In recent years, retailers have experienced a significant increase in the sale of gift cards, which have become a large percentage of total sales. With retailers receiving advance payments in increasing quantities, the issue of when this income should be reported for federal tax purposes has become more prominent. Over the past several years, the IRS has issued guidance on the treatment of advance payments. However, the complexity of gift card transactions has increased as well. The IRS has once again stepped in to provide additional clarification. This item summarizes the recently released Rev. Proc. 2011-18, which provides guidance on the deferral of income from the sale of gift cards.
Income Tax Recognition of Advance Payments
Generally, under Sec. 451(a), “[t]he amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.” Under the accrual method of accounting, income is includible in gross income when all the events fixing a taxpayer’s right to receive it have transpired. The all-events test is met when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. Therefore, advance payments received by an accrual-method taxpayer generally are included in gross income in the year of receipt.
However, their recognition may be deferred in certain situations. Regs. Sec. 1.451-5 defines advance payments to include any amounts received in a tax year by an accrual-method taxpayer for purchases and sales, pursuant to an agreement for the sale or other disposition in a future tax year of goods held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. The regulation provides that the term “agreement” includes gift cards that are redeemable for goods (Regs. Sec. 1.451-5(a)(2)(i)). Such advance payments must be included in income in either the year of receipt or the tax year that the revenue is recognized under the taxpayer’s method of accounting for financial statement purposes (Regs. Sec. 1.451-5(b)(1)).
Regs. Sec. 1.451-5(c) provides that for agreements for the sale of goods properly includible in the taxpayer’s inventory,
all advance payments received with respect to such agreement by the last day of the second taxable year following the year in which such substantial advance payments are received, and not previously included in income in accordance with the taxpayer’s accrual method of accounting, must be included in income in such second taxable year.
Simply put, for purposes of goods includible in inventory, income from advance payments, including from the sale of gift cards, that is not recognized in the year of receipt must be recognized in the following tax year.
Rev. Proc. 2004-34
Rev. Proc. 2004-34 further defined advance payments that qualify under the limited deferral provisions of Regs. Sec. 1.451-5, including payments for services, sale of goods, and use of intellectual property. It also lists exclusions from the definition of advance payments, including rent and insurance premiums.
The revenue procedure provides guidance on applying the deferral method of income recognition of advance payments for goods or services. They may be deferred to the extent the taxpayer defers recognizing the payments as revenues in its applicable financial statement. If the taxpayer does not include advance payments as revenues in its applicable financial statement in the first year of receipt, the taxpayer must include the advance payments in gross income in the next succeeding tax year.
Example: ABC, Inc., repairs television sets. ABC receives a $1,500 advance payment for a three-year contract in which ABC agrees to repair sets or replace any broken parts. In its applicable financial statements, ABC recognizes the advance payment as revenue of $500 in each of the years 2004, 2005, and 2006. However, for federal income tax purposes, ABC includes payment of $500 in gross income for 2004 and the remaining $1,000 in 2005.
When the IRS issued Rev. Proc. 2004-34, a retailer generally would redeem only gift cards it sold. Accounting for advance payments when only one retailer was involved was relatively straightforward. Since then, however, gift card arrangements have become more complex. Members of an affiliated group now set up a separate subsidiary to sell gift cards that the purchaser may redeem with any member of the affiliated group. Or a retailer may issue a gift card redeemable by it or an unrelated third party. With these new gift card arrangements, taxpayers have been confused about how to handle accounting for advance payments and when to report the revenue.
Rev. Proc. 2011-18
Effective for tax years ending on or after December 31, 2010, Rev. Proc. 2011-18 modified and updated Rev. Proc. 2004-34 to address the deferral of income arising from the sale of gift cards redeemable by entities other than the taxpayer. It added “eligible gift card sales” to the definition of advance payments. An eligible gift card sale is the sale of a gift card if:
- The taxpayer is primarily liable to the customer for the value of the card until redemption or expiration; and
- The gift card is redeemable by the taxpayer or by any other entity that is legally obligated to accept the gift card from a customer as payment for the types of items specified in Rev. Proc. 2004-34.
Provided that the other requirements of Rev. Proc. 2004-34 and Regs. Sec. 1.451-5 are met (including that goods must be held for sale by the taxpayer), a taxpayer that sells gift cards redeemable through other entities should be treated the same as a taxpayer that sells gift cards redeemable only by that taxpayer. Thus, eligible gift card sales are subject to the same two-year deferral period set out in Rev. Proc. 2004-34.
Mark Cook is a partner at SingerLewak LLP in Irvine, CA.
The editor would like to offer a special thanks to Christian J. Burgos, J.D., LL.M., for his assistance with this column.
For additional information about these items, contact Mr. Cook at (949) 261-8600, ext. 2143, or firstname.lastname@example.org .
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.