Restaurant Management Company May Not Defer Recognition of Income from Gift Card Sales

By Cory Tull, J.D., Washington, DC

Editor: David J. Kautter, CPA

The IRS has determined in a legal advice memorandum (20093801F) that a restaurant management company may not defer income recognition from the proceeds of gift card sales under Regs. Sec. 1.451-5 or Rev. Proc. 2004-34.


The taxpayer is an S corporation and full-service restaurant management company that maintains its books and files its income tax returns on an accrual basis. It has sold gift certificates (now gift cards) for many years. The IRS has audited it on several occasions, but not on the issue of its reliance on Regs. Sec. 1.451-5.

The taxpayer was incorporated in year 1 to succeed in merger to an affiliated group of restaurants. When the IRS began auditing the taxpayer, the taxpayer owned and operated several of the original restaurants, and its affiliates operated several other restaurants, all of which participated in the taxpayer’s gift card program. Today the taxpayer owns and operates only one of the original restaurants, and the bulk of its income stems from management fees it charges for services it provides to affiliate-owned restaurants. The taxpayer does not own the affiliated restaurants and has an equity interest in some, but not all, of those restaurants.

The affiliated restaurants are all advertised and promoted under the original brand name, so the “restaurant-brand” gift cards are honored at all participating restaurants, regardless of where the card was purchased. As the management company, the taxpayer has the ability to determine which of the restaurants will participate in its gift card program. If a restaurant closes or its participation in the program is otherwise terminated, the restaurant has no further rights or obligations under the program except for a right to have the taxpayer reimburse it for gift cards honored by the restaurant prior to the termination.

The participating restaurants accept the gift cards, which have no expiration date, like cash. Customers can purchase the cards in person at a participating restaurant, online, via fax or e-mail, or by telephone through the taxpayer’s gift card sales department. The participating restaurants remit the proceeds of all gift cards sold to them by the taxpayer, honor the cards when presented, and then present the taxpayer with the cards, which are exchanged for cash. The participating restaurants have no right to proceeds from the sale of gift cards that are not redeemed, and they recognize gift card income only when cards are redeemed at their restaurant.


The taxpayer and its affiliates reconcile their intercompany accounts on a monthly basis. The taxpayer recognizes income from the sale of gift cards under Regs. Sec. 1.451-5 and thus recognizes no income on the sale or redemption of the cards (other than from its own restaurant). The taxpayer recognizes income on unredeemed cards in the second year following the year in which the cards are sold.

On its books, the taxpayer records a participating restaurant’s sale of a gift card as a debit to an intercompany account (receivable) and a credit to gift card liability. The gift card liability entry is made because the taxpayer records and holds the liabilities for sales of gift cards for all the entities instead of each entity’s maintaining its own liability for outstanding gift cards. Because the taxpayer receives cash from the participating restaurants when they sell gift cards, the taxpayer debits cash and credits the intercompany account.

When a customer redeems a gift card at a participating restaurant, the taxpayer is obligated to transfer the amount of the redemption to that restaurant. The participating restaurant records on its books a debit to gift card redeemed and a credit to sales, thus reporting income from the sale of goods upon redemption of the gift card. The restaurant also records a debit to an intercompany account with the taxpayer and a credit to gift card redeemed for the same amount as the previous entry. It also records a debit to cash and a credit to the intercompany account with the taxpayer to eliminate the intercompany item between the store and the taxpayer and records the receipt of cash from the taxpayer.

The taxpayer’s merchandise inventories represent nonfood items, which it acquires on a bulk basis and then distributes/ sells and allocates the cost to its restaurant and the affiliated and managed restaurants.

The taxpayer’s tax and audited balance sheets report the entire liability for all outstanding gift cards, whether sold by it or the other participating restaurants. Citing high demand for its gift cards, the taxpayer activates the cards prior to distributing them to participating restaurants for sale. Participating restaurants may return unsold activated cards to the taxpayer, which the taxpayer then places into its inventory of activated but unsold cards.

The taxpayer uses an outside vendor to track the issuance and aging of the gift cards. The outside vendor information shows—by year and month activated and denomination/type—the total dollar amount of gift cards outstanding, the total dollar amount issued/activated, and the total dollar value of the outstanding cards. The taxpayer does not currently track individual gift cards, though it says it has the ability in most cases to determine whether an individual card was sold directly by it or through a participating restaurant.

The IRS issued an information document request (IDR) asking the taxpayer to produce documentation showing how much of the reported outstanding liability for each year relates to gift cards sold by the taxpayer itself. Because it does not track gift cards in that manner, the taxpayer submitted its response based on the average gift card redemption rate per year for all gift cards sold, multiplied by the gift cards sold by the taxpayer and its restaurant.

