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Recognition of income when affiliates are used to provide services.

Does the use of affiliates or independent contractors to provide services preclude the ability of a taxpayer to defer recognition of advance payments under Rev. Proc. 71-21?

Service providers often receive payment at the beginning of a contract to provide services. This situation arises when, for example, as part of the sale of a new appliance, the dealer also sells a separate contract under which he agrees to make all required repairs during the contract period.

When are these payments recognized as income? The general rule, based on Schlude, 372 US 128 11963), and American Automobile Association, 367 US 687 (1961), requires that service providers recognize advance payments as revenue when the payments are received. Rev. Proc. 71-21 is an exception to this general rule; it applies to accrual-basis service providers when, under the service agreement as it exists at the end of the tax year in which payment is received, all of the services are required to be performed by the end of the next succeeding tax year. Advance payments are generally recognized as income when the services are performed or, if it is difficult to determine when the services are provided, pro rata over the term of the contract. In order to qualify for Rev. Proc. 71-21 treatment, a number of conditions must be fulfilled.

One of the requirements in Rev. Proc. 71-21 that a taxpayer must meet is that the services must be "performed by him." What does this mean in the context of a taxpayer who may have an affiliated entity or an independent contractor perform the service? In a recent accounting method change request, several members of the IRS National Office articulated that a taxpayer who at times uses an affiliated company or an independent contractor to actually perform the service would not be permitted to defer the recognition of advance payments (assuming all other conditions of Rev. Proc. 71-21 are met), since the services were provided by someone other than the taxpayer who entered into the service agreement. The IRS National Office believes this applies even though the taxpayer bears the full obligation to perform and the complete economic risk, and the customer may never know the services were not provided directly by the taxpayer. Therefore, their view is that "him" applies only to the taxpayer.

The authors believe this is overly restrictive. The Service asserts that Rev. Proc. 71-21 was designed to be a very narrow exception to the advance payment recognition rules; thus, this interpretation is not unreasonable.

What options are available to taxpayers whose service agreements contain a clause permitting the service to be performed by an affiliated company? There are several alternatives: (1)Delete the clause and change the way business is conducted so only the taxpayer is authorized to and does provide services (probably not a practical alternative); (2) change the method of revenue recognition (not a good results; or is) fight it out if the issue is raised on examination. Hopefully, an appeals officer or the courts will apply a less restrictive interpretation of the phrase "performed by him" than that used by the IRS National Office.

After all, if the taxpayer still bears the complete economic risk under the agreement, what abuse results by allowing affiliates to perform services? The answer appears to be there is no abuse, so there is no rational basis for objecting to the use of affiliates under these circumstances.

From Lawrence F. Portnoy, CPA, and Everett E. Gallagher, CPA, Washington, D.C.
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Author:Gallagher, Everett E.
Publication:The Tax Adviser
Date:Jul 1, 1992
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