This item analyzes IRS audit guidelines for the treatment of gift card and gift certificate income, focusing on situations that require an examining agent to raise issues with IRS industry technical advisers. On May 23, 2007, the IRS issued Industry Director Directive LMSB-04-0507-039, a guide to when an agent should raise an issue in examinations of taxpayers in the retail, food, and beverage industries who are receiving gift card or gift certificate income. According to the directive, the IRS has identified inconsistent tax accounting treatment within the industries for the recognition of revenue and expenses related to gift cards and gift certificates, and the “variations and problems are numerous.”
Revenue Recognition Deferral
The directive notes that the use of gift cards has increased significantly. Revenue from sales of gift cards is not immediately recognized for financial reporting purposes and may also be deferred for tax purposes under the regulations or a revenue procedure. Regs. Sec. 1.451-5 allows deferral for advance payments for goods (including unredeemed gift card or gift certificate income) up to the end of the second tax year following the year of sale (although the deferral cannot be greater than it is for financial accounting purposes, and the taxpayer must have sufficient goods on hand to satisfy the outstanding gift cards or gift certificates).
Rev. Proc. 2004-34 allows taxpayers to elect a deferral method for advance payments for goods or services, or both (including unredeemed gift card or gift certificate income), up to the end of the tax year following the year of sale in certain circumstances (although the deferral cannot be greater than it is for financial accounting purposes) (Rev. Proc. 2004-34, §§5.02 and 5.03, Examples 7 and 8).
Gift Card Issues
The directive segregates the gift card and gift certificate “variations and problems” into two categories—Part A and Part B. Part B issues, for which no examination planning or procedural guidance is provided, include separate gift card companies, gift card versus gift certificate, reloadable gift cards, deposits, gift cards as refunds, dormancy fees, escheatment to states, bulk sales discounts, promotional gift cards (advertising), charitable contribution of gift cards, estimated cost of goods sold, franchise/franchisor gift cards, expiration date, and Rev. Proc. 2004-34. Part A issues, which an examining agent must raise with the IRS’s industry technical advisers, are compliance with the regulations, changes of accounting method, and the use of estimates. This item focuses on each Part A issue.
Compliance with Regulations
The first Part A issue, compliance with the regulations, focuses on a taxpayer’s failure to include with its return the information schedule required under Regs. Sec. 1.451-5(d) for taxpayers that defer recognition of revenue from advance payments. A taxpayer is required to attach to its return an information schedule
reflecting the total amount of advance payments received in the taxable year, the total amount of advance payments received in the prior taxable years which has not been included in gross income before the current taxable year, and the total amount of such payments received in prior taxable years which has been included in gross income for the current taxable year.
In most cases, the directive requires strict compliance with the information schedule requirement for a taxpayer to treat the amounts received with respect to gift cards and gift certificates as advance payments under Regs. Sec. 1.451-5(c) (and to apply the regulation’s deferral provision). The directive asserts that the Tax Court has regularly held that full compliance with a regulatory requirement is necessary when the requirement relates to the substance or essence of a statute. Therefore, it states that “substantial compliance, as opposed to strict compliance, should not be allowed to extend beyond cases in which the taxpayer has a compelling reason for its failure to comply.” The directive suggests that an examiner should consider a taxpayer’s singular failure to comply with the information schedule requirement when deciding whether to raise the issue of regulatory compliance (if Regs. Sec. 1.451-5 is otherwise satisfied). But if the taxpayer has consistently failed to include the information schedule on tax returns and did not meet other regulatory requirements, “the examiner should definitely pursue this issue.” The directive advises that when the examiner is unsure or believes a compelling reason exists for the taxpayer’s failure to strictly comply with the information schedule requirement, appropriate IRS technical advisers should be contacted.
A scenario not discussed in the directive—where the taxpayer has consistently not included the information statements with its tax returns but has in all other respects generally satisfied the regulatory requirements—may be common. By virtue of IRS silence on this scenario, it becomes less clear as to whether the Service would require strict compliance. Nonetheless, the directive appears to suggest that if the information schedule is missing, there may be other issues surrounding the deferral calculation. The directive is also silent as to the factors the examining agent should consider in such circumstances, although it suggests that a technical adviser should be consulted when the examiner is unsure whether to raise the issue in a particular case.