Law and Analysis

Regs. Sec. 1.451-1(a) permits a taxpayer to take advance payments for goods into account either in the tax year in which the taxpayer receives payment or in the tax year in which the advance payment is properly accruable under the taxpayer’s method of accounting.

Regs. Sec. 1.451-5(c) contains an exception for inventoriable goods that allows income from the sale of a gift card to be deferred until the end of the second year after the card is sold, provided certain conditions are met. Specifically, the taxpayer must receive an advance payment for the sale of goods properly includible in his or her inventory or for an agreement (such as a gift card) that can be satisfied with goods. Under the regulations, an advance payment is any amount received by a taxpayer using an accrual method of accounting for purchases and sales and to be applied against an agreement. Gift certificates and, by extension, gift cards are specifically within the definition of agreement under Regs. Sec. 1.451- 5(a)(2)(i).

The IRS concluded that where an intermediary or independent owner entity exists between the taxpayer and the restaurant in question, the taxpayer is a full-service restaurant management company and not the owner of the inventory (food) that will be redeemed with the gift card sale proceeds. As such, the taxpayer does not qualify for the deferral available under Regs. Sec. 1.451-5 because the taxpayer will not be redeeming the gift cards with its own goods held for sale. For those restaurants, the taxpayer is only providing management services and gift-card-selling services, not supplying or selling its own meals. The taxpayer will transfer cash to the seller of the meals when a customer redeems the gift card through the sale of the restaurant’s own goods. For similar reasons (lack of food inventory for restaurants it does not own), the IRS concluded that the taxpayer also did not qualify for the deferral method under Rev. Proc. 2004-34.

For the one restaurant owned and operated directly by the taxpayer, the IRS found that there was still a separate gift card company problem because a gift card can be redeemed either in the taxpayer’s restaurant or in other restaurants not owned by the taxpayer. The IRS concluded that the taxpayer has no way of knowing which gift cards will be redeemed at its restaurants versus other restaurants, and it is unable to actually track the time of the gift card sale without setting up a separate gift card program under which the cards are valid only at its restaurant. Even if the taxpayer could track an historical average, the taxpayer’s own inventory cannot be ascribed to separate entities because those separate restaurants are not using the taxpayer’s inventory to satisfy their restaurant meal sales.

The IRS further determined that the taxpayer is unable to obtain the requisite inventory for deferral purposes through its equity ownerships in the entities that own the restaurants via attribution rules. The entities incorporated under state law are separate legal entities, and the property titled in the name of the corporation is that corporation’s asset, not the property of the corporation’s shareholders. As such, the interests the taxpayer holds in the restaurants (other than the one it operates) are merely investments and do not satisfy the requirements for deferring income recognition from the sale of gift cards.


The analysis in this legal advice memorandum is consistent with the way the IRS has been approaching gift card issues. The IRS generally takes the position that a taxpayer must hold the goods to which the advance payments relate in order to qualify for deferral under Regs. Sec. 1.451-5.

Deferral of income related to gift cards in the retail, food, and beverage industries is a Tier II issue under the IRS’s issue-tiering strategy. That strategy is intended to give the IRS a consistent framework for identifying, prioritizing, and addressing issues that are deemed significant compliance risks in a nationally coordinated manner. There are a number of discrete issues related to gift cards that fall under the Tier II designation. An Industry Director Directive (IDD) issued on May 23, 2007, classified these numerous issues into parts A and B (LMSB-04-0507-039). Any examiner who identifies a part A issue during an examination is required to raise the issue and coordinate with either the food and beverage or one of the retail technical advisers.

The issue of whether a separate legal entity that administers a gift card program can elect a deferral method of reporting gift card income under either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34 was elevated to part A status in an IDD issued on October 3, 2008, making the issue a mandatory examination item (LMSB-4- 0808-042). In addition, the pro forma IDR that was developed for examiners to use during examinations of taxpayers with gift card programs includes a question designed to identify whether a separate legal entity is used to manage the gift card program. Taxpayers should expect the issue to be raised during an examination and be prepared to respond accordingly. (For more on the prior gift card IDDs, see Shevak, “Treatment of Gift Card/Certificate Sales,” Tax Clinic, 40 The Tax Adviser 74 (February 2009); Rohrs, “IRS Issues Second Directive on Gift Cards,” Tax Clinic, 40 The Tax Adviser 6 (January 2009); and Suttora and Mortenson, “Gift Card and Gift Certificate Income Deferral,” Tax Clinic, 39 The Tax Adviser 333 (June 2008).)


David Kautter retired from Ernst & Young LLP in Washington, DC, in December 2009.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.

For additional information about these items, contact Mike Dell at (202) 327-8788 or

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