Taxation of advance payments.
Rev. Proc. 2004-34 offers accrual-basis taxpayers several options to recognize income received from advance payments for goods or services, including deferral deferral - Waiting for quiet on the Ethernet. of some income into the succeeding tax year. In certain circumstances, a change to the deferral and the accrual accounting Accrual Accounting
An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions happen.
Notes: methods can be done automatically. Before the procedure, taxpayers had to meet many tests to qualify for income deferral under either Rev. Proc. 71-21 (covering advance payments for services) or Regs. Sec. 1.451-5 (covering advance payments for goods). Additionally, taxpayers who previously wanted to change to the deferral method, for either services or goods, could not do so automatically before Reg. Proc. 2004-34.
Under Sec. 451 generally, taxpayers have to recognize income in the receipt year, unless, under the accounting method used in computing computing - computer taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. , they can properly account for such amount in a different period. There is a two-pronged test for recognizing income under the accrual accrual,
n continually recurring short-term liabilities. Examples are accrued wages, taxes, and interest. method. First, all events must occur to fix the taxpayer's right to receive the income (i.e., the all-events test); second, the amount of such income must be determinable Liable to come to an end upon the happening of a certain contingency. Susceptible of being determined, found out, definitely decided upon, or settled.
determinable adj. with reasonable accuracy. Taxpayers and the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. often had different views on how to apply these tests to advance payments.
In a trilogy A company founded in 1979 by Gene Amdahl to commercialize wafer scale integration and build supercomputers. It raised a quarter of a billion dollars, the largest startup funding in history, but could not create its 2.5" superchip. of cases, including Automobile Club of Michigan, 353 US 180 (1957), American Automobile Ass'n, 367 US 687 (1961) and Schlude, 372 US 128 (1963), the IRS's position of including prepayments Prepayments
Payments made in excess of scheduled mortgage principal repayments. for services in income at the time of receipt was solidified so·lid·i·fy
v. so·lid·i·fied, so·lid·i·fy·ing, so·lid·i·fies
1. To make solid, compact, or hard.
2. To make strong or united.
v.intr. . In each case, the fact that the services had to be performed on customer demand was deemed significant. Thus, there was no certainty as to when the services would be performed and the advance payments included in income. Further, each taxpayer's method of estimating performance over time was found to be purely artificial.
Following the trilogy, the IRS took the position that accrual-method taxpayers had to report income in the year in which they satisfied the all-events test or in the year of receipt, if earlier, unless they could precisely determine when services would be performed.
However, the Service also recognized that in certain specified circumstances, income deferral was warranted; it issued Rev. Proc. 71-21, which provided that accrual-method taxpayers could defer de·fer 1
v. de·ferred, de·fer·ring, de·fers
1. To put off; postpone.
2. To postpone the induction of (one eligible for the military draft).
v.intr. inclusion in gross income of payments received in one tax year for services to be performed by the end of the next succeeding tax year. Rev. Proc. 71-21 was limited, because it applied only to (1) services and (2) contracts that extended into the next tax year. For example, a company that provided security monitoring services The general surveillance of known air traffic movements by reference to a radar scope presentation or other means, for the purpose of passing advisory information concerning conflicting traffic or providing navigational assistance. under a five-year contract with annual prepayments could not defer income under Rev. Proc. 71-21.
Advance Payments for Goods
Regs. Sec. 1.451-5(b) sets forth the circumstances under which a taxpayer can defer recognizing income from an advance payment for goods. In general, the advance payment must be reported in (1) the year of receipt or (2) the earlier of the year in which the amount would otherwise be reported for tax purposes or in which the amount would be reported for financial accounting purposes. As such, taxpayers can possibly obtain a deferral of several years. However, to limit the deferral period, a special rule applies under Regs. Sec. 1.451-5(c) when (1) the advance payment is substantial and (2) the taxpayer has on hand, in the payment year, goods of a kind and quantity sufficient to satisfy the agreement. If these tests are met, all advance payments received under the agreement by the end of the second tax year following the receipt year are includible in income.
Taxpayers wishing to change their accounting method for advance payments under either Rev. Proc. 71-21 or Regs. Sec. 1.451-5 have to follow the advance consent procedures prescribed pre·scribe
v. pre·scribed, pre·scrib·ing, pre·scribes
1. To set down as a rule or guide; enjoin. See Synonyms at dictate.
2. To order the use of (a medicine or other treatment). in Rev. Proc. 97-27 (as modified by Rev. Proc. 2002-19) governing nonautomatic changes in accounting methods. Under the advance consent procedures, taxpayers have to pay a user fee and file for the change on or before the last day of their fiscal year. Automatic changes, which are governed by Rev. Proc. 2002-9, are due on or before the due date of the return for the change year (including extensions) and do not require a user fee.
