Deferred revenue: Transactional triggering events

Editor: Jeffrey N. Bilsky, CPA

Operating businesses in various industries often receive advance payments for goods or services that will be provided in the future, and the presence of deferred or unearned revenue in a balance sheet’s liabilities section is familiar to most practitioners. Although tax law does not simply follow the financial statement presentation, the law does sanction deferral in certain limited situations. A full discussion of available deferral methods for tax purposes is beyond the scope of this item, but the following summary of some common deferral provisions facilitates further discussion:

• Sec. 451(c) provides a one-year deferral for certain advance payments for, among other items, goods, services, and the use of intellectual property.
• Sec. 455 provides a deferral method for prepaid subscription income related to newspapers, magazines, or other periodicals.
• Sec. 456 provides a deferral method for prepaid dues income of certain membership organizations (such as automobile clubs).

The liabilities recognized under these provisions will here be collectively referred to as “deferred revenue liabilities.” The Code provisions (Secs. 455(b) and 456(b)) and regulations (Regs. Secs. 1.451–8(c)(4), 1.455–4, and 1.456–4) governing these deferral methods contain rules that require the taxpayer to recognize the deferred revenue during a year in which any one of the following occurs:

• The obligation to provide the associated goods or services ends; or
• The taxpayer dies or ceases to exist (with exceptions for certain transactions).

Taxpayers engaging in various legal transactions or making certain tax elections need to be mindful of the impact — favorable or unfavorable — these rules can have. The remainder of this item discusses the application of these rules to various situations.

Taxable transactions

When a taxpayer transfers its deferred revenue liability in a taxable asset sale, its obligation related to the payments is considered to end. Two approaches could be applied to this situation: the “assumption” approach and the Pierce approach, named for James M. Pierce Corp.,326 F.2d 67 (8th Cir. 1964).

Under the assumption approach, the seller recognizes three components related to the assumption of deferred revenue. First, the deferred balance yet to be realized for tax purposes is recognized into income. Second, the buyer is considered to assume the costs of performance (providing goods, services, etc.) related to the deferred revenue. This results in the assumption of a contingent liability that increases sale proceeds. Finally, the assumption of such liability gives rise to an equal and offsetting deduction. Under the assumption method, the buyer is simply viewed as acquiring the assets for the cash consideration paid and liabilities assumed and makes a purchase price adjustment for the cost of performance as the contingent liability is recognized.

Pierce sets out a significantly different approach, albeit with similar results to the seller. Instead of treating the buyer as assuming the contingent liability, Pierce treats the assumption of the balance as a payment from the seller to the buyer. This “Pierce payment” results in the buyer realizing ordinary income, which allows the buyer to deduct the cost of performance on a go–forward basis (versus amortizing the cost of performance as a component of the purchase price).

To the seller, two separate transactions are treated as occurring. First, all of the nondeferred revenue balances are transferred and sold for the consideration. Second, the deferred revenue is transferred to the buyer with the Pierce payment. The result is that the seller recognizes the deferred revenue yet to be included in taxable income and recognizes an immediate offsetting deduction for the payment. However, the assets (cash or otherwise) used to fund the payment are removed from the aforementioned “regular” asset sale component. As a result, the gain on the sale is higher, as there is less basis.

To summarize, under the assumption approach, the seller recognizes the deferred revenue and is treated as having additional proceeds and a deduction for the cost of performance assumed by the buyer. Under Pierce, the seller recognizes deferred revenue and recognizes an offsetting deduction for the Pierce payment but also experiences more gain on the regular asset sale. The effect is that the seller may recognize more gain on the asset sale under Pierce and more ordinary income under the assumption approach, but both methods should yield the same net taxable income.

Carryover transactions

In contrast to the taxable transactions described above, the regulations cited earlier contain an exception for certain transactions that result in a carryover of attributes from one taxpayer to another. As enumerated in Sec. 381, these transactions include certain liquidations of subsidiaries and reorganizations. In such cases, it is quite appropriate that the “new” taxpayer now holding the liability should succeed to the revenue deferral, just as it succeeds to the other tax attributes of the “old” taxpayer.

Tax-free transactions

The contribution of property into a corporation or partnership is generally regarded as a tax–free transaction, provided the respective requirements of Sec. 351 (for corporations) and Sec. 721 (for partnerships) are met. However, the transfer of a deferred revenue liability in such a transaction causes the contributor’s obligation to end and may also result in the contributor ceasing to exist. Thus, the contributor will generally be taxed on the now–accelerated revenue. This stands in contrast to the carryover transactions described above. There is a limited exception in Regs. Sec. 1.451–8(c)(4)(i)(B)(2) for certain Sec. 351 transactions where the transferor and transferee are members of the same consolidated group. Note, however, that this limited exception only applies to revenue deferred under Sec. 451(c) and not other deferral regimes.

While taxpayers may be able to use a deduction to offset the accelerated revenue in certain taxable transactions, the availability of such a deduction in Sec. 351 transactions (and, presumably, Sec. 721 transactions) is much less certain. The message from the IRS to date has been that it does not believe a corresponding deduction is appropriate in such cases. The IRS reached this conclusion in both General Counsel Memorandum (GCM) 39413 (Sept. 25, 1985) and GCM 37873 (March 5, 1979). The Service’s reasoning was that even if it were appropriate to view the transferor as having paid the transferee to assume its deferred revenue liability (as the court held in Pierce), this would not result in a deduction for the transferor. The deemed payment would be treated as additional contributed property under Sec. 351. The Service also stated that it finds no authority to permit the transferor a deduction for the amount of costs the transferee is expected to incur in fulfilling the liability.

Classification elections for tax-free transactions

The preceding outcome is relevant to entity classification elections. The check–the–box regulations allow eligible entities to change their tax classification between partnership, corporation, and/or disregarded entity as appropriate. While such a change would generally be regarded as tax–free, any such change will involve a series of contributions and/or distributions that may trigger the acceleration of any deferred revenue liabilities. A similar result may also occur in certain mergers or divisions of entities.

This can lead to various planning opportunities and/or traps for taxpayers. The acceleration of revenue may be beneficial where the “old” taxpayer has expiring net operating losses or is taxed at a lower rate than the “new” taxpayer, but it will be detrimental where the “old” taxpayer is subject to a higher rate. This is particularly relevant where tax rates differ between years, as may occur during periods of tax law change. In the case of partnerships, it is also important to consider how the additional income will be allocated under the partnership agreement, a point that will be rendered moot if the entity recognizes the revenue in a year it is treated as a corporation for tax purposes.

Due to these considerations, taxpayers are encouraged to carefully consider the presence of deferred revenue liabilities when contemplating a transaction or other entity restructuring.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.