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necessary to recompute, for minimum tax purposes, the amounts that are suspended and carried forward.

For example, assume that a taxpayer has property with respect to which he is at risk in the amount of $100. For regular tax purposes, deductions relating to the property equal $110 in year 1 and $80 in year 2. For minimum tax purposes, such deductions equal $90 in year 1 and $90 in year 2. For regular tax purposes, section 465 permits the taxpayer to deduct $100 in year 1 and zero in year 2, and the taxpayer has $90 of suspended deductions as of the end of year 2. For minimum tax purposes, the taxpayer is allowed to deduct $90 in year 1 and $10 in year 2, and has $80 of suspended deductions as of the end of year 2.

The Act provides that in the case of an estate or trust, the alternative minimum taxable income of the estate or trust and its beneficiaries shall be determined under the rules generally applicable to trusts and estates by taking into account the adjustments provided in the minimum tax.

The Act provides rules for allocating items that are treated differently for regular and minimum tax purposes, respectively, are also provided with respect to common trust funds, regulated investment companies, and real estate investment trusts.33 Moreover, rules are provided relating to certain technical issues such as short taxable years and the application of exemption amounts with respect to companies filing consolidated returns.

The Act provides that except as specifically provided in the case of certain preferences such as mining exploration and development costs, for purposes of the corporate minimum tax, the amount of a preference is measured after the application of section 291 (relating of the cutback of certain corporate preferences). Thus, for example, to the extent that a taxpayer's bad debt reserve or percentage depletion for coal or iron ore is reduced for regular tax purposes pursuant to section 291, the amount of such reduction is not "doublecounted" by being treated as a minimum tax preference.

Under the Act, the application of the tax benefit rule to the minimum tax is within the discretion of the Secretary of the Treasury. Relief from either the regular or the minimum tax, when the source of the taxpayer's tax liability changes, between taxable years, from one system to the other, is not appropriate solely by reason of the fact that a taxpayer has received no benefit under one of the systems with respect to a particular item. Congress both intended that the regular and minimum taxes constitute separate and parallel tax systems, and anticipated that the source of some taxpayers' liability would change from year to year. Relief from the possible adverse impact of switching from one system to the other (e.g., the denial of deductions with respect to which there are timing differences as between the two systems) was intended to be

33 For example, if a RIC or REIT distributes all its pre-dividend taxable income in each taxable year, it is intended that the minimum tax adjustments and preferences be apportioned to the shareholders and beneficiaries since the adjustments and preferences either reduced or increased the entity's taxable income and therefore the amount of the dividend. Where any shareholder or beneficiary incurs a minimum tax attributable to deferral items, that shareholder or beneficiary may use the minimum tax credit in future years to offset regular tax under usual rules. Where the RIC or REIT distributes more or less than its taxable income in a taxable year, the Treasury Department is to prescribe regulations providing rules for apportioning the preferences and adjustments.

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provided by means of the minimum tax credit, along with the use of adjustments that give rise, in effect, to "negative preferences" with respect to items such as depreciation. Thus, application of the tax benefit rule in this context is not necessary, although the Treasury may, at its discretion, identify particular circumstances where such exercise is appropriate.

Effective Date

These provisions apply to taxable years beginning after December 31, 1986.

Revenue Effect

With respect to individuals, the provision is estimated to increase fiscal year budget receipts by $848 million in 1987, $3,904 million in 1988, $2,251 million in 1989, $862 million in 1990, and $334 million in 1991.

With respect to corporations, the provision is estimated to increase fiscal year budget receipts by $3,087 million in 1987, $5,378 million in 1988, $5,072 million in 1989, $4,466 million in 1990, and $4,155 million in 1991.

TITLE VIII-ACCOUNTING PROVISIONS

A. Limitations on the Use of the Cash Method of Accounting (Sec. 801 of the Act and sec. 448 of the Code) 1

Prior Law

Taxpayers using the cash recipts and disbursement method of accounting (the "cash method") under prior and present law generally recognize items of income when actually or constructively received and items of expense when paid. Tax shelters using the cash method of accounting generally may not recognize items of expense prior to economic performance. Taxpayers using an accrual method of accounting generally accrue items as income when all the events have occurred that establish the right to receive the income and the amount of income can be determined with reasonable accuracy. Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to the time of economic perform

ance.

Under prior law, taxpayers could generally elect to use any method of accounting, such as the cash method, an accrual method, or combinations of methods so long as the method clearly reflected income and was regularly used in keeping the taxpayer's books. However, under prior and present law, taxpayers for whom the production, purchase, or sale of merchandise is a material income producing factor are required to keep inventories and to use an accrual method of accounting with respect to inventory items (sec. 471). Also, prior and present law requires certain corporations engaged in agricultural activities with gross receipts exceeding $1 million to use an accrual method of accounting (sec. 447).

