Taxation of advance payments.

• Author: Monroe, Tracy J.

Rev. Proc. 2004-34 offers accrual-basis taxpayers several options to recognize income received from advance payments for goods or services, including deferral of some income into the succeeding tax year. In certain circumstances, a change to the deferral and the accrual accounting 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.

Background

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...