IRS issues guidance on treatment of gift cards.

• Author: Van Leuven, Mary

In recent years, the sale of gift cards, as well as the issuance of gifts cards to customers in exchange for returned merchandise, has become a widespread business practice in consumer markets industries, especially the retail industry. This increasing use of gift cards and the disparity between federal tax accounting and financial accounting treatment of advance payments have led to inconsistency among taxpayers and confusion as to the proper timing of recognizing income from the sale of gift cards--particularly in situations when the gift cards may be redeemed by someone other than the taxpayer--and the proper treatment of gift cards issued to customers in exchange for returned merchandise. This item provides background information on the tax and accounting treatment of gift card income and discusses two revenue procedures that address these issues.

Gift Card Income

In general, Sec. 451 and the regulations thereunder require accrual-method taxpayers to include an item in gross income when the all-events test is met or, as interpreted by the courts, at the earliest of when it is received, due, or earned (Schlude, 372 U.S. 128 (1963); Rev. Rul. 84-31). Thus, when a taxpayer receives an advance payment for goods or services before the goods or services are provided, the payment must generally be included in gross income upon receipt; however, Regs. Sec. 1.451-5 and Rev. Proc. 2004-34 provide limited exceptions to the general rule, allowing deferral of advance payments.

Regs. Sec. 1.451-5 allows deferral of an "advance payment," defined in relevant part as "any amount which is received ... pursuant to, and to be applied against, an agreement ... [f] or the sale or other disposition in a future taxable year of goods held by a taxpayer primarily for sale to customers in the ordinary course of his trade or business." For this purpose, an "agreement" includes a gift card that can be redeemed for goods. The income related to the gift card can generally be deferred until the earlier of when a cardholder uses the card or the second tax year following the year of the card's purchase.

Rev. Proc. 2004-34 also provides a deferral method but defines an advance payment differently than Regs. Sec. 1.451-5. Under the revenue procedure, a payment is an advance payment if:

* Including the payment in gross income for the year of receipt is a permissible method;

* The taxpayer recognizes the payment (in whole or in part) in revenues in its applicable financial statement for a subsequent tax year; and

* The payment is one of the specific items enumerated in the revenue procedure, which includes payments for services or the sale of goods (except when the taxpayer uses the Regs. Sec. 1.451-5 deferral method).

The taxpayer may defer an advance payment to the extent it is deferred for financial statement purposes in the year of receipt, but must include it in gross income in the succeeding tax year.

How retailers market, sell to customers, and redeem gift cards has evolved over time; cards are now commonly sold by one taxpayer and redeemed either by the selling taxpayer or by others, whether related or unrelated to the selling entity.

Before...