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In United States v. Anderson, 269 U.S. 422, 441 (1926), the United States Supreme Court stated that a taxpayer using the accrual method of accounting must claim a deduction when “all the events [have occurred] which fix the amount of the [liability] and determine the liability of the taxpayer to pay it.”
The regulations provide an “all events test” for deductions and another “all events test” for recognition of gross income. Not surprisingly, the regulations are stingier about permitting deductions than requiring recognition of gross income.
Deductions: Reg. § 1.461-1(a)(2) provides in part:
Under an accrual method of accounting, a liability ... is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Section 461(h) defines “economic performance.” Its effect will be to defer recognition of deductions. Read it.
Income: Reg. § 1.451-1(a) provides in part:
Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy. ... Where an amount of income is properly accrued on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, shall be taken into account for the taxable year in which such determination is made. ... If a taxpayer ascertains that an item should have been included in gross income in a prior taxable year, he should, if within the period of limitation, file an amended return and pay any additional tax due. Similarly, if a taxpayer ascertains that an item was improperly included in gross income in a prior taxable year, he should, if within the period of limitation, file claim for credit or refund of any overpayment of tax arising therefrom.
An important condition that the Supreme Court permitted the Commissioner to incorporate into the accrual method of recognizing income is that taxpayer’s receipt of cash in exchange for its promise to render services to members of a club who might need them at some undetermined future time gave rise to gross income upon receipt of the cash, American Automobile Assoc. v. United States, 367 U.S. 687 (1961), irrespective of what Generally Accepted Accounting Principles (GAAP) may prescribe. Id. at 693. Taxpayer argued that it should be permitted to recognize a pro rated amount of income monthly. See alsoAutomobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957).
- How would the prepayments be taxed under § 5.02 of Rev. Proc. 2004-34, infra?
- Compare § 455 (prepaid subscription income).
The IRS has come around to the following accommodation of its position in AAA and that of taxpayers who, under the accrual method, may be expected to pay income tax on money that they received at a time that is (quite) different from when they are expected to earn it by performing services.
Rev. Proc. 2004-34
This procedure provides a method of accounting under which taxpayers using an accrual method of accounting may defer including all or part of certain advance payments in gross income until the year after the year the payment is received. ...
SECTION 1. PURPOSE
This revenue procedure allows taxpayers a limited deferral beyond the taxable year of receipt for certain advance payments. Qualifying taxpayers generally may defer to the next succeeding taxable year the inclusion in gross income for federal income tax purposes of advance payments (as defined in § 4 of this revenue procedure) to the extent the advance payments are not recognized in revenues (or, in certain cases, are not earned) in the taxable year of receipt. ... [T]his revenue procedure does not permit deferral to a taxable year later than the next succeeding taxable year. ...
....
SECTION 2. BACKGROUND AND CHANGES
.01 In general, § 451 of the Internal Revenue Code provides that the amount of any item of gross income is included in gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, the amount is to be properly accounted for as of a different period. Section 1.451-1(a) provides that, under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. 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. See Rev. Rul. 84-31, 1984-1 C.B. 127.
.02 Section 1.451-5 generally allows accrual method taxpayers to defer the inclusion in gross income for federal income tax purposes of advance payments for goods until the taxable year in which they are properly accruable under the taxpayer’s method of accounting for federal income tax purposes if that method results in the advance payments being included in gross income no later than when the advance payments are recognized in revenues under the taxpayer’s method of accounting for financial reporting purposes.
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SECTION 3. SCOPE
This revenue procedure applies to taxpayers using or changing to an overall accrual method of accounting that receive advance payments as defined in § 4 of this revenue procedure.
SECTION 4. DEFINITIONS
The following definitions apply solely for purposes of this revenue procedure --
.01 Advance Payment. Except as provided in § 4.02 of this revenue procedure, a payment received by a taxpayer is an “advance payment” if –
(1) including the payment in gross income for the taxable year of receipt is a permissible method of accounting for federal income tax purposes (without regard to this revenue procedure);
(2) the payment is recognized by the taxpayer (in whole or in part) in revenues in its ... financial statement ... for a subsequent taxable year (or, for taxpayers without an applicable financial statement ..., the payment is earned by the taxpayer (in whole or in part) in a subsequent taxable year); and
(3) the payment is for –
(a) services;
(b) the sale of goods (other than for the sale of goods for which the taxpayer uses a method of deferral provided in § 1.451-5(b)(1)(ii));
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(f) guaranty or warranty contracts ...;
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(h) memberships in an organization (other than memberships for which an election under § 456 is in effect); ...
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SECTION 5. PERMISSIBLE METHODS OF ACCOUNTING FOR ADVANCE PAYMENTS
.01 Full Inclusion Method. A taxpayer within the scope of this revenue procedure that includes the full amount of advance payments in gross income for federal income tax purposes in the taxable year of receipt is using a proper method of accounting under § 1.451-1, regardless of whether the taxpayer recognizes the full amount of advance payments in revenues for that taxable year for financial reporting purposes and regardless of whether the taxpayer earns the full amount of advance payments in that taxable year.
.02 Deferral Method.
(1) In general.
(a) A taxpayer within the scope of this revenue procedure that chooses to use the Deferral Method described in this § 5.02 is using a proper method of accounting under § 1.451-1. Under the Deferral Method, for federal income tax purposes the taxpayer must –
(i) include the advance payment in gross income for the taxable year of receipt ... to the extent provided in § 5.02(3) of this revenue procedure, and
(ii) ... include the remaining amount of the advance payment in gross income for the next succeeding taxable year.
....
(3) Inclusion of advance payments in gross income.
