New Guidance for Vendors Income Recognition

Sec. 451 provides that the amount of any item of gross income has to be accrued in gross income for the tax year in which received by the taxpayer, unless such amount can be properly accounted for as of a different period under the accounting method used in computing taxable income. Generally, Regs. Sec. 1.451-1(a) provides that gains, profits and income have to be included in gross income in the tax year in which they are actually or constructively received by the taxpayer, unless includible in a different year under the accounting method used.

Under the accrual accounting method, income is includible in gross income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy; see Anderson, 269 US 422 (1926), and Regs. Secs. 1.451-1(a) and 1.446-1(c)(1)(ii). The all-events test is based on the existence or nonexistence of legal rights or obligations at the close of a particular accounting period (Hallmark Cards, Inc., 90 TC 26, 34 (1988)).

Although neither the Code nor the regulations have specific rules for determining when the right to an item of income becomes fixed, the Services position is that accrual-method taxpayers have to recognize income at the earliest of when it is paid, due or earned; see Rev. Rul. 74-607 and Schlude, 372 US 128 (1963). Generally, when the taxpayer receives income, it must accrue that amount, unless the receipt is subject to substantial limits or restrictions or is a deposit or loan. A contract or agreement allowing merchandise returns is not a limit or restriction permitting nonaccrual; see Continental Ill. Corp., 998 F2d 513, 520-521 (7th Cir. 1993), cert. den., and J.J. Little & Ives Co., Inc., TC Memo 1966-68.

A variety of circumstances affect whether an amount is includible in income in a particular tax year and the adjustments to be made for amounts erroneously included. When revenue from a merchandise sale is otherwise accruable under a taxpayers accounting method, a contest or dispute prevents accrual of income in the tax year that it would otherwise be includible in income. Although undefined in the Sec. 451 regulations, Regs. Sec. 1.461-2(b)(2) defines contest (from the obligors perspective) as a bona fide dispute as to the proper evaluation of the law or the facts necessary to determine the existence or correctness of the amount of an asserted liabilityAn affirmative act denying the validity or accuracy, or both, of an asserted liability to the person who is asserting such liabilityis sufficient to commence a contest.

A purchasers notification of its intent to return merchandise and request a refund arguably places the amount received by the taxpayer for such merchandise in dispute. When the taxpayer agrees to refund amounts received for merchandise the purchaser intends to return, the taxpayer cannot be said to have a fixed right to the refundable income.

If the taxpayer improperly includes income in a prior tax year, it should file a claim for credit or refund. If it accrued an amount based on an estimate that later differs from the actual amount, the taxpayer should take the difference into account in the year it makes such determination.

In Rev. Rul. 2003-10, the Service provided guidance on the tax year in which an accrual-method vendor accrues gross income under Sec. 451 when its customer disputes an amount. The ruling offers three scenarios:

1. The taxpayer ships goods and erroneously overbills the customer, and the customer notifies the taxpayer in the next tax year.

2. The taxpayer ships the wrong goods and bills the customer, and the customer disputes the liability during the tax year of sale; in the following year, the two parties agree that the customer will pay less than the invoice for such goods.

3. The taxpayer ships an incorrect quantity of goods to the customer, who discovers the discrepancy in the next tax year; by agreement, the taxpayer adjusts the quantity in the next shipment to the customer.

In the first scenario, the ruling holds that the taxpayer is only required to accrue the correct invoice amount in the year that it shipped the goods, because that amount is the only one that the taxpayer had a fixed right to in that year. If the taxpayer does not discover the mistake before filing its return for the year of sale (and accrues the incorrect amount), it has to file a refund claim (i.e., an amended return). If, however, the taxpayer treats the erroneous invoice amounts as a reasonable estimate of accrued income for two or more years, and makes the correction in the redetermination year, it has to treat this as an accounting-method change if it wants to accrue the correct amount in the year of sale.

In the second scenario, the ruling concludes that the taxpayer does not have a fixed right to the income in the year of sale, because a dispute arose in that year. Thus, the taxpayer does not have to include any amount from the transaction (including the corresponding cost of goods sold) in the year of sale. As such, it reports the gross sales and cost of goods sold from the transaction in the year it settles the dispute (i.e., the year the taxpayer and the customer agree that the customer will pay less for the goods shipped). This holding is a welcome departure from the Services annual-accounting-period concept, which requires taxpayers to take changes in estimates into account in the subsequent tax year.

In the last scenario, the ruling holds that the taxpayer meets the Sec. 451 all-events test, because the customer does not dispute the shipment and agrees to pay for the quantities shipped. Thus, the taxpayer has to include the full invoice amount in income in the year of sale, as it has a fixed right to the income for the quantity of goods shipped. (For more details, see Tax Trends, Customer Disputes and Accrual of Income, TTA, March 2003.)

Rev. Rul. 2003-10 does not address situations in which a taxpayer ships defective goods to a customer who discovers the problem or disputes the liability in the following year; however, the ruling asked for specific comments on this, such as:

1. Whether the taxpayer has a fixed right to the income in the tax year of sale;

2. Whether the fact that the dispute did not arise until the year after the sale year affects the taxpayers obligation to accrue the income in the tax year of sale (based on the tax-year concept of accounting);

3. Situations deemed a shipment of defective products; and

4. Whether the taxpayer and the customers course of dealing is relevant.

This ruling generally does not break any new ground, but is in keeping with the Service and Treasurys new desire to release guidance addressing taxpayers concerns, even though they may not have completely resolved all aspects of every issue. Additional guidance from another revenue ruling dealing with the IRSs and Treasurys areas of request for comments (on defective merchandise shipments) is probably forthcoming.

From Alexa Mortenson, J.D., LL.M., and Paul K. Gibbs, CPA, Washington, DC