LMSB Control No: 4-0808-042
Impacted IRM 4.51.2
October 3, 2008
MEMORANDUM FOR
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INDUSTRY DIRECTORS, LMSB
DIRECTOR, FIELD SPECIALISTS, LMSB
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE, LMSB
DEPUTY COMMISSIONER, LMSB
DEPUTY DIRECTOR, INTERNATIONAL, LMSB
DIVISION COUNSEL, LMSB
AREA COUNSEL, LMSB
DIRECTOR, EXAMINATION, SB/SE
CHIEF, APPEALS
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
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FROM:
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Sergio E. Arellano /s/ Sergio Arellano
Industry Director, Retailers, Food, Pharmaceuticals, and Healthcare
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SUBJECT:
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Tier II Industry Director’s Directive on the Planning and Examination of Gift Card/Certificate Issues in the Retail and Food & Beverage Industries #2
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Introduction:
On May 23, 2007, the Industry Director for Retailers, Food, Pharmaceuticals, and Healthcare issued an Industry Director’s Directive on the Planning and Examination of Gift Card/Certificate Issues (IDD #1). This directive (IDD #2) elevates the issue regarding a separate gift card company (“Giftco”) to Part A status. In addition, this second directive supplements IDD #1 by focusing on the issues categorized as Part B in IDD #1.
This memorandum is intended to provide direction to the field to effectively utilize resources in the examination of a taxpayer who is receiving gift card/certificate income. This Directive is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.
Background:
IDD #2 is a result of LMSB’s experience examining gift card/certificate issues since the issuance of IDD #1 and also includes a discussion of other specific issues relative to gift card/certificates.
According to IDD #1, issues regarding gift cards are numerous and have been classified into two categories: Parts A and B. Should an examining agent identify a Part A gift card/gift certificate issue, the issue must be raised during the examination and contact must be made with either the Food & Beverage or one of the Retail technical advisors for coordination of the issue.
Planning and Examination Guidance:
Part A. - As explained in IDD #1, Part A issues pertain to: 1. Compliance with the Regulations, 2. Changes of Accounting Method, and 3. The Use of Estimates. These issues were discussed in IDD #1.
Effective immediately, the Giftco issue is now elevated to Part A status and is accorded Part A treatment.
The Giftco issue involves the formation of a separate legal entity by a taxpayer to administer its gift card/certificate program. The primary issue is whether the entity administering the gift card/certificate program has goods for sale in the ordinary course of its trade or business and is thereby eligible to elect a deferral method of reporting gift card/certificate income under either Treas. Reg. § 1.451-5 or Rev. Proc. 2004-34. A Field Attorney Advice released July 11, 2008 provides a legal analysis on a specific case. (FAA 20082801F; Doc 2008-15466) Access to this FAA can be found on the IRS website www.irs.gov. [1]
Part B. - The updated second category of issues includes the issues set forth below. An Examiner that encounters these issues should contact one of the Retail or Food & Beverage technical advisors.
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Gift cards versus gift certificates: Are gift cards the same as gift certificates for purposes of Treas. Reg. § 1.451-5?
The Regulations, which were first issued in 1971, specify gift certificates only because gift cards were not in existence at that time. Gift cards are essentially an electronic version of gift certificates with a few enhancements such as the ability to reload or add value to the gift cards. Most states have statutory definitions of gift certificates and gift cards and the two are generally interchangeable. If a taxpayer treats gift cards differently from gift certificates for purposes of Treas. Reg. §1.451-5, the issue needs to be brought to the attention of one of the Retail or Food & Beverage technical advisors.
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Reloadable gift cards: Is the 2-year deferral period under Treas. Reg. §1.451-5 controlled by the initial purchase of the gift card or by the dates of additional reloads of the gift card?
When the holder of a gift card is able to add value or increase the worth of the gift card, it is commonly called reloadable. If a taxpayer’s gift cards are reloadable, examiners need to verify that the taxpayer’s accounting system and software takes into account the actual dates when money is added to the card for purposes of the income deferral. Examiners with this issue should contact the Retail or Food & Beverage technical advisors.
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Deposits: Is gift card/certificate income considered a deposit and, therefore, excluded from income?
