The legislation known as the Tax Cuts and Jobs Act (TCJA)1 modified Sec. 451 to allow taxpayers to defer recognizing income until it is recognized in an applicable financial statement.2 This rule helps eliminate some items that were timing differences between financial accounting income and taxable income. This article reviews the treatment of unearned revenue — also referred to as deferred revenue — from a financial accounting and tax point of view and focuses on how it can affect the seller, as well as the buyer, in a taxable acquisition.
Accounting for income
The Internal Revenue Code provides that, generally, gross income means all income from whatever source derived.3 Sec. 162 provides a deduction for all ordinary and necessary expenses paid or incurred in carrying on a business. Using the cash method to analyze transactions should help show who pays tax on income.4
Example 1. Cash-method corporation: XYZ Corp. provides software services. In year 1, Customer B pays XYZ $100,000 for the right to use its software for the next five years. It costs XYZ $8,000 per year to maintain its software per customer. Under the cash method of accounting, XYZ would recognize $100,000 of revenue, matching the cash collected, and would recognize $8,000 of expense in year 1. The net income under the cash method would be $92,000 and, in years 2 through 5, XYZ would incur losses totaling $32,000.5 The total net activity over the five years would be $60,000 of net income.
Example 1 illustrates why some taxpayers may benefit from being on the accrual method. Under GAAP,6 the accrual method of accounting is required, and, therefore, expenses and revenues should be properly reflected in each accounting period to avoid distorting income for any one accounting period. In many merger and acquisition (M&A) transactions, investors will also require GAAP financial statements to get a more accurate picture of a company's financial condition.
Example 2. Accrual-method corporation: Using the facts from Example 1, except, instead of the cash method, applying the accrual method, XYZ Corp. would record a debit to cash and a credit to unearned revenue upon the receipt of $100,000 cash. This would establish an asset on the balance sheet and a corresponding liability. The liability here demonstrates that the obligation to the customer has not been fulfilled. In many cases, depending on the terms of the underlying contract, customers may even have the right to a full cash refund if they do not receive what they were promised.
Under the accrual method, as the work is performed by XYZ, revenue is earned and recognized. In year 1, an entry would be made to recognize the revenue earned for the period by making a debit to deferred revenue of $20,000 and a credit to revenue. In year 1, $8,000 of expenses are incurred. The accounting entry would be a credit to cash and a debit to expense (e.g., salaries). At the end of the year, using the accrual method, revenue on the income statement would be recognized for $20,000, and an expense of $8,000 would be recognized. On the balance sheet, the cash balance would go from $100,000 to $92,000, and the deferred revenue balance would go from $100,000 to $80,000. In summary, the net income would be $12,000 in year 1. These same entries would be recorded for years 2, 3, 4, and 5. The result is a normalized stream of net income over the next five years. Notice that regardless of whether XYZ Corp. uses the cash or accrual method, the total net income over the five years is $60,000. However, the income recognized each year varies significantly between the two methods.
In summary, when a taxpayer receives an advance payment for services, income should eventually be recognized. Said differently, unearned revenue is the liability account used to measure how much income the taxpayer has not yet recognized.7
Analysis of seller tax treatment in James M. Pierce Corp.
James M. Pierce Corp. operated a newspaper publishing business through its various subsidiaries. Pierce Corp. had a practice of selling "perpetual" subscriptions that were redeemable by the subscriber or heirs over a 10-year period ratably. Pierce Corp. recognized one-tenth of the income each year and recorded the unrecognized portion as a "reserve" (i.e., unearned revenue).8 As the subscription was redeemed, the corresponding reserve was reduced and income was recognized.
In 1957, the Prairie Farmer Publishing Co. paid Pierce Corp. $1,406,789 in cash to acquire its assets. Prairie also assumed the obligation of Pierce Corp. to publish its Wallaces' Farmer and Iowa Homestead newspaper and agreed to carry out the terms of all subscription contracts in force as of the date of closing for the unexpired subscriptions. The balance of the reserves (unearned revenue) was $436,359, which included $40,340 in reserves for partial redemptions of the perpetual subscriptions. The remaining $396,019 was for unearned subscription revenue. The $436,359 was taken into account as an adjustment to the cash paid by Prairie. In other words, Prairie would have paid that amount more in cash to Pierce Corp. if Pierce Corp. had paid off the reserves before closing.9
Pierce Corp. did not record any of the reserves as gain on the sale on its 1957 income tax returns. The Tax Court sided with the IRS and held that the assumption of the reserves by Prairie was the appropriate time for Pierce Corp. to recognize income.10 The Eighth Circuit agreed with the Tax Court that the reserves were includible in income because the seller's obligation to perform services had ended.11 Even using GAAP matching principles, one can agree with this outcome. Pierce Corp. had received the cash, and it no longer was going to perform on the contract. The income deferral period should end with the extinguishment of the obligation. Notice that the recognition of income causes the reserve account for unearned revenue to become zero.
