Gift cards remain a popular offering, with sales exceeding $200 billion annually. But when must retailers recognize income from gift card sales for tax purposes? Can related deductions be taken immediately, or only as gift cards are redeemed over time? Get it wrong, and businesses face cash flow headaches or penalties.
The IRS Office of Chief Counsel recently released guidance directly addressing the tax treatment of gift card programs in TAM-121007-08. This guidance is a reminder that tax planning strategies are needed to minimize tax distortions caused by the sale of gift cards.
Accrual Method Taxpayers
The IRS gift card guidance primarily affects taxpayers using an accrual method of accounting, so we first have to start with these concepts.
Accrual method is different than the cash method. The key difference between the two lies in when income and expenses are recognized.
Cash method – Income is reported when cash or payment is actually received. Expenses are deducted only when paid. There are no timing differences or mismatches. The cash method ties income and deduction timing directly to inflows and outflows.
Accrual method – Income is generally recognized as soon as the right to receive the income becomes fixed and determinable. This is known as the “all events test.” Expenses are deducted when a definite liability is incurred. Accrual accounting recognizes income when the “all events test” is satisfied – when the right to receive income becomes fixed and determinable. There can be timing mismatches between income recognition and the related cash flows.
Accrual accounting aims to match revenue and expenses to the period in which transactions, events, or obligations occur, regardless of when cash changes hands. The cash method simply follows the cash flows. As you can see, the accrual method differs from cash method taxpayers who don’t report income until cash or payment is actually received.
Which method is best depends on the taxpayer’s business model and what provides the clearest picture of income.
IRS Gift Card Guidance
TAM-121007-08 provides instructions on the timing of income recognition and deductions related to gift card sales and redemptions for accrual method taxpayers.
The memo uses this example – if an accrual method retailer sells $100 of gift cards in Year 1 but only $50 is redeemed that same year, the full $100 of income must be reported in Year 1 but only a $50 deduction is allowed. The timing mismatch continues into future years as more cards are redeemed.
For accrual method taxpayers who sell gift cards, the IRS states the all-events test is satisfied upon the customer’s purchase. At that point, the business gains an unrestricted right to the sale proceeds so income recognition cannot be deferred even though goods will be provided later. In contrast, deductions under accrual accounting arise only when a fixed liability is incurred, such as when gift cards are actually redeemed by customers.
So accrual taxpayers must report gift card income when received but can only deduct related costs as gift cards are used. The all-events test mandates this mismatch across tax years.
To illustrate, consider this example:
- In Year 1, a retailer sells $1,000 in gift cards, recognizing $1,000 of income.
- By Year 1 year-end, $200 of cards are redeemed, creating a $200 deduction.
- In Year 2, $500 of the original cards are redeemed, generating a $500 deduction.
- The remaining $300 is redeemed in Year 3 for a final deduction.
The original $1,000 in income was fully recognized in Year 1, but deductions lagged behind in each year gift cards were redeemed.
Strategies to Minimize Negative Tax Impacts
What planning steps can businesses take to minimize the negative tax consequences of gift card accounting?
- Consider deferring revenue recognition closer to redemptions through methods like estimating breakage. Require professional guidance on proper procedures.
- Structure gift card programs to incentivize redemption soon after purchase to accelerate deductions.
- Develop reliable gift card usage estimates for tax planning and provisioning.
- Discuss tax accounting method change procedures if desired, but expect high hurdles.
Proper compliance, tracking, documentation, and planning are imperative to maximize tax position strength–which is critical in case of an IRS audit.
Tax Treatment of Trading Stamp Companies
The tax issues around gift card accounting have parallels in the treatment of trading stamp companies. The trading stamp company rules should be considered, as providing a point-based system rather than a gift card system can make a lot of sense for some taxpayers.
Historically, trading stamp companies issued stamps or coupons to retailer customers who then distributed them to consumers as rewards or incentives. Once consumers accumulated enough stamps, they could redeem them for products from the trading stamp company’s catalog. Modern day trading stamp companies are best represented by fuel point rebates and flight and hotel rebates based on points. The old Starwood SPG are an example.
Trading stamp companies are provided for in sections 405a and 451(b) of the tax code. These sections provide deduction rules and income deferral methods for trading stamp companies. These provisions acknowledge the mismatch between when stamps are issued and when consumers ultimately redeem them. For example, trading stamp companies can only deduct the cost of redeemed stamps/coupons in the tax year of redemption. And they can defer including unredeemed stamps in income until redemption. This treatment aligns income and deductions more closely.
While trading stamp company rules don’t apply directly to modern gift card programs, the underlying concepts are similar–prepaid receipts where liability timing is uncertain. The parallels help illustrate the broader tax policy issues.
The income timing rules for gift card sales can create challenges. However, with care and expertise, retailers can appropriately manage their tax obligations. Key considerations include properly reporting income when received, claiming deductions when cards are redeemed, and crafting tax strategies to align tax liability with business cash flows. Consult a tax advisor to ensure income and expenses are handled correctly.