Rev. Proc. 2004-34, Section 2.04 states:
Considerable controversy exists about the scope of Rev. Proc. 71-21. In particular, advance payments for non-services (and often, for combinations of services and non-services) do not qualify for deferral ... and taxpayers and the [IRS] frequently disagree about whether advance payments are, in fact, for "services." In addition to the issue of defining services ..., questions also arise about whether advance payments received under a series of agreements, or under a renewable agreement, are within the scope of Rev. Proc. 71-21. In the interest of reducing the controversy surrounding these issues, the Service has determined that it is appropriate to expand the scope of Rev. Proc. 71-21 ...
"Advance payments," as defined in Rev. Proc. 2004-34, Section 4.01(3), include (1) a payment for services or the sale of goods (except when the taxpayer uses the deferral method provided in Regs. Sec. 1.451-5(b)(1)(ii)); (2) the use of intellectual property; (3) the occupancy or use or property if ancillary to the provision of services; (4) the sale, lease or license of computer software; (5) some guaranty As a verb, to agree to be responsible for the payment of another's debt or the performance of another's duty, liability, or obligation if that person does not perform as he or she is legally obligated to do; to assume the responsibility of a guarantor; to warrant. or warranty contracts; (6) subscriptions (other than those for which a Sec. 455 election is in effect); (7) membership in an organization (other than one for which a Sec. 456 election is in effect); or (8) any combination of these items when a payment is received in advance of services or goods provided. Advance payments do not include (1) rent; (2) insurance premiums governed by subchapter L; (3) payments for financial instruments (including prepayment Prepayment
1. The payment of a debt obligation prior to its due date.
2. The excess payment over a scheduled debt repayment amount.
1. Examples include deferred expenses such as rent and early loan repayments.
2. of interest); (4) payments for a warranty contract under which a third party is the primary obligor The individual who owes another person a certain debt or duty.
The term obligor is often used interchangeably with debtor.
obligor (ah-bluh-gore) n. ; (5) payments subject to withholding Withholding
Any tax that is taken directly out of an individual's wages or other income before he or she receives the funds.
In other words, these funds are "withheld" from your wages. for either foreign corporations or individuals; and (6) payments in property to which Sec. 83 applies.
Accounting Methods Permitted
Rev. Proc. 2004-34, Section 5, outlines several permissible per·mis·si·ble
Permitted; allowable: permissible tax deductions; permissible behavior in school.
per·mis accounting methods for taxation of advanced payments. In addition to full inclusion, the deferral method is also permissible, in certain circumstances. For taxpayers with an applicable financial statement, advance payment income is recognized for tax purposes in year 1, to the extent that it is recognized for financial statement purposes. Any income not recognized in the receipt year generally must be recognized in the succeeding tax year. Short tax years of less than 92 days have special rules. Changes in accounting method to either the full inclusion method or the deferral method, with an applicable financial statement, are automatic changes. Under Rev. Proc. 2004-34, Section 4.06, an "applicable financial statement" is one that is (1) required to be filed with the Securities and Exchange Commission (SEC); (2) a certified See certification. audited financial statement accompanied by an independent CPA's report; or (3) a financial statement (other than a return) required to be provided to a Federal of state government of any Federal or state agency (other than the SEC or IRS).
Taxpayers without an applicable financial statement would still be allowed an automatic change to the deferral method if they could determine how much of the advance payment was earned in the receipt year. If taxpayers cannot determine this, they can use statistics (if adequate data is available), using straight-line ratable That which can be appraised, assessed, or adjusted through the application of a formula or percentage.
Ratable property is that which is taxable or capable of being appraised or assessed.
ratable adj. basis over the life of the contract (however, they will still need to recognize all income by the end of the succeeding tax year), or any other method that clearly reflects income. Only income recognized over the straight-line method Noun 1. straight-line method - (accounting) a method of calculating depreciation by taking an equal amount of the asset's cost as an expense for each year of the asset's useful life
straight-line method of depreciation will be afforded treatment as an automatic accounting-method change.
Effective Date of Election
Taxpayers that qualify for an automatic change to the full inclusion, deferral or accrual method, if applicable, can make that change for any tax year ending after Dec. 30, 2003, provided their accounting method for advance payments is not an issue under consideration for any tax year under examination.
Making the election: For purposes of Line 1a, Form 3115, Application for Change in Accounting Method, the designated automatic accounting-method change numbers are 83 for changes to the full-inclusion method, 84 for the deferral method and 30 for the overall accrual-accounting method. The taxpayer must file a single Form 3115 for changes to the treatment of advance payments and to the overall accrual accounting method.
In lieu of Instead of; in place of; in substitution of. It does not mean in addition to. providing the information and documentation required by Form 3115, Line 1, Schedule B, a taxpayer changing to the deferral method must:
1. State whether it has an applicable financial statement and, if so, identify the type;
2. Describe the basis used for deferral; and
3. If the taxpayer has payments allocable al·lo·ca·ble
Capable of being allocated.
