Gift card sales are becoming more and more a part of our retail shopping experience. The IRS is aware that the popularity of gift cards has increased “at a remarkable rate in recent years” (LMSB-04-0507-039).
Gift card sales raise a variety of interesting federal income tax questions. The answers to these questions may depend on who is selling the gift card and for whom. For example, certain federal income tax issues arise with the use of gift card managing subsidiaries (gift card companies, described in more detail below) to sell gift cards and also with the sale of cross-redeemable gift cards.
The IRS announced that it plans to focus more on this area. Given the level of gift card sales and the surrounding tax issues, one might think that the IRS would have resolved some of the questions. But as of the writing of this item, the IRS has not yet provided answers—only more questions.
This item highlights certain issues raised by a recent IRS Large and Mid-Size Business (LMSB) Division directive dated Oct. 3, 2008, about the treatment of revenue from the sale of gift cards (IDD No. 2). Before discussing IDD No. 2, however, this item discusses a March 26, 2007, field attorney advice (FAA) (released July 11, 2008) discussing the proper treatment of gift card sales and a prior LMSB directive (IDD No. 1) discussing gift cards dated May 23, 2007.
Proper Treatment of Sales by a Gift Card Company
FAA 20082801F addressed several revenue recognition issues that arise in connection with the sale of gift cards by a gift card company. The company described in the FAA was a separate wholly owned subsidiary of the taxpayer and did not have any inventory of its own. The FAA addressed specifically:
Whether the gift card company had income from the sale of gift cards;
When proceeds from the sale of gift cards were to be included in income; and
When the gift card company could take a deduction in connection with the redemption of gift cards.
The FAA first discussed whether the money received by the gift card company constituted income to that company. The FAA stated that the gift card company received the money under claim of right and therefore had income from the sale of gift cards. The FAA held that the amounts received by the company were not in the nature of a deposit because such amounts were not generally refundable to either the retail stores or the customers who purchased the gift cards. The FAA stated that the gift card company “will keep the proceeds from the gift card purchases unless, and until, the consumer redeems the gift card (a condition subsequent).”
The FAA next held that a gift card company may not rely on Treas. Reg. § 1.451-5 to defer the recognition of income because the amount collected for the gift cards is not an advance; the cards will not be redeemed for goods held for sale by the gift card company. The FAA also held that, under the facts presented, the taxpayer could not rely on Rev. Proc. 2004-34 to defer revenue recognition because the gift card company was unable to determine the extent to which it would recognize the amounts received as revenue in the gift card company’s applicable financial statements in a particular year.
However, the FAA and the language of Rev. Proc. 2004-34 seem to support the idea that a gift card company can use Rev. Proc. 2004-34 to defer revenue recognition despite the fact that the company has no inventory of its own. The FAA stated that the gift card company had a “liability … to provide gift card customers with ... products.”
It is important that the IRS viewed the gift card company as having the liability to provide goods in the future because Rev. Proc. 2004-34 defines an “advance payment” as including a payment received for the sale of goods. In other words, the language of Rev. Proc. 2004-34 supports that a taxpayer with no inventory can obligate itself to sell goods (and can therefore receive an advance payment for goods).
Specifically, Rev. Proc. 2004-34, § 5.02(5), provides that any deferred revenue relating to the advanced payment will be accelerated once the underlying liability is satisfied (by another party). Therefore, when a retailer satisfies the gift card company’s obligation to provide goods, the gift card company would recognize the deferred revenue associated with that gift card (assuming it has not been recognized earlier under Rev. Proc. 2004-34).
IDD No. 1
IDD No. 1 (LMSB-04-0507-039) identifies two categories: Part A issues and Part B issues. The directive requires examining agents to raise Part A issues during an examination and to contact an LMSB Food and Beverage or Retail technical adviser.
The Part A issues in IDD No. 1 involve the application of Treas. Reg. § 1.451-5. The first Part A issue raised in the IDD was whether the IRS should deny a taxpayer the use of Treas. Reg. § 1.451-5 if the taxpayer fails to include the information schedule required by Treas. Reg. § 1.451- 5(d). The practical answer in the IDD seems to be that examining agents may overlook noncompliance in situations in which a “taxpayer inadvertently left off the information schedule” but should “pursue the issue” where the taxpayer consistently did not include the information return as required.
