$10,000 $200,000 Total to be included in 1958 return__. HOW TO ELECT. If you sell real estate or have a casual sale of personal property which meets the requirements above, you may elect, with respect to each such sale, to report your profit on the installment method. Such an election may be made regardless of the method of accounting regularly employed in reporting income. If an election to use such method is made, it must be made in a timely filed return for the tax year in which such sale was made, and may not be made at any other time. A dealer in personal property may adopt the installment method in accounting for income from personal property regularly sold on the installment plan without the prior approval of the Commissioner. However, in changing from the installment method to any other method of accounting, prior approval of the Commissioner is required. See Chapter 5. A dealer using the accrual method who changes to an installment method may not exclude any part of the installments collected in the year of the change or in later years from the computation of his profit, even though the entire profit on sales in years before the change had been reported on an accrual method. An adjustment, however, is provided to the extent that the gross profit for the same item sold is included in income twice. The adjustment is in the form of a reduction in tax for the year in which the profit is included the second time. The reduction is the amount of the tax attributable to the profit reported in the prior year but not in excess of the tax attributable to the profit in the year in which it is included the second time. Example for dealers in personal property: (c) Tax attributable to second inclusion of gross profit from year 2 is.. In year 2 Tax attributable to prior inclusion. $60, 000 $3,000 (d) Tax attributable to original inclusion is.. Adjustment in respect of year 2 item is the lesser of (c) or (d), or.. $3,000 The tax for year 3 would be reduced by $4,000 plus $3,000, a total of $7,000. The tax would then be $53,000 in year 3. A DEFERRED-PAYMENT SALE which does not meet the requirements set forth above for installment sales must be reported, and any gain there from taxed, in the year of sale. However, some sales of real estate or personal property are covered by obligations of the buyer which are payable to the seller over a term of years. The sales price under this method takes into account any cash plus the fair market value of the buyer's obligations and other property received as consideration by the seller. In other words, the obligations of the buyer received by the seller are the equivalent of cash to the extent of their fair market value. Negotiable notes, mortgages and land contracts which the seller receives are examples of obligations which are included at their fair market value in computing the amount realized from the sale of the property. Example. A parcel of real estate was sold for $50,000, payable $40,000 down and the balance over a period of 5 years at $2,000 a year, plus 4% interest. The balance payable was represented by the purchaser's note which had a fair market value of 75% of its face value. A commission of 5%, or $2,500, was paid to a broker for negotiating the sale. The real estate cost the seller $25,000 and was held by him for more than 6 months. Computation of profit: Selling price Less: Commission_-_ Selling price less commission_ Adjusted basis of property-- Profit to be realized_. Profit recognized in year of sale: Cash---- Market value of note (75% of $10,000). Total realized in year of sale_ $50,000 2,500 $47,500 25,000 $22, 500 $40,000 7,500 $47, 500 $2,500 25,000 27,500 Profit recognized in year of sale. $20,000 The $20,000 may be a capital gain. See Chapter 22. However, as collections are made on the note, the amount by which each collection exceeds its pro portionate valuation is included in the seller's return as ordinary income. In this example, 25% of each principal payment received on the $10,000 note would be reported as ordinary income in the year of collection. The interest on the note would also be ordinary income. Repossessions When a buyer defaults on his contract and a seller repossesses the property, either through a voluntary surrender by the buyer or through foreclosure, the result to the seller may be a gain, a bad debt, or other loss. BAD DEBT UPON SALE OF REPOSSESSED PROP ERTY. Where mortgaged or pledged property is lawfully sold for less than the amount of the debt, whether to the creditor or another purchaser, and the portion of indebtedness remaining unsatisfied after such sale is wholly or partially uncollectible, the creditor may deduct the uncollectible amount as a bad debt for the tax year in which it becomes wholly worthless or is charged off as partially worthless. In such a case, the bad debt deduction is further limited to the amount of the indebtedness which constitutes capital or represents an item the income of which has been reported by the creditor. But, in the case of foreclosure, the creditor is not entitled to any deduction for a bad debt unless it is clearly shown that the debtor remained liable for the unpaid portion of the debt after the property was sold. GAIN OR LOSS, in addition to a bad debt, is realized if there is a difference between the amount of the obligations of the debtor applied to the purchase or bid price of the property and the fair market value of the property, if the creditor buys in the property, provided the obligations surrendered constitute capital or represent items the income of which has been reported by the creditor. However, fair market value of the property in such a case is presumed to be the amount for which it is bid in by the creditor in the absence of clear and convincing proof to the contrary. If the creditor subsequently sells the property so acquired, the basis for determining gain or loss is the fair market value of the property at the date of acquisition. INSTALLMENT SALE-REPOSSESSION. Gain or loss to seller upon repossession of personal property sold