IRS Issues Second Directive on Gift Cards

By Jane Rohrs, CPA, Washington, DC

Editor: David J. Kautter, CPA

The IRS has issued a second industry director directive (IDD No. 2) (LMSB 4-0808-042) on gift cards and gift certificates, elevating the use of a separate gift card company (Giftco) to administer a taxpayer’s gift card or certificate program to Part A status and providing more information on issues categorized as Part B.

IDD No. 1 (LMSB-04-0507-039), issued on May 23, 2007, classified gift card “variations and problems” into two categories, Part A and Part B. Part A includes compliance with regulations, accounting method changes, and the use of estimates. Part A concerns must be raised on examination, and contact must be made with a Food and Beverage or a Retail technical adviser for coordination of the issue. (For more on IDD No. 1, see Suttora and Mortenson, “Gift Card and Gift Certificate Income Deferral,” Tax Clinic, 39 The Tax Adviser 333 (June 2008).)

Planning and Examination Guidance: Part A

IDD No. 2 states that the question of a taxpayer’s use of a separate legal entity to administer its gift card or certificate program is now elevated to Part A status and accorded Part A treatment. The primary concern is whether the entity has goods for sale in the ordinary course of its trade or business and is therefore eligible to elect a deferral method of reporting gift card income under Regs. Sec. 1.451-5 or Rev. Proc. 2004-34.

The directive refers examiners to field attorney advice (FAA) 20082801F, released on July 11, 2008, which provides a legal analysis of a specific case.

Planning and Examination Guidance: Part B

In addition to elevating the Giftco matter to Part A status, the IRS has also updated the issues under Part B in a question and answer format. Part B covers the following topics:

Gift cards versus gift certificates: The IRS explains that gift cards and gift certificates are the same for purposes of Regs. Sec. 1.451-5. If a taxpayer treats gift cards differently from gift certificates, the IRS advises an examiner to raise the issue with one of the Retail or Food and Beverage technical advisers.

Reloadable gift cards: If a taxpayer’s gift cards are reloadable, the IRS tells examiners to verify that the taxpayer’s accounting system and software take into account the actual dates when money is added to the card for purposes of income deferral.

Deposits: The IRS takes the position that gift card or certificate income is not a deposit that is excludible from income. If a taxpayer excludes from taxable income gift card or certificate proceeds as deposits, the IRS advises examiners to bring the issue to the attention of one of the Retail or Food and Beverage technical advisers.

Gift cards as refunds: The IRS is still formulating a position on whether a taxpayer may treat the issuance of a gift card for returned merchandise, in lieu of a cash refund, as equivalent to a sale of a gift card but indicates that a Retail or Food and Beverage technical adviser should be contacted in such cases.

Dormancy fees: The IRS’s position is that a taxpayer may not report as income dormancy or latency fees that are charged against the gift card or certificate. Examiners will need to verify that the income is properly reported when dormancy, latency, or other administrative fees may be incurred on a taxpayer’s gift cards or certificates.

Escheatment to states: Some taxpayers are arguing that they do not have to recognize income on unredeemed gift cards until the earlier of redeeming the gift card/certificate or turning over the balances to a state. The IRS points out that a technical adviser can help examiners determine whether the taxpayer’s position is in accord with the income deferral methodology under Regs. Sec. 1.451-5. (For more on the impact of state escheat laws on gift cards, see Kile and Wall, “States Bite into Broken Gift Cards,” 206 Journal of Accountancy 76 (December 2008).)

Bulk sales discounts: If sales discounts on gift cards are not expensed in direct relationship to the recognition of income from the cards, the IRS advises examiners to contact a technical adviser, who will help determine whether the taxpayer’s treatment of expensing discounts while deferring the income from the related gift cards is an improper acceleration of the deduction under Sec. 461(h).

Promotion gift cards: When gift cards are given away by the taxpayer, the IRS takes the position that the advertising expense is a deferred expense because the credit is to a deferred income account. However, the IRS notes that examiners need to consider whether the deferred advertising expense should be recognized under the provisions of Regs. Sec. 1.446, the clear reflection of income standard, and Sec. 461 in determining when the advertising expense is deductible.

Charitable contribution of gift cards: The IRS indicates that facts would have to be ascertained to establish whether the donated gift card has been redeemed and the item has been released from inventory through cost of goods sold. A technical adviser may aid examiners in determining when liability becomes fixed and economic performance occurs to entitle the taxpayer to a deduction.

Estimated cost of goods sold: Taxpayers using the deferral method of income recognition have asserted that they are entitled to a cost of goods sold deduction for the unredeemed gift cards that they include in income two years after the sale of the gift card. The IRS states, however, that Regs. Sec. 1.451-5(c)(1)(iii) provides that the reduction for cost of sales does not apply if the goods for which the advance payments are received are not identifiable. Therefore, in a typical situation, a taxpayer is not allowed to reduce its cost of goods sold until the goods are shipped or otherwise identified to the contract because it is not known which products will be ordered.

Other legal entities and franchisor/franchisees: The IRS is currently formulating a position on how its position on Giftco applies to other legal entities, such as partnerships, S corporations, and franchisors and franchisees.

Expiration date: The IRS asserts that if a taxpayer is using the income deferral procedures under Regs. Sec. 1.451-5, gift card income must be recognized on the expiration date if it is earlier than two years after the sale of the gift card.

Rev. Proc. 2004-34: Regs. Sec. 1.451- 5 provides income deferral for advance payments of goods for up to two years after the gift card sale, while Rev. Proc. 2004-34, which provides a one-year deferral, covers sales of goods, services, and mixtures of goods and services. The IRS states that taxpayers may be able to defer qualifying advance payments under the regulations or the revenue procedure.

Not-for-profit entities: Some taxpayers have argued that they will use all gift card income to satisfy future redemptions and therefore no profit or loss is recorded. If a gift card company is set up as a not-forprofit entity, all other income will never be recognized for tax purposes. They cite Seven-Up Co., 14 T.C. 965 (1950), to support the argument that they are only holding gift card sale revenues as a fund to satisfy the liabilities of others. The IRS advises examiners to contact technical advisers for assistance on this topic.

Intermediaries: Technical advisers are uncertain as to the scope of issues involving the use of third-party intermediaries to sell gift cards, but the IRS advises examiners to contact technical advisers if they encounter them.


This second directive covers a range of concerns related to the broadly defined Tier II gift card/deferral of income issue. Interestingly, the IRS had previously posted to its website a second gift card directive (on September 12, 2008), but shortly thereafter removed it without explanation. It now appears that the September 12 directive was a draft posted in error. The final version, released on October 3, contains a number of substantive revisions. The September 12 draft set forth positions on many of the items noted above, while the final version identifies the potential issue but advises examiners to consult a technical adviser, indicating that the IRS has not fully developed its position for a number of these items.

The directive also confirms the differences in procedural treatment to which the various gift card issues will be subject, depending on whether the topic falls under Part A or Part B. While issues under Part A are mandatory examination items and require coordination with the appropriate technical advisers, taxpayers should nonetheless be aware that examiners auditing any concern related to gift cards will likely contact the appropriate technical advisers for guidance.


David Kautter is a partner with Ernst & Young LLP in Washington, DC.

Contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mr. Kautter at (202) 327-8878 or

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