IRS determines treatment of advance payments before and after stock acquisition

In a recent IRS Office of Chief Counsel advice (CCA) memorandum (CCA 201619009) the IRS determined what a taxpayer must do if it has deferred recognizing revenue into income under Rev. Proc. 2004-34 and its stock is subsequently acquired by an unrelated corporation that, for financial accounting purposes, writes down the associated deferred revenue liability to its fair value as of the acquisition date. The taxpayer must include the advance payment in its gross income for federal income tax purposes in the year of receipt to the extent the payment is recognized in revenues in the taxpayer’s applicable financial statement (AFS) for that taxable year. The taxpayer must also include the remaining amount of the advance payment in its gross income in the next subsequent taxable year, irrespective of any write-down of the deferred revenue liability for financial accounting purposes.

Under the facts of the CCA, a calendar year taxpayer received a total amount as an advance payment for a two-year contract to provide services. For federal income tax purposes, the taxpayer uses the deferral method described in Section 5.02 of Rev. Proc. 2004-34 as its method of accounting for advance payments. For financial accounting purposes, the taxpayer recorded this total amount as a deferred revenue liability on its AFS, expecting to report some portion of the advance payment in revenues in its AFS through 2015, 2016 and 2017.

Subsequently, the taxpayer joined an unrelated corporation’s consolidated group when all of the taxpayer’s stock was acquired, creating a short taxable year ended on Aug. 31, 2015. On Sept. 1, 2015, after the stock acquisition, and in accordance with purchase accounting rules under GAAP, the taxpayer’s deferred revenue liability was written down to its fair value. This reduced amount was to be recognized in revenue on the taxpayer’s AFS in accordance with the method of accounting used for financial accounting purposes. The written-down portion of the advance payment was to never be recognized in revenues on the taxpayer’s AFS.

The IRS noted that the advance payment the taxpayer received was an accession to wealth that it must include in its income under Section 61 under its proper method of accounting. Furthermore, the IRS determined that the advance payment the taxpayer received satisfied the definition of an advance payment in Section 4.01 of Rev. Proc. 2004-34 because as of the end of short taxable year ending Aug. 31, 2015, some amount would be recognized in its AFS for a subsequent taxable year. Subsequent factual developments occurring after yearend, such as the eventual write-down of the taxpayer’s deferred revenue liability, don’t affect this determination.

The IRS indicated that Rev. Proc. 2004-34 neither authorizes nor permits a taxpayer to exclude from gross income any part of the advance payments received under a service contract. In addition, GAAP purchase accounting rules don’t override the mandate under Section 61 that the taxpayer should include in gross income the entire amount of the accession to wealth it received under the service contract. Thus, for the taxable year beginning Sept. 1, 2015, the taxpayer must include in income the full amount of the advance payment that wasn’t previously included in income for the taxable year ended Aug. 31, 2015, in accordance with Section 5.02 of Rev. Proc. 2004-34, even though the remainder of the advance payment liability will never be recognized in revenues in the taxpayer’s AFS.

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