Adj. 1. allocable - capable of being distributed
distributive - serving to distribute or allot or disperse to categories other than qualified advance payments, include a statement that the allocation method is based on payments the taxpayer regularly receives for an item or items it regularly provides separately.
Taxpayers that already timely filed their return for the tax period ending after Dec. 30, 2003, and that want to change the accounting method for advance payments under the automatic-change procedures, are granted an automatic six-month extension from the original due date of the return for the change year (excluding extensions), provided that the taxpayer attaches Form 3115 to an amended return Amended Return
A return filed in order to make corrections to a tax return from a previous year. It can be used to correct errors and claim a more advantageous filing.
An amended return is filed using Form 1040X. for the change year and otherwise complies with Rev. Proc. 2002-9.
Taxpayers without an applicable financial statement that desire to change to a deferral method in which income is recognized based on a statistical basis or some other manner deemed appropriate, do not qualify for an automatic accounting change and have to use Rev. Proc. 97-27, which governs advance consent changes (i.e., nonautomatic changes). In lieu of providing the information and documentation required by Form 3115, Schedule B, Line 1, taxpayers changing to the deferral method must:
1. State whether they have an applicable financial statement and identify the type;
2. Describe the basis for deferral;
3. Provide a redacted copy of representative contracts;
4. If the taxpayer has allocated payments, include a representation that the claimed allocation is based on objective criteria and a description of the criteria used; and
5. If the taxpayer plans to recognize advance payments on a statistical basis, describe that basis (including the data and methodology) or, if the taxpayer desires to recognize income on a nonstatistical basis, explain how the basis for deferral results in a clear reflection of income.
The accounting-method change for advance payments under the advance consent provisions is effective for years ending after May 5, 2004.
Partial attribution at·tri·bu·tion
1. The act of attributing, especially the act of establishing a particular person as the creator of a work of art.
2. : Rev. Proc. 2004-34, Section 5.02(4), also allows taxpayers to treat a payment partially attributable to an item as an advance payment. The taxpayer may use the deferral method for the portion allocable to such item and any other proper accounting method for the remaining portion of the payment, provided the taxpayer's method for determining the portion allocable to such item is based on objective criteria. A taxpayer's allocation method will be deemed objective if the taxpayer regularly receives payments for an item or items that it regularly sells or provides separately.
Taxpayers may be required to accelerate advance payments in income under the deferral method. All advance payments not previously included in gross income will be accelerated if, in the tax year, the taxpayer dies or ceases to exist in a transaction other than a transaction to which Sec. 381(a) applies. Sec. 381(a) applies to liquidations and reorganizations when the acquiring company succeeds to the target's tax attributes. Additionally, a taxpayer is required to accelerate income recognition if it satisfies its obligation as to advance payment in some other manner before the end of the succeeding tax year.
The following examples from Rev. Proc. 2004-34 illustrate these points.
Example 7: F, a hair styling studio, receives advance payments for gift cards that may later be redeemed re·deem
tr.v. re·deemed, re·deem·ing, re·deems
1. To recover ownership of by paying a specified sum.
2. To pay off (a promissory note, for example).
3. for hair styling services or hair care products at the card's face value. The cards look like standard credit cards; each has a magnetic strip that identifies the available balance. They cannot be redeemed for cash and have no expiration date Expiration Date
The day on which an options or futures contract is no longer valid and, therefore, ceases to exist.
The expiration date for all listed stock options in the U.S. . In its applicable financial statement, F recognizes advance payments for cards when redeemed. It cannot determine the extent to which advance payments are recognized in revenue for the tax year of receipt and, thus, does not meet the requirements for deferral. Further, F does not determine under an acceptable basis (e.g., statistical, straight-line or other method deemed appropriate) the extent to which payments are earned for the tax year of receipt. Thus, it may not use the deferral method for these advance payments.
Example 8: The facts are the same as in Example 7, except (1) the gift cards have an expiration date 12 months from the date of the sale, (2) expired gift cards are not accepted and (3) F recognizes unredeemed gift cards in revenue in its applicable financial statement for the tax year in which the cards expire.
In Example 8, F can use the deferral method for the advance payments, because it can determine the extent to which such payments are recognizable in income for the receipt year and the subsequent year in which the cards expire.
Rev. Proc. 2004-34 has greatly expanded the options for recognizing income from advance payments for goods and services In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility (unless the "good" is a "bad"). It is often used when referring to a Goods and Services Tax. . For many taxpayers, it will provide an opportunity to defer income recognition from such payments into the succeeding tax year. Taxpayers need to analyze their clients' situations and advise them of this new opportunity.
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