The gift of complexity: Recognizing gift card revenue for tax purposes
Gift cards have revolutionized our ability to purchase a last-minute gift. However, they’ve also created challenges for businesses that sell them. For accounting purposes, revenue from the sale of a gift card is generally deferred until the card is redeemed. However, for federal income tax purposes, revenue is generally recognized when it’s earned, due, or collected —whichever comes first; this means that revenue from gift card sales is recognized in taxable income when the gift card is sold rather than when it’s redeemed.
Exceptions to the general rule permit the deferral of revenue from gift card sales for either one year or two years, depending on the circumstances.
However, exceptions to the general rule permit the deferral of revenue from gift card sales for either one year or two years, depending on the circumstances. Recent guidance has further expanded opportunities in this area.
One-year deferral exception
A business may defer revenue from the sale of gift cards until the end of the year following the year in which the gift card was sold. This exception applies to almost any gift card regardless of the services or products for which it can be redeemed. Businesses make no additional disclosures about the cards on their tax returns, but they are required to properly adopt this method of accounting for tax purposes. A business that has not previously used this deferral but wants to start will need to file a Form 3115 with the IRS to change its accounting method.
Two-year deferral exception
A taxpayer may defer recognition of gift card revenue until the last day of the second taxable year following the year in which the gift card was sold if the card can be redeemed only for goods. This restriction is particularly complicated when a gift card can be redeemed for a combination of goods and services. Services that are considered integral to the sale of goods, like delivery and installation, may be viewed as part of the goods and will not disqualify the revenue from the two-year deferral. If the gift card can be redeemed for non-integral services, like third-party warranties or repair services, the revenue does not qualify for the two-year deferral.
In December 2016, a customer purchases a $200 gift card from Electronic Store, Inc. which sells, delivers, and installs electronics. The customer did not redeem the gift card in 2016. The entire $200 of revenue can be deferred in 2016.
During 2017, the customer purchased $150 of electronics and $25 for delivery and installation. The $175 attributed to goods, delivery, and installation must be recognized as revenue in 2017.
Because the taxpayer sells goods and performs only services that are integral to the sale of the goods, the remaining $25 balance of the gift card can be deferred until the end of 2018, the second taxable year after the gift card was sold. Even if the remaining $25 balance wasn’t redeemed by the customer until 2019, the $25 must still be recognized in 2018.
The use of the two-year deferral method requires the taxpayer to properly adopt this method but also requires specific disclosures on the tax return each year. Without these disclosures, the IRS may disallow the deferral and require the taxpayer to report the revenue as income on a cash basis. Much like the one-year deferral, taxpayers that have not previously used this deferral but want to begin using it must file a Form 3115.
Things get even more complicated for taxpayers that also sell non-integral services. Fortunately, the IRS recently issued guidance clarifying how the rules operate for these taxpayers. The portion of gift card revenue that will be redeemed for goods and integral services will still qualify for the two-year deferral. Any remainder is eligible for only the one-year deferral.
The taxpayer must estimate the portion of the gift card allocable to each category. This estimate may be done using any reasonable method but many taxpayers use a historical average based on previous gift card redemptions.
During December 2016, a customer purchases a $200 gift card from Electronic Store, Inc. which sells electronics, provides delivery, and installation for those electronics, but also provides repair services for any electronic item. The repair services are non-integral services. Historically, repair services accounted for 20% of total gift card usage. The gift card is not redeemed until 2019.
The $40 attributable to repair services can be deferred until 2017 while the $160 attributable to goods and integral services can be deferred until 2018.
Taxpayers sometimes mistakenly assume that gift card revenue can’t be deferred for tax purposes or that it’s only eligible for a one-year deferral. But many may be able to defer that revenue for even longer. It’s advisable to review the current accounting practices and gift card usage to determine if there may be an opportunity for longer deferral, especially in light of the recent IRS guidance.