Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 72-33

1972-1 C.B. 130

Sec. 453
Sec. 1372
Sec. 1376

IRS Headnote

Procedure to be used by a small business corporation and its shareholders in making the computations required when changing from the accrual method to the installment method of reporting income from installment sales.

Full Text

Rev. Rul. 72-33

Advice has been requested regarding the applicability, under the circumstances described below, of section 1.453-7(b) of the Income Tax Regulations that deals with adjustments to tax when a change from the accrual method to the installment method of reporting income on installment sales is made.

The taxpayer is a corporation engaged in the business of manufacturing and installing a product. It has had an effective election to be treated as a small business corporation under section 1372 of the Internal Revenue Code of 1954 since its incorporation in 1965. There has been no change in the ownership of stock since the Subchapter S election was made. Sales are made for cash and on the installment basis. For the years 1965 through 1968, the corporation used the accrual method of accounting to report income from installment sales. During the year 1969, the corporation elected to report the income from installment sales on the installment method of accounting. The installment period extends over a maximum of 10 years. Installment sales during the year in which the change in accounting method was made had a maturity of from 12 to 120 months and amounted to approximately 25 percent of all sales.

Section 453(c) of the Code provides that installment payments actually received during the year an election is made under section 453(a) of the Code, or any subsequent year, on account of sales made in any taxable year before the year of election shall not be excluded in computing taxable income for the year of receipt. However, it also provides for an adjustment to the tax due for the year of inclusion.

Since the corporation has effectively maintained an election to be treated as a Subchapter S corporation since its incorporation, the corporation's shareholders were taxed on the installment contract amounts that had been accrued as income in the years prior to the corporation's change from the accrual method of accounting to the installment method.

Pursuant to section 453(c)(1)(A) of the Code, installment payments received during the year in which an election is made to change from the accrual method of accounting to the installment method, or in subsequent years, on account of sales made in any taxable year before the year of change in accounting method shall not be excluded in computing taxable income for the year of receipt. Thus, since the corporation effectively maintained its election to be treated as a Subchapter S corporation during, and subsequent to, the year in which the corporation changed to the installment method of accounting, the shareholders of the corporation would also be taxed on those installment payments that are collected in the year in which the change in accounting method occurred, or in subsequent years, but which payments resulted from installment contracts that were executed in a taxable year prior to the year in which the installment method was elected.

Accordingly, since the shareholders of the corporation would be taxed twice on the profits attributable to the installment payments that are required to be included in the shareholders' income pursuant to section 453(c)(1)(A) of the Code, the shareholders are entitled to the adjustment provided for in section 453(c)(2) of the Code.

The election to adopt the installment method of reporting income must be made as provided in section 1.453-8 of the regulations except that instead of the schedule required by section 1.453-8(a)(3)(iv) of the regulations, a schedule should be submitted by the corporation showing the collections during the taxable year of change on the installment sales of each year for which collections were made. The schedule should show the allocation of the profits on the installment sales of each year to the shareholders in proportion to the number of shares owned. Each of the shareholders must compute the adjustment to the tax as required and illustrated in section 1.453-7(b) of the regulations and attach a schedule to his return showing the computation pursuant to section 1.453-7(b) of the regulations.

The gross income of the corporation should include the profits on the installments collected during the taxable year of change on installment sales of all years, whether made before or after the election of the installment method; the profits on all other sales made during the year; and all other income.

Section 1376(a) of the Code provides that the basis of a shareholder's stock in an electing small business corporation shall be increased by the amount required to be included in the gross income of such shareholder under section 1373(b) of the Code, but only to the extent to which such amount is included in his gross income in his return, increased or decreased by any adjustment of such amount in any redetermination of the shareholder's tax liability. Section 1.1376-1 of the regulations provides that this increase in basis affects only those shares in the Subchapter S corporation which the shareholder owned at the end of the corporation's taxable year and is apportioned in equal amounts to each such share.

Finally, some of the installment payments on installment sales made prior to the year the installment method was elected are collected in, and subsequent to, the year the installment method was elected. To the extent that the profits attributable to the installment payments collected in, and subsequent to, the year the installment method was elected are used in a redetermination of the shareholder's tax liability, such profits reduce the increase in basis otherwise provided for in section 1.1376-1 of the regulations.