Despite what the directive suggests, the courts have not required literal compliance where a taxpayer has substantially complied with regulatory requirements, unless the regulatory requirements relate to the substance or essence of a statutory provision. Therefore, the directive’s suggestion that the failure to strictly comply with the regulatory requirement should prevent the taxpayer from being able to treat the amounts received as advance payments under Regs. Sec. 1.451-5 does not appear to be supported by case law. See Young, 783 F2d 1201 (5th Cir. 1986), and authorities cited therein; American Air Filter Co., 81 TC 709 (1983); Taylor, 67 TC 1071 (1977); and Columbia Iron & Metal Co., 61 TC 5 (1973). See also Penn-Dixie Steel Corp., 69 TC 837 (1983); Dunavant, 63 TC 316 (1974); and Valdes, 60 TC 910 (1973).
The directive also does not address Rev. Proc. 2004-34 as an apparent discrepancy to the information schedule requirement. Recall that deferral of recognition of revenue from advance payments may also be made via Rev. Proc. 2004-34, which does not require an information schedule. It appears inconsistent that nonadherence to an administrative requirement in the regulations could make a taxpayer ineligible for deferral when such a requirement does not exist when deferral is allowed under another, substantially similar, regime.
Changes in Accounting Method
The second Part A issue the directive identifies is changes in accounting method. The directive poses the following: “Is a taxpayer required to file a Form 3115, Application for Change in Accounting Method, in order to adopt and/or to switch to the deferral method under section 1.451-5?” Three scenarios are considered.
In scenario 1, a taxpayer formerly used gift certificates and accounted for advance payments under the Regs. Sec. 1.451-5 deferral method but now uses only gift cards. Because gift cards are a continuation of the gift certificate program, the taxpayer is not required to file a Form 3115.
In scenario 2, the facts are the same as in scenario 1, but the taxpayer was not in compliance with the deferral regulations for the gift certificates. The taxpayer must obtain IRS consent to change its accounting method before using a deferral method for the gift cards because it was not using a proper deferral method for gift certificates. The directive points out that “the change from gift certificates to gift cards is not a change in underlying facts that would permit the adoption of different accounting treatment” and, if a proper deferral method is adopted without consent, the method is considered impermissible.
In scenario 3, the facts are the same as in scenario 1 but the taxpayer does not defer income from the sale of gift certificates. For the taxpayer’s first year of issuing gift cards, it cannot adopt a deferral method without consent, for the reasons outlined in scenario 2.
Use of Estimates
The final Part A issue is the use of estimates. The directive states that some taxpayers use estimates or assumptions as to the redemption rate for gift cards in any particular year. These estimates and assumptions are therefore used to determine the amount of gift cards outstanding. The directive does not allow estimates to determine outstanding gift cards or gift certificates, concluding that the use of estimates does not meet the regulatory requirements, which implicitly require that amounts identified and included in the information schedule be accurate and based on supporting documentation. Therefore, “a taxpayer must specifically track gift cards/certificates as to the year sold. A taxpayer cannot attest to the accuracy of estimated statements because outstanding gift cards/certificates are not tracked.”
The examination guidance in the directive includes two substantive statements:
- To be eligible for the deferral method under Regs. Sec. 1.451-5, there must be strict compliance with the information schedule requirement, absent a compelling reason for noncompliance.
- The use of estimates to determine the amount of unredeemed gift cards is not allowed.
The directive states, however, that it “is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.”
The directive may allow taxpayers deferring advance payments from gift card or gift certificate sales to anticipate the questions that may be posed by an examining agent and to prepare for the potential requests. In addition, when a taxpayer’s issue is identified as a Part A issue, the taxpayer should expect that the examination team will request technical assistance from a specialist. The directive and its attachments are useful tools for both IRS examination teams and taxpayers under examination.
Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC
The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.
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