The Tax Court had rejected Pierce Corp.'s argument to be allowed a deduction for the reduction in price caused by the reserves. This is a reasonable result because a taxpayer should not be allowed to claim a deduction for a payment in which the taxpayer has not established basis for tax purposes. For example, taxpayers who donate their time for charitable work should not be allowed a deduction unless they recognize income for a salary. Here, the seller should not receive a deduction unless it also recognizes the income associated with the obligation assumed by the buyer.
The Eighth Circuit, however, disagreed with the Tax Court about the deemed payment that Pierce Corp. had made to Prairie by agreeing to reduce the purchase price by the assumed liability. The Eighth Circuit held that the buyer assumed an actual liability associated with the future obligation to fulfill the unexpired subscriptions. This assumption was therefore part of the amount realized by the seller, much like the sale of real estate subject to a mortgage.12 The amount the parties used to quantify this cost was the balance of the reserves.
In this case, the contract with the "perpetual" subscribers gave the subscribers and their heirs the right to redeem nine-tenths of the price of the contract. Therefore, the buyer had become directly obligated to incur a cost to the subscribers without any additional cash payment from them. If the buyer was unable to perform, it would likely have to refund the balance to the subscriber. This obligation for the buyer was a reserve for a future expense and different from the unearned revenue balance that was used to track the seller's unrecognized income. In fact, for tax purposes, the seller recognized income for the entire unearned revenue balance, and this was never in dispute.
The Eighth Circuit went on to explain that the buyer's obligation to subscribers did not cease when the seller recognized revenue. Because the buyer and seller reduced the purchase price by the liability assumed, the seller was treated as making a payment to the buyer for the assumption of the subscription liability. This deemed payment resulted in a deduction under Sec. 162 for the seller, but the court did not explain why the seller obtained a deduction without first creating basis in the deduction for tax purposes.13
To begin understanding the holding of the Eighth Circuit, it is crucial to discuss Sec. 337 as it read before 1986. In 1957, Pierce Corp. had adopted a plan of liquidation before selling its assets. Pursuant to Sec. 337, any gain associated with a capital transaction was not taxable to the corporation.14 Therefore, in this case, the Eighth Circuit indeed held the right answer. The amount realized on the sale of assets by Pierce Corp. would be the cash paid plus the liability assumed, including the reserves. Using the numbers above, the amount realized would become $1,843,148 ($1,406,789 cash received plus the $436,359 obligation assumed by the buyer). Pierce Corp. would allocate the amount realized to the basis of assets, and the resulting gain would be excluded from taxation under Sec. 337. However, because the amount realized on the asset sale includes the reserves, the seller is also allowed a deduction for the deemed payment to the buyer. The court simply left out the reason why the income related to the assumed liability did not have to be recognized by Pierce Corp.
To recap, according to the Eighth Circuit, Pierce Corp. would have (1) ordinary income of $436,359 for the extinguishment of its unearned revenue obligation (this item was not in dispute); (2) an amount realized of $1,843,148, which included $436,359 related to the buyer's assumed subscription liability (all of which was nontaxable pursuant to Sec. 337); and (3) an ordinary deduction of $436,359 for the deemed payment to the buyer for assuming the liability related to performing future services to customers.
The results enjoyed by Pierce Corp. are no longer available today because in 1986 the statute was amended, and liquidating distributions became taxable under Sec. 336. However, a difference in the character of the income or deduction realized can be material for sellers that are individuals or flowthrough entities. The results under today's law for individuals who sell a business with unearned revenue and include the amount as part of working capital would be (1) to recognize ordinary income for the extinguishment of the unearned revenue obligation; (2) to recognize additional capital gain for the service liability assumed by the buyer; and (3) to enjoy an ordinary deduction for the deemed payment to the buyer for assuming the obligation to perform future services to customers. In other words, sellers have capital gain for the additional gain related to the future liability that the buyer assumes and get to enjoy an ordinary expense for the deemed payment to the buyer for assuming the obligation. The holding in James M. Pierce Corp. essentially allows sellers in sale transactions to convert what otherwise would be ordinary income for advance payments into capital gain as a result of the deemed payment mandated in the case.