on the installment plan where the purchaser defaults in his payments, is determined by the same method 'whether title to the property is retained by the seller or transferred to the purchaser and regardless of whether the sale was a casual sale or by a dealer. The seller's gain or loss in such a case is the difference between the fair market value of the property repossessed and the basis in the hands of the seller of the obligations of the purchaser which are satisfied or discharged upon the repossession, or are applied by the seller to the purchase or bid price of the property, with proper adjustment for any other amounts realized or costs incurred in connection with the repossession. The basis in the hands of the seller of the obligations of the purchaser so satisfied, discharged, or applied upon the reacquisition of the property is the excess of the face value of such obligations over an amount equal to the income which would be reported if the obligations were paid in full. The fair market value is a question of fact to be established in each case. But, if the property repossessed is bid in by the seller at a lawful public auction or judicial sale, the fair market value of the property is presumed to be the purchase or bid price in the absence of clear and convincing proof to the contrary; and the property repossessed should be carried on the books of the seller at its fair market value. Character of Gain or Loss. If the property is repossessed in connection with a sale reported on the installment method, the repossession gain or loss is of the same character as the gain or loss on the original sale. Thus, if the sale initially resulted in a capital gain or loss, the repossession gain or loss will also be a capital gain or loss. See chapter 22. If, however, the property was sold by a dealer in the ordinary course of his trade or business, the repossession gain or loss must be treated as ordinary income or loss. The piano should be included in inventory at $150. Gain or loss to seller upon repossession of real property sold on the installment plan is figured by the same method as that used in the case of personal property sold on the installment plan, regardless of whether title passed at the time of the sale. DEFERRED-PAYMENT SALES-REPOSSESSION. Gain or loss upon repossession of real property sold on the deferred-payment plan is figured by one of two methods, dependent upon whether the seller retained title to the property or transferred title to the purchaser. Where the seller retained title and the purchaser defaults in any of his payments and the seller repossesses the property, gain or loss to the seller for the year in which the property is repossessed is measured by the difference between: 1. The entire amount of the payments received on the contract and retained by the seller, plus the fair market value at the time of repossession of fixed improvements placed on the property by the purchaser, and 2. The sum of the profits previously returned as income in connection therewith and an amount representing what would have been a proper adjustment for exhaustion, wear and tear, obsolescence, amortization, and depletion of the property during the period the property was in the hands of the purchaser had the sale not been made. The basis of property reacquired, where the seller retained title, is the original basis at the time of the sale, plus the value at the time of repossession of any fixed improvements placed on it by the purchaser. If repossession occurs after September 18, 1958, the basis of the property must, in addition, be reduced by an amount equal to the depreciation the seller would have been entitled to during the period the property was held by the purchaser, had the sale not been made. Where the seller did not retain title and the purchaser defaults in any of his payments and the seller repossesses the property, the method of determining gain or loss to the seller depends upon whether the reconveyance is voluntary or involuntary. If the seller accepts a voluntary reconveyance of the property in partial or full satisfaction of the unpaid portion of the purchase price, the receipt of the property so reacquired, to the extent of its fair market value at that time, including the fair market. value of fixed improvements placed on the property by the purchaser, is considered as the receipt of payment on the obligations satisfied. Thus, if the fair market value of the property reacquired is greater than the basis of the obligations of the purchaser so satisfied, the excess constitutes ordinary income. But if the value of the property reacquired is less than the basis of such obligations, the difference may be deducted as a bad debt if wholly uncollectible or charged off as partially uncollectible, except that if the obligations satisfied are securities which are capital assets, any gain or loss resulting from the transaction is a capital gain or loss. If the reconveyance is involuntary, gain or loss results measured by the difference between: 1. The amount of the obligations of the purchaser which are applied to the purchase or bid price of the property (to the extent that such obligations constitute capital or represent an item the income of which has been reported by him), and 2. The fair market value of the property (which, however, is presumed to be the amount for which it is bid in by the taxpayer in the absence of clear and convincing proof to the contrary). Any portion of the obligation not applied to the purchase or bid price may be deducted as a bad debt as provided above. The basis of the property reacquired, where the seller transferred title, is the fair market, value of the property at the time of reacquisition. TIME OF SELLER'S GAIN OR LOSS. Where under State law a mortgage foreclosure sale of real property is subject to redemption of the property within a certain period, the expiration of the redemption period fixes the time in which a foreclosure loss is sustained or a gain is realized. Thus the creditor's gain or loss from the foreclosure