Electing to Defer Advance Payments under Rev. Proc. 2004-34

Sec. 451 generally requires taxpayers to recognize all gross income in the year received. Rev. Proc. 71-21 (which intended to reconcile financial and tax treatments for certain services) allowed a one-year deferral for accrual-basis taxpayers that received advance payments for services in specific, limited situations. However, considerable controversy arose as to the definition of advance payments for services and the treatment of payments received under renewable agreements.

In Rev. Proc. 2004-34, the IRS expanded Rev. Proc. 71-21s scope. It permits accrual-basis taxpayers to defer recognizing advance payments for tax purposes, including those that blend services and nonservices and those with terms that extend beyond the succeeding tax year. (Cash-method taxpayers considering a change to the accrual method may also benefit.) Rev. Proc. 2004-34 describes the procedure for making the election.

This item outlines the basic factors involved in calculating a deferral and, thus, determining whether an election is in a taxpayers best interest. (This item does not summarize all of Rev. Proc. 2004-34s requirements.) To make this determination, the taxpayer would calculate the immediate and projected future tax effects of the deferral election.

The Rules

Under Rev. Proc. 2000-34, Section 4.01(3), taxpayers who receive payments for any of the following may be eligible to make the election:

• Services;

• Merchandise (if not already deferred under Regs. Sec. 1.451-5(b)(1)(ii));

• Use of intellectual property;

• Occupancy or use of property, if ancillary to the provision of services;

• Sale, lease or license of computer software;

• Guarantee or warranty contracts ancillary to items(s);

• Subscriptions, if Sec. 455 is not elected; and

• Membership in an organization, if Sec. 456 is not elected.

This includes, for example, professional service firms and others offering services to consumers; software firms and Internet service providers; insurance administrators; and membership organizations. The following are not eligible: rent (unless ancillary to services provided for sale/lease of software or occupancy/use of property), insurance premiums, and payments (1) with respect to financial instruments; (2) for service warranty contracts for which income is recognized over the contracts life (in accordance with Rev. Proc. 97-38); (3) to which Sec. 83 applies (i.e., property transferred for the performance of services); and (4) to foreign nonresident aliens or foreign corporations for which withholding is required.

To benefit from an election, an accrual-basis taxpayer must currently include the eligible revenue in gross income for tax purposes in the receipt year, but recognize the revenue in subsequent years financial statements. Applicable financial statements include Schedules 10-K, certified audited financial statements with a report by an independent CPA (or similar) and financial statements required by Federal or state governments or agencies (other than the Securities and Exchange Commission or the IRS).

Calculating the Elections Immediate Tax Effect

In the first year of the election, a taxpayer must calculate and recognize in taxable income that portion of the prior-years advance payments deferrable to the current year under the new method. Because Sec. 481s provisions for changing accounting method apply, the taxpayer must calculate the Sec. 481(a) adjustment and recognize it in taxable income ratably over four years.

Example 1: T, a professional services firm, makes an election for its fiscal year ending Dec. 31, 2004. It received $100,000 in advance payments for 2003, of which $20,000 was recognized in the financial statements for that year. The remaining $80,000 will be recognized in its financial statements over the following four years. For tax purposes, T already recognized the full $100,000 in gross income for 2003. Due to the election, it must now recognize in 2004 taxable income, the portion of the 2003 advance payments allocable to 2004 under the new method (i.e., the deferred $80,000). In effect, T will recognize that portion of the advance paymentsthe amount properly deferrable to 2004 under Rev. Proc. 2004-34twice. T will then recover that amount through deductions (i.e., Sec. 481(a) adjustments) over the next four tax years; see Exhibit 1 below.

   

Calculating an Ongoing Deferrals Tax Effect

Ignoring Sec. 481 for the moment, the amount of a qualifying advance payment that a taxpayer must include in taxable gross income for the year received is the amount earned and recognized in the applicable financial statements for the year. (Special provisions apply to short tax years of 92 days or less.) The entire remainder of the advance payment must be recognized, in full, in the next tax year (i.e., the maximum deferral is limited to one year). Note: If a taxpayer receives a payment of which only a portion can be deemed an advance payment, it must allocate the full payment based on objective criteria. If the taxpayer allocates the payment between items eligible and ineligible for advance payment treatment under Rev. Proc. 2004-34 and the method of allocating the payment is not deemed to be based on objective criteria, it must obtain advance consent.

Example 2: The facts are the same as in Example 1, except T receives similar advance payments each year. The effect on taxable income, with and without the election, is shown in Exhibit 2 below.

As Exhibit 2 illustrates, if the total of advance payments T receives in each tax year remains relatively constant over time, T will benefit only in the first year of the election (ignoring the short-term effect of Sec. 481).

Deciding Whether and When to Implement

By combining the economic analyses of the projected deferral and the Sec. 481(a) adjustment, it is possible to determine if the election provides a net benefit; see Exhibit 3.If the annual advance payments will decrease over time, the election will not likely provide a significant economic benefit. If, however, the annual advance payments will increase over time, the election may be worthwhile.

The election should be timed such that the current advance payment is low relative to projected future advance payments. This minimizes the effect of the Sec. 481(a) adjustment and provides an increasing deferral over time.

Conclusion

Besides calculating the economic benefit of making the election, a taxpayer should also consider in its analyses the ongoing cost of implementing the required tracking procedures, as well as taking into account nonrecurring costs (e.g., professional fees to prepare Form 3115, Change in Accounting Method) and costs of securing advance consent, if required.

From Pam Spaletta, CPA, Bader Martin Ross & Smith, P.S., Seattle, WA