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INSTALLMENT SALES

(Section 212(d) and 1208)

Investigation of the installment sales provisions of the Revenue Act has been made on account of certain criticisms of these sections by taxpayers rather than on account of any apparent difficulties in the way of the effective administration of the present statute.

SYNOPSIS

1. There has been a widespread increase in installment sales during the past few years until such sales are now estimated at the amount of $6,000,000,000 per annum.

In connection with such installment sales, it came to be realized that the ordinary merchant's system of accounting failed to properly reflect the true net income, due to the fact that the sales price is not even approximately the equivalent of cash for the year of sale and that certain expenses in connection with these transactions are postponed to a year subsequent to the year of sale. To fill this apparent need in accounting systems, the installment method of reporting income was evolved and has now become recognized throughout the country as a proper method of reflecting the true net income from this type of transaction.

2. An investigation of individual cases shows that while there have been some technical disputes, on the whole the present provisions have caused no serious administrative difficulty.

3. The principal criticisms which have been directed at the provisions appear to be based on considerations of equity, and may be classified and briefly discussed.

(a) Double taxation. The double-taxation feature, while not strictly equitable is justifiable. In the first place, the installment basis has always been optional with the taxpayer. In the second place, the change appears generally to have been beneficial to the taxpayers in spite of the double-taxation feature. Finally, the difference in rates applicable to the taxable years in the past gave the taxpayer an unreasonable advantage when by changing his basis in a high tax year he was enabled to reduce his taxable income to a figure far below his true income computed on any consistent basis. This was the effect of the regulations with double taxation eliminated.

(6) Inequity in closed cases.—While, as stated, considerable advantage generally accrued to the taxpayer in changing from the accrual to the installment basis, even with the double-taxation feature included in the regulations, those to whom the regulations without this feature were applied derived an additional benefit which was often of great magnitude. They were not equitably entitled to this additional benefit, and there is no reason why a similar benefit should be extended to those who in the past were denied it. On the other hand, it is undesirable now to open up cases in which the benefit was granted in accordance with regulations in force at the time. To open up a large number of closed cases is no more required in this instance than it would be in hundreds of cases closed on bases at variance with later Board of Tax Appeals and court decisions. Retroactive legislation and reopening of cases must be avoided if the

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bureau is to accomplish the much-to-be-desired object of disposing finally of old cases.

(c) Twenty-five per cent limitation on real-property sales.—There are essential differences in the business and accounting methods of the personal-property dealer and of the real-property dealer which make the 25 per cent limitation reasonably appropriate in the one case though not in the other. There are, however, certain types of real-estate sales in which it is unreasonable to tax as income the whole difference between cost and selling price, even though 25 per cent of the latter has been collected. These cases can best be dealt with by a reasonable extension of the principle of applying proceeds against cost until the latter is recouped, leaving the whole of further receipts to be taxed as income.

(d) Arbitrary definition of " initial payments.—From the standpoint of logical classification of sales it is obvious that a definition based on terms of the contract would be more correct than the existing rule based on the payments within the taxable year. It seems necessary, however, if evasion is to be prevented, to treat payments made within a limited period of the sale as initial payments, and there is probably little to be gained by rescinding the existing rule and substituting another which must still be arbitrary.

RECOMMENDATIONS

In view of the above and of the discussion which follows the following recommendations are made:

(1) No retroactive legislation should be attempted in regard to installment sales except to validate settlements made under regulations in force at the time of settlement.

(2) The 25 per cent limitation on the purchase price should be retained in case of casual sales and sales made by dealers in real property.

(3) Specific authority should be granted to the commissioner to determine the taxable income on the basis of applying receipts against the basis of property sold until that basis has been recovered, and tax all further receipts as income in any case in which he finds that obligations received on the sale have no fair market value determinable with reasonable certainty by the application of standards customarily accepted in business practice.