sale of property is reportable or deductible in the tax year in which the debtor's right of redemption under State law expires and the foreclosure sale becomes absolute and indefeasible. LOSS OF PURCHASER-DEBTOR. When the purchaser's equity in property acquired for investment or the production of income is relinquished either through the voluntary surrender of the property as consideration to the seller in exchange for a release of the purchaser's obligations, or through foreclosure, the purchaser sustains a deductible loss for income tax purposes. If the property involved is a capital asset, the loss is a capital loss. If the property was used in the taxpayer's trade or business, the loss might also be subject to treatment as a capital loss. See Chapter 22. Time of Purchaser's Loss. A loss sustained from the involuntary relinquishment of property is deductible when the statutory period of redemption under the State law expires. For example, where under State law the debtor, or the owner of the mortgaged property, has 18 months in which to redeem the foreclosed property, he does not, by virtue of such sale, sustain a loss for income tax purposes until the 18-month redemption period expires, without redemption by him. Disposition of Installment GAIN OR LOSS will result when installment obligations are satisfied at other than face value or disposed of by the vendor. Such gains or losses are considered as resulting from the sale or exchange of the property in respect of which the installment obligations were received. If the obligations are satisfied at other than face value or are sold or exchanged, the gain or loss is measured by the difference between the basis of the obligations and the amount realized. If the obligations are distributed, transmitted, or disposed of other than by sale or exchange, the gain or loss is measured by the difference between the basis of the obligations and their fair market value at the time of such distribution, transmission, or disposition. THE BASIS OF AN INSTALLMENT OBLIGATION in any such transaction is the excess of the face value of the obligation over the income which would be reportable were the obligation paid in full. Example. Unimproved real estate is sold for $20,000. The seller acquired the property in a prior tax year at a cost of $10,000. In the year of the sale the seller received $5,000 in cash and the purchaser's notes for the remainder of the selling price, or $15,000, payable in subsequent years. In a subsequent tax year, before the purchaser made any further payments, the seller sold the notes for $13,000 cash: Selling price of property (also contract price) Cost of property--. $20,000 10,000 A 7. Long-Term Contracts CONTRACTOR who has a building, installa tion or construction contract covering a period of more than 1 year from the date of execution of the contract to the date the contract is completed and accepted, may report gross income from the contract by either the percentage of completion method or the completed-contract method. These methods are in addition to the methods discussed in Chapter 5. Contracts involving the mere sale of completed property do not qualify as long-term contracts. THE PERCENTAGE OF COMPLETION METHOD provides that you report as gross income only that part of the contract price which represents the percentage of the entire contract which was completed during your current tax year. Deduct all expenditures made during your tax year in connection with the contract. However, expenditures for materials and supplies on hand at the beginning and end of your tax year, which you hold for use in the work under the contract, cannot be considered as part of cost until they are used. A certificate of the architect or engineer, showing the percentage of completion during your tax year of the entire work to be performed under the contract, must accompany your income tax return. Example. Mr. Ham Err has a contract for the construction of a building. The contract was executed June 27, 1958, and provides for payment of $180,000 for a building which is to be completed by November 16, 1959. Construction began July 1, 1958, by Mr. Err, who uses the calendar year as his tax year. On December 31, 1958, the architect certified that 25% of the work was completed. Mr. Err will report gross income from the contract of ANY 8. $45,000 for 1958. He will also deduct all his expenditures made during 1958 in connection with the contract, taking account of his materials and supplies on hand. THE COMPLETED-CONTRACT METHOD provides that you report gross income from a long-term contract and deduct all expenses properly allocable to it in the year the contract is finally completed and accepted. You may not deduct, however, the cost of any materials and supplies charged to the work under the contract but remaining on hand at the time of completion. Depreciation and other overhead costs must be allocated to specific jobs. Example. A contractor using the completed-contract method started constructing a building in 1956 and finally completed the contract, which was accepted, in 1958. His expenses, allocated to the job. were $50,000 during 1956, $90,000 during 1957, and $30,000 during 1958. He received $80,000 during 1956, $100,000 during 1957, and $35,000 during 195 as payments from the contract. His income tax returns for 1956 and 1957 will show no income or expenses attributable to this particular contract. His income tax return for the year 1958 will disclose the total income and expenses of this job, and will reflect his profit of $45,000 from this contract. OTHER EXPENSES, such as office salaries, rent, taxes. etc., not directly attributable to a long-term contract, are deductible only in the year paid or incurred, depending on the method of accounting you otherwise use. See Chapter 5. These expenses may not, under any circumstances, be made part of the computations under the percentage of completion or the completedcontract method. CHANGE OF METHOD. You may elect to change your method of accounting to accord with either of the