Analysis of buyer treatment
The IRS continued its analysis of unearned revenue transactions by issuing Rev. Ruls. 71-450 and 76-520. In Rev. Rul. 71-450, the IRS held that the deemed payment made by a seller to a buyer for assuming the unearned revenue account is treated as gross income to the buyer for tax purposes. Presumably, the buyer can defer the income recognition if it uses the accrual method. This result would force the buyer to recognize income for the deemed payment by making a credit to revenue and an offsetting debit entry to goodwill, because the seller paid no actual cash.15 This results in increasing the buyer's purchase price. The courts have not weighed in on the buyer's tax treatment.
To make things more complicated, in Rev. Rul. 76-520, the IRS held that buyers are required to capitalize costs incurred in servicing the unearned revenue contracts that were acquired from sellers. Presumably, the IRS would require the buyer's expenses incurred to fulfill the subscription contracts to be capitalized as part of the purchase price when the buyer incurs the expenses.16
It is unclear whether both of these rulings should be applied to the same transaction or whether buyers can choose one ruling.17
Purchase agreement language
Buyers and sellers would benefit from clearly defining in their purchase agreements how deferred revenue will be treated for income tax purposes.18 For example, it would be wise to require the seller to recognize deferred revenue as ordinary income as of the closing date and to state that none of the deferred revenue balance will carry over to the buyer for income tax purposes. Furthermore, it will be important to separately define what the future obligation will cost the buyer. The estimate of the future cost should be reserved as part of working capital instead of the entire unearned revenue balance. When possible, this future obligation that the buyer is assuming should be labeled with a different title instead of "unearned revenue."
One big obstacle is the GAAP treatment of unearned revenue in M&A transactions. When a target company is acquired, the GAAP reporting period does not end. The GAAP financials are focused on the target company's financial performance without regard to who the owner is. In a purchase, GAAP will require all assets acquired and liabilities assumed in a business combination to be recorded at their respective fair values. As a result, the target will normalize its gross margin, which will permit the target to recognize future revenue as the deferred revenue is earned subsequent to the acquisition date. GAAP will not require the seller to accelerate revenue recognition when a company is sold, nor will it require the buyer to capitalize costs post-closing. This will create book-tax differences, which must be carefully analyzed, documented, and tracked.
Permissible methods of revenue recognition for tax
Taxpayers have relied on Rev. Proc. 2004-34 to defer the recognition of income for tax purposes on prepayments.19 In general, taxpayers were able to defer income from advance payments for tax purposes if they adopted the accrual method and deferred the income for financial reporting purposes. However, taxpayers generally are not able to defer the income recognition beyond the year following the year of receipt.
As discussed above, the TCJA has modified Sec. 451 by effectively codifying the principles of Rev. Proc. 2004-34. Taxpayers are now able to defer income recognition based on how the income is recognized in their applicable financial statements.20 The new rules provide that accrual-method taxpayers receiving advance payments must recognize them as gross income in the year of receipt unless the taxpayer makes an election to defer the income. The deferred income must be recognized in the tax year following the year of receipt. The deferral is also accelerated in a year in which the taxpayer ceases to exist.21
Avoiding M&A surprises
It is critical to properly define the language in purchase agreements dealing with the tax treatment of deferred revenue accounts to help avoid surprises after closing, whether the adviser represents the buyer or the seller in an M&A transaction. The treatment of unearned revenue can have a material impact not only on taxes, revenue recognized by the seller, and revenue recognized by the buyer, but also on the amount of the working capital target in M&A transactions. Buyers and sellers would be wise to work together and bring more certainty to their intended tax treatment for unearned revenue for purposes of both tax and target working capital.
1P.L. 115-97. This article focuses on the federal income tax consequences and does not address state income taxation. This article also does not address the rules for long-term contracts under Sec. 460 or the rules for the treatment of deferred revenue in tax-deferred transactions.
2See Sec. 451(b), as amended by TCJA §13221(a).
4Note that taxpayers can now use the cash method of accounting for federal income tax purposes if their average annual gross receipts for the prior three years do not exceed $25 million. Also, such taxpayers can treat inventory as nonincidental materials and supplies and avoid the rules of Secs. 471 and 263A. SeeTCJA §13102.
5TCJA §13302 amends Sec. 172 to prevent net operating losses from being carried back.
6See FASB Concept Statement 6, ¶¶134-49.
7A typical liability account, such as accounts payable, accrued expenses, warranty reserves, inventory allowances, or allowances for bad debt is generally used to record expenses (e.g., a debit to salary expense and a credit to accounts payable). Debt is used to record borrowed funds (e.g., a debit to cash and a credit to long-term liability). Unearned revenue is used to record future income that is not yet recognized.
