Proposed Rev. Proc. on Advance Payments Clears Up Ambiguities

In Notice 2002-79, the IRS proposed a revenue procedure to allow certain taxpayers using the accrual method of accounting to defer the inclusion of certain advance payments in gross income in limited situations. If finalized, this revenue procedure will modify and supersede Rev. Proc. 71-21.

In general, Sec. 451 provides that the amount of any item of gross income is included in income in the tax year in which it is received by a taxpayer. According to Regs. Sec. 1.451-1(a), income is includible in gross income, under the accrual method, when all the events have occurred that fix the right to receive such income and the amount can be determined with reasonable accuracy. As interpreted by the courts and the Service, in the absence of a contingency affecting a taxpayers right to income, the all-events test is satisfied on the earliest of when (1) the income is received, (2) the income is due or (3) the required performance or events have occurred; see, e.g., Schlude, 372 US 128 (1963) and Rev. Rul. 84-31.

Under certain circumstances, Rev. Proc. 71-21 allows accrual-method taxpayers to defer the inclusion of payments received (or amounts due and payable) in one tax year if the payments are attributable to services to be performed by the end of the next succeeding tax year. The revenue procedure was designed to reconcile the tax and financial accounting treatment of payments received for services to be performed by the end of the next succeeding tax year, without permitting an extended income deferral for tax purposes.

Considerable controversy exists as to Rev. Proc. 71-21s scope. Specifically, taxpayers and the IRS frequently disagree about whether advance payments are for services, nonservices or a mixture of both. This distinction is important, as payments for nonservices and certain mixtures of services and nonservices do not qualify for deferral. In addition, it is unclear whether advance payments received under a series of agreements or a renewable agreement are within the revenue procedures scope. 

To reduce controversy, the Service issued the proposed revenue procedure, which would expand the scope of Rev. Proc. 71-21 to include:

• Advance payments for certain nonservices and mixed services/nonservices; and

• Advance payments received under an agreement or series of agreements, with a term extending beyond the end of the next succeeding year.

The proposed revenue procedure applies to accrual-method taxpayers that receive advance payments that are properly includible in income in the year received under Sec. 451, but are included in income for financial reporting purposes in a subsequent year. For this purpose, the term advance payment includes payments for the following:

• Services (other than service warranty contracts for which a taxpayer uses the accounting method provided in Rev. Proc. 97-38);

• The sale of goods (other than sales of goods for which a taxpayer uses a deferral method provided in Regs. Sec. 1.451-5(b)(1)(ii));

• The use of intellectual property (e.g., copyrights, trademarks, tradenames, etc.);

• The occupancy of space or the use of property if ancillary to the provision of services;

• Guaranty or warranty contracts ancillary to the above items;

• Subscriptions (other than those for which a Sec. 455 election is in effect);

• Memberships in organizations (other than those for which a Sec. 456 election is in effect); or

• Any combination of the above.

Advance payments do not include rent, insurance premiums or payments for financial instruments.

Under the proposed revenue procedure, a taxpayer may either (1) include the full amount of advance payments in taxable income in the year received (the full-inclusion method) or (2) include the advance payments in taxable income in the year received to the extent included for financial-reporting purposes, with the remainder included in the next succeeding tax year (the deferral method). Under no circumstances may the taxpayer defer income to a tax year later than the next succeeding tax year.

Unlike Rev. Proc. 71-21, the proposed revenue procedure does not require advance payments to relate to services expected to be provided in the next succeeding year, to be deferred. Thus, payments relating to multi-year or renewable contracts would be properly deferrable.

Under the proposed revenue procedure, a taxpayer who wants to change its treatment of advance payments to either the full-inclusion or the deferral method may obtain automatic consent under Rev. Proc. 2002-9 (as modified by Rev. Proc. 2002-19, Ann. 2002-17 and Rev. Proc. 2002-54). For this purpose, the scope limitations under Rev. Proc. 2002-9, Section 4.02, would not apply to a taxpayer changing its method for its first or second tax year ending on or after the date the final procedure is published, provided the taxpayers accounting method for advance payments is not an issue under consideration for tax years under examination.

If finalized, the revenue procedure would be effective for tax years ending on or after the date of its publication.

From Christine Woehrle, CPA, and Cathy Fitzpatrick, CPA, MST, Washington, DC