Taxation of advance payments.
Under Sec. 451 generally, taxpayers have to recognize income in the receipt year, unless, under the accounting method used in computing taxable income, they can properly account for such amount in a different period. There is a two-pronged test for recognizing income under the accrual 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 with reasonable accuracy. Taxpayers and the IRS often had different views on how to apply these tests to advance payments.
In a trilogy 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 for services in income at the time of receipt was solidified. 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 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 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 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 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 of interest); (4) payments for a warranty contract under which a third party is the primary obligor; (5) payments subject to withholding 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 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 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 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 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 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 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 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: 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 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. 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. 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.
FROM TRACY J. MONROE, CPA, MT, COHEN & COMPANY, LTD., CPAs, AKRON, OH
|Printer friendly Cite/link Email Feedback|
|Author:||Monroe, Tracy J.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 2004|
|Previous Article:||Getting started in ElderCare/PrimePlus.|
|Next Article:||Net unrealized appreciation.|