IRS Continues to Challenge Deferral of Revenue from Gift Cards

By Cathy Fitzpatrick, CPA, MST, and Carol Conjura, J.D., CPA, Washington, DC

Editor: Mary Van Leuven, J.D., LL.M.

In recent years, due to the increasing use of gift cards and the disparity between the federal tax accounting and financial accounting treatment of advance payments, there has been inconsistency among taxpayers and confusion as to the proper timing of recognizing income from gift cards. One specific issue that has arisen is the treatment of gift card income when a taxpayer maintains a separate gift card company that is responsible for selling the cards and operating the gift card program for it and other related entities but does not itself sell or provide the goods for which the cards can be used. The IRS recently addressed this issue in Technical Advice Memorandum (TAM) 200849015.

Summary of TAM 200849015

In the TAM, Taxpayer, a C corporation, uses the overall accrual method and is a subsidiary of Parent and part of Parent’s consolidated group. Parent formed Taxpayer to manage Parent’s gift card program and oversee the entire gift card program for the Parent consolidated group in exchange for a management fee. Taxpayer issues and sells all gift cards used in stores operated by Parent and related entities and in certain stores operated by an unrelated entity. The gift cards can be redeemed for goods (or limited services integral to those goods) from retailers operated by other taxpayers within the consolidated group (the retailers) and from the unrelated entity.

Under the gift card program agreement, the retailers agree to sell and reload Taxpayer’s gift cards in their stores, remit all amounts paid to Taxpayer, and redeem the cards in exchange for merchandise. After the cards are redeemed, Taxpayer pays the retailers amounts equal to the amounts of the redeemed cards. Taxpayer is solely liable and obligated to the purchasers and holders of the gift cards—except the retailers are liable to Taxpayer to accept the balance on a gift card as payment for goods and services. Under the retailers’ business practices, gift card holders can receive cash refunds for card balances under a certain amount. If a cardholder returns a purchase made with a gift card, the retailer will increase the balance on the gift card by the amount of the return; however, for returns below a certain amount the retailer will issue a cash refund.

The TAM addresses three issues related to the amounts received by Taxpayer on its sale of the gift cards (gift card receipts):

  1. Are the gift card receipts includible in Taxpayer’s gross income (i.e., are they considered income or deposits)?
  2. Are the gift card receipts “advance payments” within the meaning of either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34 (and therefore eligible for deferral)?
  3. If the gift card receipts are includible in income upon receipt, may the Taxpayer take an immediate deduction for the liability to pay the amount to a retailer?

Income or deposits: The TAM concludes that the gift card receipts are payments over which Taxpayer exercises complete dominion and control and over which it holds a claim of right unless, and until, a subsequent event occurs that would require it to transfer amounts to retailers or refund amounts to a customer; therefore, the gift card receipts are income and not deposits.

Taxpayer had argued that the gift card receipts are not income but are instead nontaxable deposits because the gift card holders may request and obtain a full cash refund at any time under state law. In refuting this argument, the IRS first sets forth the Sec. 61 general rule that gross income includes all income from whatever sources derived, including “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion” (citing Glenshaw Glass Co., 346 U.S. 426 (1955)). It then goes on to say that the taxpayer has a claim of right to the amounts upon receipt, since whether and to what extent Taxpayer will be required to reimburse a retailer is subject to the contingency that the customer will redeem the card for goods or services or obtain a refund. Further, the IRS distinguishes the gift card receipts from the receipts in Indianapolis Power and Light Co., 493 U.S. 203 (1990), in which the Supreme Court held that amounts received by a utility from customers constituted deposits because the right to refund was based on the customers’ actions (making timely payment for several months), and therefore the taxpayer did not have “complete dominion” over the funds. In the case of Taxpayer’s gift card receipts, the IRS places great weight on the fact that, under state law, a customer who buys a gift card cannot demand a full cash refund for the initial value of the card (except in limited circumstances in which the gift card is below a certain amount), and thus any refund is dependent on the subsequent action of the customer and requires an affirmative action of the customer to obtain goods and request a refund (i.e., it is a condition subsequent).

Advance payments: The IRS concludes that the gift card receipts do not fall within the scope of either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34 and therefore are not eligible for deferral under either provision. In general, Sec. 451 and the regulations require accrual-method taxpayers to include an item in gross income when the all-events test is met or, as interpreted by the courts, at the earliest of when it is received, due, or earned (see Schlude, 372 U.S. 128 (1963)). Thus, when a taxpayer receives a payment for goods or services prior to the goods or services being provided (advance payments), the payment must generally be included on the receipt; however, Regs. Sec. 1.451-5 and Rev. Proc. 2004-34 provide limited exceptions to the general rule whereby a taxpayer may defer advance payments.

As noted in the TAM, Regs. Sec. 1.451-5 defines advance payment, in relevant part, as “any amount which is received . . . pursuant to, and to be applied against, an agreement . . . [f]or the sale or other disposition in a future taxable year of goods held by a taxpayer primarily for sale to customers in the ordinary course of his trade or business.” For this purpose, an agreement includes a gift certificate that can be redeemed for goods. If the regulation applies to a payment received on the sale of a gift card, the related income can generally be deferred until the earlier of when a cardholder uses the card or the second tax year following the year of purchase. Rev. Proc. 2004-34 defines advance payment differently than the regulation. Under the revenue procedure, a payment is considered an advance payment if:

  • Including the payment in gross income for the year of receipt is a permissible method;
  • The payment is recognized by the taxpayer (in whole or in part) in revenues in its applicable financial statement for a subsequent tax year; and
  • The payment is for services or the sale of goods (except where the taxpayer uses the Regs. Sec. 1.451-5 deferral method).
Under the revenue procedure, the advance payment may be deferred in the year of receipt to the extent deferred for financial statement purposes, but it must be included in gross income in the next succeeding tax year.