Most gift cards/certificates state that they may be used towards the purchase of any taxpayer product, and the card/certificate will not be exchanged for cash. At the time the payment is made to purchase such card/certificate, the nature of the rights and obligations assumed by each party is normally stipulated on the card/certificate. Typically, the gift card/certificate must be used exclusively for the purchase of goods (e.g., clothing, food, and/or beverages) from the taxpayer. The fact that a customer may subsequently receive the remaining balance on a card in cash upon his redemption of the gift card/certificate for goods, in violation of the card/certificate’s written terms, does not change the character of the gift card/certificate income as an advance payment. If a taxpayer excludes from taxable income gift card/certificate proceeds as deposits or otherwise, the issue needs to be brought to the attention of one of the Retail or Food & Beverage technical advisors.
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Gift cards as refunds: May a taxpayer treat the issuance of a gift card for returned merchandise, in lieu of a cash refund, as equivalent to a “sale” of a gift card, for purposes of Treas. Reg. § 1.451-5, effectively voiding the initial sale of goods and associated current recognition of income from the sale of goods under IRC §§ 61 and 451?
The technical advisors are currently formulating a position on this issue. Further guidance regarding the issue will be forthcoming. Please contact one of the Retail or Food & Beverage technical advisors if you encounter this issue.
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Dormancy fees: Is the taxpayer bringing dormancy fees into income?
Service charges or fees relative to a gift card/certificate, including dormancy fees, latency fees, or other administrative fees, that have the effect of reducing the total amount for which the holder of the gift card/certificate may redeem the gift card/certificate until the expiration date on the card/certificate has expired may not be properly reported as income by the taxpayer when charged against the gift card/certificate. Examiners will need to verify that the income is properly reported when dormancy fees, latency fees, or other administrative fees can be incurred relative to a taxpayer’s gift cards/certificates. Examiners faced with this issue should contact the Retail or Food & Beverage technical advisors.
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Escheatment to states: If a taxpayer must escheat (i.e., surrender) all unredeemed gift cards to a state, can it defer the recognition of income of the unredeemed gift cards beyond two years?
Although the escheatment laws vary from state to state, some states take the position that gift card/certificate balances that have remained unclaimed by the owner for a certain period of time (e.g., 5 years) are presumed abandoned. These states require the issuer of the card/certificate to turn such unclaimed balances over to the state. Some taxpayers argue that since they have to either redeem the gift card/certificate or escheat the balances to a state, they should not recognize income until the earlier of those two events. The technical advisor can help you determine whether this position comports with the income deferral methodology under Treas. Reg. § 1.451-5.
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Bulk sales discounts: How should bulk gift card sales discounts be treated for tax purposes?
Where sales discounts on gift cards are not expensed in direct relationship to the recognition of income from the gift cards, the issue needs to be brought to the attention of one of the Retail or Food & Beverage technical advisors. The technical advisor can assist the Examiner to determine whether the taxpayer’s treatment of expensing discounts while deferring the income from the related gift cards is an improper acceleration of the deduction. (IRC § 461(h))
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Promotional gift cards (advertising): What is the proper tax treatment of gift cards given away by the taxpayer?
Generally when advertising is purchased, the taxpayer would debit advertising expense and credit cash or a payable account. However, in this situation, the advertising expense is a deferred expense since the credit is to a deferred income (liability) account. Consideration needs to be given to whether the deferred advertising expense should be recognized under the provisions of Treas. Reg. § 1.446, the clear reflection of income standard, and IRC § 461 in determining when the advertising expense is deductible for Federal Income Tax purposes. An Examiner that encounters these issues should contact one of the Retail or Food & Beverage technical advisors.
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Charitable contribution of gift cards: When is a taxpayer entitled to a deduction for the value of the gift cards donated to a qualified charitable organization?
Facts must be ascertained to establish whether the donated gift card has been redeemed and the item has been released from inventory through cost of goods sold. The technical advisor can assist the examiner in determining the time when liability becomes fixed and economic performance occurs to entitle the taxpayer to a deduction. Furthermore, the Examiner should contact one of the Retail or Food & Beverage technical advisors if a taxpayer claims an enhanced deduction under IRC § 170(e)(3) when the gift cards are redeemed by individuals.