(a) Except as provided in paragraph (b) of this § 5.02(3), a taxpayer using the Deferral Method must –
(i) include the advance payment in gross income for the taxable year of receipt ... to the extent recognized in revenues in its applicable financial statement ... for that taxable year, and
(ii) include the remaining amount of the advance payment in gross income in accordance with § 5.02(1)(a)(ii) of this revenue procedure.
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(4) Allocable payments.
(a) General rule. A taxpayer that receives a payment that is partially attributable to an item or items described in § 4.01(3) of this revenue procedure may use the Deferral Method for the portion of the payment allocable to such item or items and, with respect to the remaining portion of the payment, may use any proper method of accounting (including the Deferral Method if the remaining portion of the advance payment is for an item or items described in § 4.01(3) of this revenue procedure with a different deferral period (based on the taxpayer’s applicable financial statement or the earning of the payment, as applicable)), provided that the taxpayer’s method for determining the portion of the payment allocable to such item or items is based on objective criteria.
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.03 Examples. In each example below, the taxpayer uses an accrual method of accounting for federal income tax purposes and files its returns on a calendar year basis. ...
Example 1. On November 1, 2004, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2004 and another 35 lessons in 2005. In its ... financial statement, A recognizes 1∕6 of the payment in revenues for 2004, and 5∕6 of the payment in revenues for 2005. A uses the Deferral Method. For federal income tax purposes, A must include 1/6 of the payment in gross income for 2004, and the remaining 5∕6 of the payment in gross income for 2005.
Example 2. Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2004, 48 lessons in 2005, and 40 lessons in 2006. In its ... financial statement, A recognizes 1∕12 of the payment in revenues for 2004, 6∕12 of the payment in revenues for 2005, and 5∕12 of the payment in gross revenues for 2006. For federal income tax purposes, A must include 1∕12 of the payment in gross income for 2004, and the remaining 11∕12 of the payment in gross income for 2005.
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Example 4. On July 1, 2004, C, in the business of selling and repairing television sets, receives an advance payment for a 2-year contract under which C agrees to repair or replace, or authorizes a representative to repair or replace, certain parts in the customer’s television set if those parts fail to function properly. In its ... financial statement, C recognizes 1∕4 of the payment in revenues for 2004, 1∕2 of the payment in revenues for 2005, and 1∕4 of the payment in revenues for 2006. C uses the Deferral Method. For federal income tax purposes, C must include 1∕4 of the payment in gross income for 2004 and the remaining 3∕4 of the payment in gross income for 2005.
Example 5. On December 2, 2004, D, in the business of selling and repairing television sets, sells for $200 a television set with a 90-day warranty on parts and labor (for which D, rather than the manufacturer, is the obligor). D regularly sells televisions sets without the warranty for $188. In its applicable financial statement, D allocates $188 of the sales price to the television set and $12 to the 90-day warranty, recognizes 1∕3 of the amount allocable to the warranty ($4) in revenues for 2004, and recognizes the remaining 2∕3 of the amount allocable to the warranty ($8) in revenues for 2005. D uses the Deferral Method. For federal income tax purposes, D must include the $4 allocable to the warranty in gross income for 2004 and the remaining $8 allocable to the warranty in gross income for 2005.
Example 6. E, in the business of photographic processing, receives advance payments for mailers and certificates that oblige E to process photographic film, prints, or other photographic materials returned in the mailer or with the certificate. E tracks each of the mailers and certificates with unique identifying numbers. On July 20, 2004, E receives payments for 2 mailers. One of the mailers is submitted and processed on September 1, 2004, and the other is submitted and processed on February 1, 2006. In its ... financial statement, E recognizes the payment for the September 1, 2004, processing in revenues for 2004 and the payment for the February 1, 2006, processing in revenues for 2006. E uses the Deferral Method. For federal income tax purposes, E must include the payment for the September 1, 2004, processing in gross income for 2004 and the payment for the February 1, 2006, processing in gross income for 2005.
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Example 12. On December 1, 2004, I, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. Upon payment of the fee, a member is allowed access for a 1-year period to I’s stores, which offer discounted merchandise and services. In its ... financial statement, I recognizes 1∕12 of the payment in revenues for 2004 and 11∕12 of the payment in revenues for 2005. I uses the Deferral Method. For federal income tax purposes, I must include 1∕12 of the payment in gross income for 2004, and the remaining 11∕12 of the payment in gross income for 2005.
Example 13. In 2004, J, in the business of operating tours, receives payments from customers for a 10-day cruise that will take place in April 2005. Under the agreement, J charters a cruise ship, hires a crew and a tour guide, and arranges for entertainment and shore trips for the customers. In its ... financial statement, J recognizes the payments in revenues for 2005. J uses the Deferral Method. For federal income tax purposes, J must include the payments in gross income for 2005.
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Notes and questions:
1. According to the revenue procedure, when must an accrual method taxpayer include income in his/her/its gross income?
2. Why was taxpayer in Example 13 able to defer recognition of income for tax purposes, but taxpayers in the other examples were not?
- In Artnell v. Commissioner, 400 F.2d 981 (7th Cir. 1968), the owner of the Chicago White Sox, an accrual method taxpayer, sold tickets in late fall of one year for games scheduled to be played the following spring and summer. [There’s never been much October baseball in Chicago.] In its financial statement, taxpayer recognizes the payments in revenue for the following spring and summer. Taxpayer sought to defer recognition of this ticket income until the following year. What result?
Do the CALI Lesson, Basic Federal Income Taxation: Timing: Cash and Accrual Methods of Accounting
Don’t worry about question 17, 18, and 19 (points on a mortgage).
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