bill could not exceed the original tax of $97,500. The remaining tax of $520,000 would still be almost 3 times the net profit.
What is worse is that there will be many situations in which the House provision will provide still less adequate relief, or even no relief at all, from the penalty exacted by the present law.
The following example illustrates a case in which the House provision would provide no relief whatever. Assume that a taxpayer enters into business on January 1, 1953, and subsequently on January 1, 1957, sells or otherwise disposes of the business. During his period of operations the taxpayer earned a gross profit of $6 million and had expenses of $5 million thus netting $1 million before taxes. Assume also that the year-by-year distribution of the taxpayer's gross profit computed under the accrual basis, his gross profit computed under the installment basis, and his expense deductions were as follows:
NOTE.-The table is prepared on the assumption that the selling price is collected 42 in the year of sale and 42 in the succeeding year. Thc $800,000 profit uncollected as of Jan. 1, 1957, becomes taxable in the year in which the taxpayer disposes of the business. The expense deductions are, as is usual with a new business, proportionately heavier in the initial year than in later years.
The exhibit attached at the end of this memorandum shows a computation of the taxable income of this taxpayer on the assumption that he continuously reported income on the installment basis. It also shows three sets of computations based on the assumption that he reported income on the accrual basis for 1953 and 1954, and then switched to the installment basis. These last three computations show taxable income: (1) Under present law, (2) under the proposal in the House bill, and (3) under a proposal to be advanced below, which would eliminate the double inclusion of gross profit inhering in the receivables on the taxpayer's books at the time of the change in accounting method. The results of the attached computations are compared below:
In the above example, the House bill affords no relief. It will continue to exact a full tax upon $2 million, which is twice the amount of the taxpayer's true income. The relief provided by the bill fails in this case because the income-tax liability of the taxpayer for the year at the close of which the change from the accrual to the installment method was made was wiped out by the carry-forward from the taxpayer's initial loss year. This situation will not be infrequent where the taxpayer who seeks to change from the accrual to the installment method has not been in business long. The House bill will also give little or no relief where there is little or no income-tax liability for the year immediately following the change in accounting method. This may result from any of a number of unforeseen causes. For example, sales may unexpectedly decline or overhead unexpectedly increase. Or a corporation one of whose branches has had installment sales may sustain unexpected losses in another branch of its business. These and other situations in which the House bill affords little relief or no relief whatever are just as deserving as those in which the bill gives greater relief.
In every type of change in accounting method other than the change from the accrual to the installment method, the House bill? permits a complete adjustment in order to insure that every item of gross income or deduction is taken into account once and only once. Under this general provision governing all other types of accounting changes, items of income which were included in gross income prior to the change will not be again included thereafter. There is no good reason why the change from the accrual to the installment method should be excluded from the general provision and given inadequate, and in many cases no, relief.
2 Sec. 481.
It is realized that the change from the accrual to the installment method of accounting may permit some temporary deferment of income as compared to a continued use of the accrual method. However, insofar as there is any temporary deferment, this is inherent in the installment method ; the deferment arises merely from the use of the installment method and not from the fact that the taxpayer adopted the installment method after previously using the accrual method. By authorizing the use of the installment method, Congress has determined that this temporary deferment represents desirable tax policy, since it enables the taxpayer to pay the tax on his profits when those profits are received by him in the form of cash. Moreover, any initial deferment under the installment method will subsequently be offset by a continuation of heavy tax payments when the volume of installment sales declines or when the taxpayer sells or liquidates the business.
Temporary deferment of income is also permitted by the present law in some situations and is authorized by the House bill in still others. Examples of this are the use of the cash method of accounting; the first-out inventory method; the reserve method for bad debts; reserves permitted by the House bill; and the declining-balance depreciation method authorized by the House bill. No penalty is exacted from a taxpayer who switches to any of these methods. A temporary deferment of income clearly can never justify a severe penalty, since the Government will collect a full measure of tax. And the Government would collect a full tax where the installment method of accounting is used, even though the penalty exacted by present law for a change to that method from the accrual method, and only partially ameliorated by the House bill, is eliminated entirely. Indeed, this is the one case in which the Government is assured of an ultimate tax on all income, for there are special provisions designed to prevent taxpayers from escaping tax on installment obligations.
It is believed, therefore, that section 453 (c) and its companion provision, section 481 (d), should be stricken from the House bill, thus permitting changes from the accrual to the installment method of accounting to be treated under the more general and equitable provisions of section 481. Profits once included in income under the accrual method would then not be included a second time after the taxpayer switched to the installment method. All changes in accounting methods would then be treated fairly and consistently.
EXHIBIT.—Computation of taxable income
B. UNDER SWITCH FROM ACCRUAL TO INSTALLMENT METHOD AT END OF 1954,
Balance Loss carryover.
$800,000 $2,000,000 $1,800,000 $1,600,000 1,400,000 1,400.000 1,100,000 1,100,000 (600, 000) 600,000 700,000 500,000 0 600,000
Taxable income (loss).
0 700,000 500,000
8 Sec. 44 (d) of present law ;, sec. 453 (a) of the House bill.