8This method was endorsed in Treasury Income Tax Ruling (Office Decision) I.T. 3369, 1940-1 C.B. 46, and became industry practice for accrual-method publishers.
9In practice, the unearned revenue balance is commonly used to estimate a buyer's future cost.
10James M. Pierce Corp., 38 T.C. 643 (1962).
11James M. Pierce Corp., 326 F.2d 67 (8th Cir. 1964). See also IRS Letter Ruling 7943156.
12The amount realized typically includes cash received plus liabilities assumed. See Crane, 331 U.S. 1 (1947).
13See Rev. Rul. 68-112. See also Commercial Security Bank, 77 T.C. 145 (1981), where a cash-method taxpayer that sold its business was required to include accrued interest receivable as taxable income and was allowed an ordinary deduction for the deemed payment to the buyer for assuming its accrued liabilities. This case also involved the sale of assets pursuant to a plan of liquidation, and the assumed obligation increased the sale price of the business assets but was not taxable due to the gain exclusion principles of Sec. 337 (pre-1986).
14As enacted in 1954, Sec. 337(a) provided that no gain or loss would be recognized by a corporation on the sale or exchange (or distribution) of property pursuant to (and within 12 months of) a plan of complete liquidation. This provision was revised by the Tax Reform Act of 1986, P.L. 99-514, §631(a), to limit the nonrecognition of gains and losses only to liquidations to which Sec. 332 applies.
15In general, Sec. 197 permits goodwill amortization ratably over 180 months.
16See Commercial Security Bank, 77 T.C. 145 (1981), where the assumption of "accrued business liabilities" of a cash-method taxpayer increased the sale price of the business assets at the close of the transaction, thus increasing the basis of the assets acquired by the buyer; cf. David R. Webb Co.,708 F.2d 1254 (7th Cir. 1983) (assumption of an obligation to make pension payments to the wife of an employee who died 20 years prior to the acquisition did not increase the basis of the business assets acquired at the close of the transaction; instead, the buyer's basis in the acquired assets increased when subsequent payments were made to satisfy the assumed obligation); Pacific Transport Co., T.C. Memo. 1970-41, rev'd per curiam, 483 F.2d 209 (9th Cir. 1973), cert. denied, 415 U.S. 948 (1974) (subsequent payment related to contingent liability related to lawsuits assumed by the parent company upon the liquidation of the subsidiary added to the parent's cost basis in the assets acquired); and Illinois Tool Works, Inc., 117 T.C. 39 (2001) (subsequent payment related to contingent liability related to a patent infringement lawsuit assumed by the buyer added to the buyer's cost basis of the property that was acquired in the asset acquisition).
17See AICPA letter to Andrew Keyso Jr., IRS associate chief counsel, dated April 23, 2015, regarding the tax treatment of deferred revenue in taxable asset acquisitions, available at www.aicpa.org.
18It should be noted that the IRS is not bound by contracts between taxpayers and can make its own determination of the proper application of the tax law.
19Rev. Proc. 2004-34 modifies and supersedes Rev. Proc. 71-21.
20Under Sec. 451(b)(3), "applicable financial statement" means a financial statement that is:
(1) certified as being prepared in accordance with GAAP and is: (a) a Form 10-K or annual statement to shareholders required to be filed with the SEC; (b) an audited financial statement of the taxpayer used for credit purposes, reporting to shareholders, partners, beneficiaries, or for any other substantial nontax purpose, but only if there is no statement described in (a); (c) filed by the taxpayer with any other federal agency for purposes other than federal tax, but only if there is no statement described in (a) or (b);
(2) made on the basis of international financial reporting standards and filed by the taxpayer with an agency of a foreign government that is the equivalent of the SEC and that has reporting standards no less stringent than those of the SEC, but only if there is no statement described in (1); or
(3) filed by the taxpayer with any other regulatory or governmental body specified by the IRS and Treasury, but only if there is no statement described in (1) or (2).
21Under Sec. 451(c)(4)(B), advance payments for the following items are not eligible for deferral: (1) rent; (2) insurance premiums; (3) payments with respect to financial instruments; (4) payments with respect to warranty or guarantee contracts under which a third party is the primary obligor; (5) payments subject to Sec. 871(a), 881, 1441, or 1442; and (6) payments to which Sec. 83 applies.
|Andy A. Torosyan, CPA, is a tax partner at Holthouse, Carlin & Van Trigt LLP, based in Los Angeles. Rob Razani, CPA, MST, is a revenue agent in the Large Business & International business unit of the IRS and an adjunct professor in taxation at California State University, Northridge, Calif. The comments in this article express the authors' personal views. For more information on this article, contact firstname.lastname@example.org.