In general

Reasons for Change

The Congress believed that the cash method of accounting frequently fails to reflect accurately the economic results of a taxpayer's trade or business over a taxable year. The cash method of accounting recognizes items of income and expense based on the taxable year in which funds are received or disbursed. This may result in the recognition of income and expense items without regard to the taxable year in which the economic events giving rise to the items occurred and a potential mismatching of income with related expenses. For these reasons, the cash method generally is not in accord with generally accepted accounting principles. The cash

1 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 902; H. Rep. 99-26, pp. 604-609; H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 321; S. Rep. 99-313, pp. 118-119; and H. Rep. 99-841, Vol. II, (September 18, 1986), pp. 285-289 (Conference Report).

method also produces a mismatching of income and deductions when all parties to a transaction use different methods of accounting.

Exceptions

On the other hand, the Congress also recognized that the cash method generally is a simpler method of accounting and that simplicity justifies its continued use by certain types of taxpayers and for certain types of activities. The Congress believed that small businesses should be allowed to continue to use the cash method of accounting in order to avoid the higher costs of compliance which will result if they are forced to change from the cash method. Similarly, the Congress believed that farming businesses (other than farming tax shelters and certain corporate farming businesses required to use an accrual method under present law) should be able to continue to use the cash method in order to avoid the complexities required to account for growing crops and livestock under other acceptable methods of accounting.

Finally, the Congress believed that individuals, whatever the size of their activities, should be able to continue to use the cash method. Individuals, especially individuals engaged in professional activities, traditionally have used the cash method of accounting in the operation of their trades or businesses. Similarly, the Congress believed that personal service corporations and entities where the income is taxed at the individual level (such as partnerships and S corporations) traditionally have used the cash method of accounting in the operation of their trades or businesses and, accordingly, should be eligible for the continued use of the cash method of accounting.

Tax shelters

The Congress believed that tax shelters should not be allowed to use the cash method of accounting, regardless of the form in which business is conducted and regardless of whether or not the tax shelter satisfies one or more of the exceptions that would otherwise allow use of the cash method. In choosing to conduct business as a tax shelter, the entity has indicated a sufficient sophistication in the use of the tax laws to justify requiring the use of a more difficult method than the cash method. In addition, the use of the cash method itself may assist the tax shelter in obtaining unwarranted benefits under the tax laws.

Nonaccrual of certain items unlikely to be collected

The Congress was concerned that certain taxpayers could be required to accrue income from services with respect to amounts they are unlikely to collect. Where a taxpayer includes accounts receivable, which do not bear interest or a late charge in its income, accrual in income of the full sales price immediately, combined with a bad debt deduction allowed at a later time, will overstate the taxpayer's income because the present value of the bad debt deduction will be less than the present value of the accrued income. Accordingly, the Act provides that taxpayers on an accrual method will not be required to accrue income attributable to that portion of their accounts receivable derived from the performance of services

which are unlikely to be collected. This exception does not apply where the accounts receivable bear interest or a late charge because the face amount of the obligation bearing interest or late payment charges is the present value of the accrued income and, consequently, the present value of the accrued income will not exceed the present value of the later bad debt deduction.

In general

Explanation of Provision

The Act generally provides that the cash method of accounting may not be used by any C corporation, by any partnership that has a C corporation as a partner, or by a tax-exempt trust with unrelated business income. Exceptions are made for farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5 million or less for all prior taxable years (including the prior taxable years of any predecessor of the entity). The Act also provides that the cash method of accounting may not be used by any tax shelter.

In determining whether a partnership has a C corporation as a partner, a C corporation that is a qualified personal service corporation (discussed below) is treated as an individual. Thus, partnerships qualifying to retain the use of the cash method are those partnerships in which all of the partnership interests are held by individuals, qualified personal service corporations, S corporations, or other partnerships qualifying to retain the cash method.

The Congress denied the use of the cash method of accounting to a partnership that has a C corporation as a partner in order to prevent entities that themselves could not use the cash method from obtaining the advantages of the cash method through investments in partnerships. Accordingly, if a C corporation which is not a qualified personal service corporation is the beneficial owner of a partnership interest, the partnership may not use the cash method of accounting, unless it meets one or more of the exceptions provided. For example, if two C corporations are partners in a partnership that is in turn a partner in another partnership, neither of the partnerships are intended to be allowed to use the cash method of accounting.2

The use of a hybrid method of accounting which records some, but not all, transactions using the cash method is considered the same as the use of the cash method for these purposes. Any change from the cash method necessitated by the provision is treated as a change in accounting method, initiated by the taxpayer with the approval of the Secretary of the Treasury. The provision does not change the rules of present law relating to what accounting methods clearly reflect income or the authority of the Secretary of the Treasury to require the use of an accounting method that clearly reflects income.

Qualified personal service corporations

A qualified personal service corporation is a corporation that meets both a function test and an ownership test. The function test

2 A technical correction may be needed to reflect this intention.

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