The second Part A issue raised by the IDD was whether a taxpayer must complete a Form 3115, Application for Change in Accounting Method, to change to the deferral method. The IDD states that the treatment of gift cards is a “material item” and that a change to a deferral method of accounting (under either Rev. Proc. 2004-34 or Treas. Reg. § 1.451-5) would require the filing of a Form 3115.
The IDD clarifies that gift cards and gift certificates are essentially the same item and that the transition from gift certificates to gift cards does not create a “new item” that would allow a taxpayer to adopt a method of accounting for that item (as opposed to requesting a change in accounting method).
The third Part A issue raised by the IDD was whether a taxpayer may use estimates to determine the amount of unredeemed gift cards. The IDD indicates that a taxpayer may not use estimates for this purpose. The IDD goes on to list, but does not discuss, a number of other issues that are categorized as Part B issues: gift cards vs. gift receipts; reloadable gift cards; deposits; gift cards as refunds; dormancy fees; escheatment to states; bulk sales discounts; promotional gift cards; charitable contribution of gift cards; estimated cost of goods sold; franchisee/franchisor gift cards; expiration dates; and Rev. Proc. 2004-34. Several of these issues are highlighted in IDD No. 2, which was issued on Oct. 3, 2008.
IDD No. 2
Like IDD No. 1, IDD No. 2 (LMSB 4-0808-042) contains two categories: Part A issues (these must be raised during the examination, and contact must be made with technical advisers) and Part B issues (contact should be made with the technical advisers). The sole Part A issue discussed in IDD No. 2 involves the use of a gift card company (as in the FAA described above) to sell gift cards/certificates. IDD No. 2 states that the primary issue in this context is whether the gift card company has goods available for sale in the ordinary course of its trade or business and is therefore eligible to use a revenue deferral method under either Treas. Reg. § 1.451-5 or Rev. Proc. 2004-34. IDD No. 2 then points out that FAA 20082801F provides a legal analysis of these issues.
It is not surprising that the directive chose to treat the use of Treas. Reg. § 1.451- 5 as a Part A issue. It is surprising, however, that the directive uses language indicating that there may be an inventory requirement associated with the use of the deferral method under Rev. Proc. 2004-34, given the fact that FAA 20082801F and the language in Rev. Proc. 2004-34 support that a taxpayer with no inventory can use Rev. Proc. 2004-34.
IDD No. 2 raises, but provides no conclusions on, several Part B issues. The following are some (but not all) of the Part B issues raised:
Reloadable gift cards: These are cards that allow value to be added after the initial purchase. IDD No. 2 states that examining agents should verify that the taxpayer’s accounting system tracks the actual dates when money is added to the card for purposes of income deferral.
Deposits: The issue is whether proceeds from the sale of a gift card/certificate could be viewed as a deposit (as opposed to income). IDD No. 2 states that if a taxpayer excludes gift card/certificate proceeds from taxable income (that is, treats proceeds as a deposit), the issue needs to be brought to the attention of a Retail technical adviser.
Gift cards as refunds: The issue is whether a taxpayer can “void” the original sale of goods where a customer later returns the goods and receives a gift card in lieu of cash. IDD No. 2 states that the technical advisers are currently formulating a position on this issue.
Sale of gift cards/certificates by unrelated third parties: Numerous retail and restaurant outlets sell gift cards/certificates through unrelated third parties. The issue is whether a taxpayer that sells gift cards/certificates on behalf of an unrelated entity has income on the receipt of the gift card/certificate proceeds and, if so, whether it can use a revenue deferral method under either Treas. Reg. § 1.451-5 or Rev. Proc. 2004-34. IDD No. 2 asks examining agents to contact a technical adviser if faced with this issue.
IDD No. 2 raises several other issues and asks that examining agents faced with such issues contact a technical adviser.
Although the two industry directives are not official pronouncements of the law or the position of the IRS and cannot be used, cited or relied on as such, the directives put taxpayers on notice that the IRS is planning to focus more attention on the issues raised by the sale of gift cards. Unfortunately, taxpayers currently are left with no firm answers in the form of official guidance as to how the IRS will rule on any of these issues; however, guidance on the treatment of gift cards is an item on the Treasury Department and IRS business plan.
Richard Shevak, Esq., is a manager in Grant Thornton LLP’s Washington, D.C. office.
This article appeared in the February 2009 issue of The Tax Adviser, the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price. Call 800-513-3037 or e-mail firstname.lastname@example.org for a subscription to the magazine or to become a member of the Tax Section.