DISCUSSION OF RECOMMENDATIONS

Selling on the installment plan, though only of recent prominence and present wide usage, is, nevertheless, long established as a manner of doing business. Building and loan associations have had a recorded and prosperous existence of at least 75 years. This type of association deals largely in extending credit facilities to purchasers of real property on the installment plan. Items of personal property have been offered for sale on the installment plan at a time even antedating real property sales on the same basis. Indeed the origin of the system of installment buying along modern lines may be traced to personal-property sales. For instance, pianos, encyclopedias, and other commodities having durability and life for

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a sustained period of at least several years have been sold on the installment plan for practically an entire century.

Until recent years installment selling constituted but a small fraction of the business of the country. When, in the period between 1910 and 1915, the automobile industry evolved a plan of selling automobiles on the installment basis a new era began. Growth was phenomenal. It was found an expedient method of selling after the World War, in so far as it stimulated business at a time when plant facilities for the making of automobiles were in excess of the existing demand for them.

The character of goods bought on the installment plan, in the order of volume of sales of each as taken from the best obtainable sources for the years 1925 and 1926, is as follows: 1. Automobiles.

8. Jewelry. 2. Household furniture.

9. Clothing. 3. Pianos.

10. Tractors. 4. Sewing machines.

11. Gas stoves. 5. Phonographs.

12. Electric refrigerators. 6. Washing machines.

13. Vacuum cleaners. 7. Radio sets.

14. Farm equipment. To-day it is estimated that approximately $6,000,000,000 of goods are sold at retail annually on the installment plan. This amount constitutes about 15 per cent of all goods bought at retail. As a result of separate investigation by the economic policy commission of the American Bankers' Association, the National Association of Credit Men, and the National Association of Finance Companies, it has been quite reliably established that at the present time the amount of the installments outstanding at any date is probably $2,750,000,000. Of this figure, $1,500,000,000 constitutes the outstanding indebtedness on automobile sales. A clearer visualization of the extent of installment buying in certain industries may be obtained from the fact that 75 per cent of all automobiles (considered with respect to value) are sold on the installment plan, 85 per cent of all furniture, 80 per cent of all phonographs, 75 per cent of washing machines, 65 per cent of vacuum cleaners, and at least 25 per cent of all jewelry, pianos, clothing, radios, and electric refrigerators.

Enough has been said to indicate the importance of the installment method of doing business; it is also quite clear that in the ordinary case of an installment sale the obligation of the purchaser is not the equivalent of cash. It follows that on such a sale there is not a gain realized equal to the difference between the cost of the goods sold and the nominal sale price. A method of accounting which would avoid the error of treating the difference between the cost of the goods sold and the nominal sale price as income at the time of sale was, therefore, imperatively called for by section 212 of the act of 1918, which provided that returns should be made on such a basis as would clearly reflect income. The view sometimes expressed that Congress in the 1918 act recognized two and only two methods of accounting finds no support in the language of the act. On the contrary, the intent of Congress was clearly to give the commissioner proper latitude to accept standard methods of accounting which resulted in a fair reflection of the income of the taxpayer. This intention has been recognized in all regulations since issued (art. 28

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of Regs. 45, 62, and 69), but has frequently been ignored or overridden in practice and in some decisions of the Board of Tax Appeals.

Recognition of the propriety of a special method of accounting for the installment sale business had been given by the commissioner prior to the passage of the 1918 act, in a Treasury decision and in Regulations 33, revised, promulgated January 2, 1918. Article 42 of Regulations 45, issued April 17, 1919, laid down the rules to be followed under the 1918 act, and, except as regards the accounting in the the period of transition to the prescribed method, that regulation has remained substantially unaltered.

The validity of the main features of that regulation does not seem open to serious question. The Board of Tax Appeals, however, in the case of B. B. Todd, Inc. (1 B. T. A. 762), used language that suggested that the board held the contrary view, and section 212 (d) of the act of 1926, and section 1208, applying the rule retroactively, were inserted in the law to eliminate any uncertainty. The chairman of the Senate Finance Committee, speaking for the committee in the Senate, said:

While the committee believes that the 1919 installment regulations were a proper interpretation of the existing law in determining net income, because of the confusion now existing, it is deemed advisable to make the amendment precise in the interest of certainty.