The TAM concludes that the gift card receipts are not advance payments within the meaning of the regulation because Taxpayer is not the party that provides the goods, and its assertion that it is contractually obligated to provide goods to customers does not reflect either the form or substance of its agreement with the retailers. With respect to Rev. Proc. 2004-34, the TAM acknowledges that unlike the regulation, the revenue procedure does not explicitly require that the payment be for goods “held for sale by the taxpayer.” However, it goes on to say, with no further analysis or explanation, that the IRS National Office agrees with the examination team’s interpretation of the revenue procedure in that it should not be interpreted broadly to apply to situations in which goods are provided by a party other than the taxpayer. As discussed in more detail below, the TAM is silent as to why Taxpayer’s advance payment is not considered an advance payment for services to which the deferral provisions of Rev. Proc. 2004-34 could potentially apply.

Liability to retailer: The TAM concludes that Taxpayer’s liability to the retailer is not deductible in the year of purchase because the liability is contingent and not fixed at the end of the year. According to the TAM, the liability does not become fixed (and therefore deductible) until the customer redeems the gift card at the retail location because the redemption is a condition precedent to the fixing of the liability.

Implications of TAM 200849015

The rationale and conclusions in TAM 200849015 underscore the continuing disparities between the financial accounting and tax accounting treatment of advance payments. Absent further official guidance, controversies will continue to arise in this context because of the everincreasing incidence of gift card programs and the gaps in the existing guidance addressing the tax accounting rules for advance payments, which cause continuing uncertainties.

The IRS has long sought to limit the amount of deferral permitted for the recognition of advance payments as a result of Supreme Court decisions requiring current recognition of advance payments for tax purposes. However, the existing rules appear to be out of step with business realities associated with the operation of gift card programs. Specifically, in the TAM Taxpayer was not permitted to use the deferral method in Regs. Sec. 1.451-5 because it did not sell inventory, even though an affiliate or franchisee of Taxpayer would redeem the gift cards for inventory. This is a harsh result when compared with the treatment of a business that sells inventory from the same entity that operates the gift card program. Further, this raises the question of whether Taxpayer in the TAM would have avoided the challenge if it had actually sold some inventory that could have been used to satisfy its gift card obligations, even if the majority of the cards were redeemed from other sources. The result is similarly harsh when compared with a business that happens to operate in a state where the gift card management company can operate in the disregarded entity structure and its owner sells the inventory.

Taxpayer’s deposit argument appeared to fail, at least in part, because Taxpayer was not able to prove to the IRS that gift card holders could obtain a cash refund upon demand. If a taxpayer in another case could show that its customers are contractually entitled to redeem the card for cash equal to its face value, the IRS could have great difficulty overcoming the Supreme Court’s ruling in Indianapolis Power, notwithstanding the fact that the cards are not considered deposits by the customer and do not function as security for payment of any kind. From the standpoint of deferral, this fact pattern might be beneficial in that it could permit a taxpayer to use a method that mirrors its financial reporting method, without the deferral limits in the existing guidance. Although there is some overlap in the eligibility requirements for advance payments under Regs. Sec. 1.451-5 and Rev. Proc. 2004-34, taxpayers who are eligible for Regs. Sec. 1.451-5 generally prefer to use those rules over Rev. Proc. 2004-34 because the regulatory method permits a longer period of deferral.

While Regs. Sec. 1.451-5 indicates that it applies only to advance payments related to “goods held by the taxpayer primarily for sale to customers,” the wording in Rev. Proc. 2004-34 is not as limiting because it applies to advance payments, including gift cards, that involve the sale of goods and/or services. If the gift card management company is not responsible for selling the goods, it would clearly seem to be engaged in providing management services, which fits squarely into the requirements for the Rev. Proc. 2004-34 deferral method. The IRS in the TAM offers no rationale for why the gift card management company’s advance payments should not be considered to be payments for services under an arrangement whereby it earns a contingent management fee through the breakage (i.e., the amount of gift cards sold but never redeemed) in the program over time.

In contrast, the IRS implied in recent Field Attorney Advice 20082801F that Rev. Proc. 2004-34 would be available to a gift card management company that sells no inventory, provided that the taxpayer tracked its gift card redemptions on a cardby- card basis, such that it could tell when the revenue from a gift card has been “recognized as revenues in its applicable financial statements for the tax year of receipt” as required by §5.02(1)(b)(i) of the revenue procedure. Conversely, in the TAM the IRS does not suggest that a taxpayer who actually sells inventory from the same company that issues gift cards would be disqualified because the taxpayer allowed customers to redeem the cards, at their option, for either goods or services.

While the IRS may be justified in limiting the amount of deferral for advance payments overall, the rules arguably should not operate in such a form-driven fashion for gift card programs when some taxpayers are permitted to use one deferral method and others a different but more restrictive method, while leaving some taxpayers no choice but to recognize gift card revenue upon receipt. Given that the IRS issued Rev. Proc. 2004-34 to make the deferral rules less restrictive than they had previously been, it would seem incumbent on the IRS to issue administrative guidance that makes some form of a deferral method available equally to all gift card programs.


Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

© 2009 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or

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