Tax Accounting Issues for Gift Certificates and Gift Cards

For a number of years, retail merchants have boosted their sales volume (and cashflow) by offering gift certificates. More recently, they have either augmented their gift certificate programs or replaced them entirely with gift cards. Gift cards offer flexibility in promoting customer loyalty because they make it easier to track purchases and thus offer opportunities to enhance future sales.

Advance Payments

Depending on the laws of a particular state and the terms of gift cards or certificates (e.g., expiration dates), unredeemed gift cards or certificates can fall under a state’s abandoned or unclaimed property (AUP) statute (i.e., the escheat laws). Whether amounts attributable to unredeemed gift certificates or gift cards must be remitted to a particular state’s AUP bureau should be reviewed by legal counsel.

For tax accounting purposes, receipts from the sale of gift certificates or gift cards are treated as “advance payments” under Regs. Sec. 1.451-5(a)(2). Generally, advance payments  must be reported as income either (1) in the year of receipt or (2) in the year properly accruable under the taxpayer’s method of (tax) accounting, provided they are reported no later than they would be for financial statement purposes. An exception to this general rule exists for advance payments under an agreement (such as a gift card or gift certificate) to sell inventoriable goods. Regs. Sec. 1.451-5(c) provides guidance when the taxpayer (1) accounts for advance payments for tax purposes under the method in Regs. Sec. 1.451-5(b)(1)(ii), (2) receives “substantial advance payments” and (3) has on hand (or available through a normal supply source) goods of substantially similar kind and in sufficient quantity to satisfy the agreement. In such cases, the taxpayer must include in income all advance payments received under the agreement by the last day of the second tax year following the year in which it receives the advance payments.

Example 1: X, a calendar-year retail merchant, sold $100 of gift cards during December 2005, none of which was redeemed by the end of that year. Further, $80 in gift cards are redeemed during 2006, and $10 are redeemed during 2007. Under Regs. Sec. 1.451-5(c), X reports the following amounts for tax purposes:

Although $10 remains outstanding at the end of 2007, it must be included in income no later than the last day of the second tax year following the year of receipt (i.e., Dec. 31, 2007).

Taxpayers required to include advance payments in income prior to fulfilling an agreement (i.e., before delivering the goods) can take the costs and expenditures into account with respect to such goods included in inventory; if the goods are not on hand by the last day of the second tax year, taxpayers can use an estimate. In Example 1, X would take into account in 2007 the costs (or an estimate) of the goods included in inventory related to the $10 advance payments that represent the unredeemed gift card balance as of Dec. 31, 2007.

Income Deferrals

Provided that all the requirements of Regs. Sec. 1.451-5(c) are met, taxpayers are permitted a two-year deferral when their accounting method for financial statement purposes results in advance payments being included in income earlier than they would have been for tax purposes. Also, Rev. Proc. 2004-34, which generally permits a one-year deferral for advance payments received by accrual-basis taxpayers, does not apply to advance payments received for the sale of goods when taxpayers use the deferral method under Regs. Sec. 1.451-5(b)(1)(ii).

Although Rev. Proc. 2004-34 generally does not apply to advance payments received for inventoriable goods, it does apply to other types of gift certificate or gift card transactions. For example, gift certificates or cards for redeemable services (e.g., dance lessons) would be eligible for a one-year deferral under Rev. Proc. 2004-34, provided the requirements for the deferral method are met. For advance payments received for gift certificates or gift cards redeemable for either services or merchandise (e.g., a hair salon offering styling services and hair care products), a question arises whether advance payments may be deferred under Regs. Sec. 1.451-5 or under the revenue procedure.

Ann. 2004-48 indicates that the deferral methods permitted under the regulations and the revenue procedure are not mutually exclusive. Further, advance payments partially eligible under the deferral method in the revenue procedure and partially eligible for deferral under another method (such as permitted under Regs. Sec. 1.451-5) may be allocated between each item. To support an allocation, taxpayers must use objective criteria. Further, they must also satisfy the requirements of Rev. Proc. 2004-34 and Regs. Sec. 1.451-5 for each respective item, to achieve the appropriate allocation and the desired deferrals.

Based on the above, there is an opportunity to apply the two-year deferral period under the Sec. 451 regulations, rather than the one-year deferral under Rev. Proc. 2004-34. However, taxpayers should recognize the potential escheat issues surrounding gift cards or gift certificates.

Example 2: The facts are the same as in Example 1, except the $10 unredeemed in 2007 is never redeemed. X is domiciled in a state that requires dormant gift certificates or gift cards to be escheated, and it has no record of the gift card owner’s last known address. As a result, X remits the $10 to the state of domicile under the state’s escheat law, and should be entitled to a deduction for the $10, which had been included in income in 2007.

From Nicholas A. Nesi, CPA, J.D., LL.M., New York NY