Recognition of income when affiliates are used to provide services.

• Author: Portnoy, Lawrence F.

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...