By Randy Frischer and Patricia Brandstetter
Gift card sales have flourished in recent years, with electronic purchase and redeeming options and smart phone applications furthering the expansion of retail sales in this area. Our recent survey of 100 retail CMOs found that 58 percent expect gift card sales to increase this holiday season. In addition, retailers frequently issue gift cards to customers in exchange for returned goods. However, the tax, financial, and legal reporting requirements for gift cards have become increasingly complex.
A retailer issuing a gift card receives an “advance payment” in exchange for the obligation to provide goods or services at a future date. For tax purposes, although advance payments must generally be included in gross income upon receipt, the sale of a gift card may be deferred from immediate income recognition under two exceptions: Treas. Reg. §1.451-5 and Rev. Proc. 2004-34.
Treas. Reg. §1.451-5 applies to the sale of goods only, and allows an accrual-method taxpayer to defer recognition of advance payments until the taxable year the payments are recognized as revenue for financial reporting purposes. However, inventoriable goods may not be deferred beyond the end of the second taxable year following the year the taxpayer receives the advance payment. This effectively grants a two-year deferral.
Rev. Proc. 2004-34 allows an accrual-basis taxpayer to defer recognition of advance payments for goods, services, or a mix of both, but provides for one-year deferral only: The advance payment must be included in gross income for the taxable year of receipt to the extent recognized in the financial statements for that taxable year; the remaining amount of the advance payment must be included in gross income in the subsequent taxable year.
In addition, the IRS has issued the following guidance involving gift cards:
Rev. Proc. 2011-17 provides a safe harbor method of accounting for returned merchandise: 1. A merchant may give the customer a cash refund in exchange for returned goods, reducing gross receipts in the amount of the refund, or 2. A gift card may be issued in exchange for the returned goods, treating the gift card issued as the payment of a cash refund and sale of a gift card. The retailer may account for the amount deemed received for the sale of the gift card under Treas. Reg. §1.451-5 or Rev. Proc. 2004-34.
Rev. Proc. 2011-18 modifies Rev. Proc. 2004-34 to allow taxpayers to defer revenue from the sale of gift cards that are redeemable for goods or services of the taxpayer or a third party. Deferral is thus permitted even when the gift cards are redeemed by a third party, related or unrelated to the selling entity, under a gift card service agreement.
Effective for taxable years ending on or after December 31, 2010, taxpayers changing to the deferral method as a result of Rev. Proc. 2011-17 and Rev. Proc. 2011-18 may do so as an automatic method change. According to IRS interpretation, Treas. Reg. §1.451-5 does not apply to goods provided by entities other than the taxpayer. Taxpayers currently deferring gift card sales under the two-year deferral of Treas. Reg. §1.451-5 might consider filing an automatic consent Form 3115 to change to the one-year deferral method afforded by Rev. Proc. 2004-34.
Beware of escheat
Retailers’ short-term cash flows benefit greatly where gift cards are never redeemed. This gift card “breakage”, i.e. unredeemed balances, may create legal reporting and remittance requirements for retailers under unclaimed property (escheat) laws in various states, including Delaware and New York. State escheat laws entail a “due diligence” obligation to attempt to return unclaimed property to its owner after expiration of a statutory dormancy period. The dormancy period for unredeemed values ranges from two to five years in the various jurisdictions, and escheat ranges from 60 percent to 100 percent of the value. Some states exempt cards with minor values or cards with clearly stated expiration dates. While online registration systems for gift cards may be helpful in meeting escheat reporting obligations, the transferability of gift cards raises complex legal issues.
To avoid potential unclaimed property liability, and to claim deferral under Treas. Reg. §1.451-5 (which rules out goods provided by third parties), companies often establish a separate gift card management company in the form of a single-member LLC, located in a state with favorable escheat laws. However, any such arrangement must serve a valid business purpose to withstand challenge by the IRS. The subsidiary must have its own management, accounting, board of directors, and anything else that avoids being considered a “sham.”
It should be noted that for financial statement purposes under GAAP, no income from unredeemed value is recognized if amounts are remitted to a government agency under state escheat laws. If no escheat laws apply, GAAP rules would generally not allow for de-recognition of a liability until relief from the liability, i.e., use of the gift card. However, under a special exception for gift cards, where a company can establish that the chance of the customer redeeming the gift card is remote, the revenue from breakage is recognized.
Gift cards can also create state nexus -- a physical or economic presence sufficient to establish jurisdiction to tax in the state. For example, if gift cards are issued pursuant to a license granted by the retailer, the retailer may be considered to have economic nexus in certain states where the cards are sold. Gift cards, although representing intangible value, are (unless issued electronically) physical objects whose presence in a store may create nexus for tax purposes, even if the issuer otherwise has no presence in that state. It is therefore vitally important for retailers to understand nexus requirements in the respective states where their gift cards are sold.
With sales of gift cards surging, retailers’ strategies to maximize earnings should include knowledge of the rules to achieve deferral of revenue for federal income tax purposes, minimizing breakage subject to state escheat laws, and awareness of state income tax consequences of issuing and distributing gift cards.
Randy Frischer (email@example.com) is a tax partner in the Retail and Consumer Products practice and Patricia Brandstetter (firstname.lastname@example.org) is a senior tax associate at BDO USA, LLP, an accounting and consulting firm.
** To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any links to outside sources) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.
Material discussed in this blog post is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances.
By Randy Frischer and Patricia Brandstetter