The Todd case, above referred to, arose under the 1921 edition of Regulations 45, which differed materially from the regulations of 1919 in respect to the accounting in the period immediately following the transition. The regulations issued in 1919 presented a method of determining income that was consistent in its treatment of transactions in course of completion at the beginning and at the end of the year, but was open to the objection that it resulted in the taxation of income which had already been taxed. The 1921 regulations, under which the Todd case arose and which were criticized by the board in that case, involved no double taxation, but admittedly did not result in a consistent treatment of items overlapping from one year into another, or in a correct reflection of income in the period immediately following the adoption of the new method.

Taxpayers concerned have strenuously insisted that the 1921 regulations should be adhered to, and that consistency in the computation of income should be sacrificed, if necessary, in order to avoid double taxation.

In considering this question from the broad standpoint of equity it is important to note that the right to adopt the installment method has always been optional, and existed in 1917, the first year of high war taxes. It is also pertinent that changes to that basis were freely made while double taxation was a feature of the regulations governing the accounting in the transition period. It appears also that the exclusion from taxation in the year of transition of both gross income reported on the old basis in the prior years and gross income which would have been reported on the old basis in the current year left the remaining gross income in many cases so small that the. transition year showed a loss and the taxpayer thus entirely escaped taxation for that year, which was usually a year of high war taxation. No consideration of equity seems to require or even to justify such an extremely favorable treatment.

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The question was presented to Congress when the revenue bill of 1926 was before it, and though neither section 212 (d) nor section 1208 dealt specifically with the question whether the regulations of 1919 or those of 1921 were to be applied, the report of the conference committee to the Senate contains the explicit statement that,

In the application of this provision it is intended that the installment provisions of Regulations 45, promulgated on December 25, 1919, will be substantially followed in settling all cases under prior acts and under this bill.

The House conference report is to the same effect. We see no reason for a change in this position. It may be said that with taxes reduced and more nearly uniform the objection to giving relief from double taxation is lessened. Equally, however, the need for any option or change of method is lessened. There is little reason why corporations should to-day be contemplating a change to the installment basis unless their installment business is new or for the first time assuming real importance, and in such cases the double taxation will not be serious and there will still probably be a tax advantage in the change in spite of it. Corporations which have been in the installment business for a number of years should have made their election before now and certainly should not be offered a substantial inducement to adopt a method they have hitherto declined to adopt. We see no reason, therefore, to change the existing rules covering the period of transition either for the past or for the future.

There are a number of cases in the bureau which had been closed on the basis of the regulations as revised in 1920 by the elimination of the double-taxation feature, and the bureau appears to feel that it is its duty under the act of 1926 to reopen these cases and redetermine the tax. It is very clear that such reopening is inexpedient and unnecessary and it is suggested that in the next revenue act proper provision should be made that where returns were filed and accepted under regulations in force and the cases have been closed the cases should remain closed and no attempt should be made to collect additional sums from the taxpayers in respect of the years covered by such returns. The war taxes were bound to operate with some inequitable results, and it is impossible now to remedy all such inequities. The need now is to dispose finally of cases for those years, and the bureau should not, in general, be required, nor should it undertake except in case of fraud, to reopen cases once disposed of in accordance with existing regulations.

Section 212(d) of the Revenue Act of 1926 sets up a distinction between dealers in real property and dealers in personal property, in so far as granting them the installment basis is concerned, to the effect that while the installment basis is allowed dealers in personal property without consideration of the extent of initial payment, it is allowed dealers in real property only if the initial payment does not exceed 25 per cent.

Considerable criticism has been leveled against this restriction as affecting real property dealers on the grounds of (1) inequality, in that the basis should not be different for dealers in real property and dealers in personal property, and (2) hardship, in that the denial of the installment basis, because of the 25 per cent limitation, produces a situation where cash is not available with which to pay taxes on the completed sales.

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