If an accrual method taxpayer issues a gift card, does the taxpayer have to recognize taxable income at the time that the card is sold or when the card is redeemed? The IRS Office of Chief Counsel recently issued a legal memorandum that addresses this question.
According to the IRS attorneys, taxpayers who issue gift cards are to recognize income for federal tax purposes when its gift cards are purchased. The IRS attorneys also conclude that taxpayers are not able to deduct the expense until the time that the gift cards are used.
Here is an example based on the conclusion reached by the IRS attorneys. Say that an accrual method business issues ten $10 gift cards in year one. The business would recognize $100 of income at the time that the gift cards were purchased. If five of the gift cards were used at participating stores in year one, the business would be required to pay $50 to the stores. The business would be able to deduct this expense in year one. If three of the gift cards were used at participating stores and the business paid the stores $30 in year two, the business would be able to deduct the $30 expense in year two. If the two remaining gift cards are not ever used, the business will not be entitled to a deduction for the remaining amount.
In analyzing the tax consequences of gift cards, the IRS attorneys compare payment for the gift cards to situations where a taxpayer receives a non-taxable deposit. With deposits, the recipient generally does not have to recognize income at the time of the payment because the recipient is, in most cases, required to refund the monies at some future time.
The recipient may have to recognize the payment as income when the recipient becomes entitled to retain the payment. This is often referred to as the “all events test.” This test provides that all the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. This often occurs at a subsequent date when the recipient does something to earn the money, such as when the recipient provides a product or service to the payee.
The IRS attorneys discounted the fact that the taxpayer who issued the gift cards may have to refund the monies at any time. The IRS attorneys argue that the payor has immediate control over the payments, given the uncertainties associated with the amount and timing of when the gift cards will be redeemed. In support of this position, the IRS attorneys noted that the taxpayer had not deposited the sale proceeds into a separate account.
The IRS attorneys do note that the result may be different if the payment is actually an advance payment for the sale of the payor’s own goods. If this is the case, the payment may fit within an exception in the Regulations.