above methods of reporting income from longterm contracts only with the permission of the Internal Revenue Service, as explained in Chapter 5. If you elect to use either the percentage of completion method or the completed-contract method, you will be bound by such election and may not later change to another method without permission.. You will also be required to employ the method elected in connection with any other long-term contracts you may secure, unless permission is obtained from the Service to change to another recognized method. What Is Income? NY income which you receive, regardless of its source and whether in cash, property or services, must be reported on your income tax return, unless specifically excluded by law. In addition to the gross income from your business, your income tax return must reflect gross income from all other sources, including, but not limited to, compensation received for services; interest; rents; dividends; royalties; gains derived from dealings in property; distributive share of partnership income: and income from an estate or trust. This chapter is concerned primarily with business income. BUSINESS INCOME arises from your business activity whenever there is a sale of your product or services in the ordinary course of business. Interest is business income to a lending company; fees are business income to a professional man; rents are business income to a person in the real estate business; and dividends are generally business income to a dealer in securities. However, for corporations, all income received, regardless of source, is business income. Income other than cash received by you, such as property or services, is included in your income tax return to the extent of its fair market value on the date received. Example. If you received warrants from a State for work performed under a contract, you would include in your income their fair market value on the date they were received. Upon conversion of the warrants into cash, you are entitled to a loss deduction in the year of conversion if the amount realized is less than that previously included in income. However, if you realize more, the excess should be included in income in the year the warrants are converted. WHEN INCLUDED. Income from your business must be computed in accordance with the method of accounting which you regularly employ, provided such method clearly reflects your income. The cash and accrual methods are the most common. If you use the cash method you include only cash or property in income in the year actually or constructively received. If you use the accrual method, you include amounts earned whether or not received. See Chapter 5. SALE OF STOCK IN TRADE. Where the sale of a product is the income-producing factor in your business, the use of inventories and the accrual method of accounting are usually required in order to clearly reflect income. Exceptions to this general rule are farmers and dealers in securities where the use of inventories is optional, and dealers in real estate where their use is prohibited. SALES RETURNS AND ALLOWANCES. Credits which you allow to customers for returned merchandise and any other allowances which you make on sales should be treated as deductions from gross sales in arriving at net sales. CONTAINER DEPOSITS. If your customers fail to return durable containers or if, for other reasons you are not required to refund the deposits, ordinary gain or loss is realized. Though depreciation is allowed on durable containers, they are treated as sold when not returned and their disposition is considered an integral part of your regular business. CONSTRUCTIVELY RECEIVED INCOME consists of income which becomes subject to your control during the year, even though you do not have physical possession of it. It must be reported in the year it is constructively received. See Chapter 5. Receipt of Check. A valid check received before the close of the tax year constitutes constructive receipt of income in such year, even though you do not cash or deposit the check until the following year. Agents and Partnerships. Income received by your agent is constructively received by you in the year it is received by your agent. If you are a member of a partnership, you are required to include your 484986-58- 4 For example, the amounts you receive for tickets sold during December 1958 are included in your income for 1958, even though the performance for which the tickets are sold will not be held until January 1959. If you must repay any part, or all, of such income in a later year, see Chapter 5. Subscriptions. If a publisher does not use the cash method of accounting, he may elect, for years beginning after 1957, to include subscription income in taxable income on a pro rata basis in the years he is liable to furnish or deliver the publication. PAYMENT PLACED IN ESCROW. If part or all of the purchase price is placed in escrow by the purchaser, you should not include in gross sales any portion thereof until actually or constructively received, whether you use the cash or accrual method. However, upon performance of the terms of the contract and the escrow agreement, you will realize taxable income, even though you may not accept the money until the following year. PROPERTY PLACED IN ESCROW. If when you sell property it is placed in escrow to secure notes accepted in payment, then the proceeds of the sale (cash and fair market value of notes received) are included in your income on the date received by you. INSTALLMENT SALES. Under the installment method, gross profit from sales is reported, proportionately, as the installment payments are collected. See Chapter 6. FEES FOR PERSONAL SERVICES. Gross income from this type of business is generally the same as the gross receipts, that is, the total amount received. BOND PREMIUM received by a corporation upon issuance of its bonds is included in gross income. However, the entire amount of bond premium is not included in gross income in the year the bonds are issued but is included ratably over their life. 23 |