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Estimated cost of goods sold: Are taxpayers entitled to an estimated cost of goods sold deduction when they recognize income from unredeemed gift cards?
Some taxpayers using the deferral method of income recognition under Treas. Reg. § 1.451-5 have taken the position that they are entitled to a cost of goods sold deduction for the unredeemed gift cards that they bring into income on the last day of the second year following the sale of the gift card citing Treas. Reg. § 1.451-5(c)(1)(ii). However, section 1.451-5(c)(1)(iii) of the regulations provides that the reduction for cost of sales does not apply if the goods with respect to which the advance payment is received are not identifiable. In the typical situation, no reduction is allowed for cost of goods sold until the goods are in fact shipped or otherwise identified to the contract, since it is not known which products will be ordered. See Rev. Rul. 72-208, 1972-1 C.B. 129. Examiners with this issue should contact the Retail or Food & Beverage technical advisors.
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Other Legal Entities and Franchisor/Franchisees: How does the position identified in Part A on page 2 of this document apply to other legal entities, such as a partnership, subchapter S corporation, limited liability company, or to a franchisor/franchisee?
The technical advisors are currently formulating a position on this question.
Further guidance regarding this issue will be forthcoming. Please contact one of the Retail or Food & Beverage technical advisors if you encounter this issue.
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Expiration date: What happens when the expiration date on the gift card is less than the two-year deferral period under the Regulations?
If the taxpayer is following the income deferral procedures under Treas. Reg. § 1.451-5, gift card income, arguably, must be recognized on the expiration date if it is earlier than the end of the second year following the year of the sale of the gift card. An Examiner that encounters this issue should contact one of the Retail or Food & Beverage technical advisors.
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Rev. Proc. 2004-34: What are the differences between deferrals under Treas. Reg. § 1.451-5 and Rev. Proc. 2004-34?
Treas. Reg. § 1.451-5 expressly provides income deferral for advance payments of goods for up to two years after the year of sale of the gift card. Rev. Proc. 2004-34 expressly covers sales of goods, services, and mixtures of goods and services and provides a one-year deferral. Taxpayers may be able to use either the Regulations or the Rev. Proc. for deferral of qualifying advance payments. An Examiner that encounters these issues should contact one of the Retail or Food & Beverage technical advisors, who can assist in distinguishing these situations.
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Not-for-Profit Entities: Can a Giftco, set up as a not-for-profit entity, avoid reporting gift card income?
Some taxpayers have taken a position that all gift card income will be utilized to satisfy future redemptions, and therefore no profit or loss is recorded. If a not-for-profit entity is utilized, all other income (e.g., breakage) will never be recognized for tax purposes. Taxpayers have cited Seven-Up Company v. Commissioner, 14 T.C. 965 (1950), to support the argument that they are only holding gift card sale revenues as a fund to satisfy the liabilities of others. The technical advisors can assist the Examiner that encounters this issue.
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Intermediaries: Numerous retail and restaurant outlets are selling their gift cards through third-party intermediaries. At this time, the technical advisors are uncertain as to the scope of this issue. Please contact one of the Retail or Food & Beverage technical advisors if you encounter this issue.
Issue tracking codes for this issue are: UIL 451.13-04, a primary SAIN 221, and an Issue Tracking Attribute Code R310.
While the second category of issues constitutes all the significant issues involving gift cards/certificates that the technical advisors are currently aware, there may be new issues arising which involve gift cards/certificates and which are also potentially significant. Any such circumstances should be brought to the attention of the Food & Beverage or one of the Retail technical advisors so they can evaluate whether or not the foregoing list should be expanded.
If you have any questions, please contact Phil Hofmann, LMSB Food & Beverage Technical Advisor at 316-352-7434, Dave Moser, LMSB Retail Technical Advisor at 636-255-1246, Maria Montani, LMSB Retail Technical Advisor at 636-255-1385, or Cindy S. Kim, Senior Program Analyst at 630-493-5934.
- The FAA can be found on www.irs.gov by typing in the search function “20082801F.” This will bring you to the page titled “Legal Advice Issued by Field Attorneys.” You will find FAA 20082801F in the document entitled “Recognition of Gift Card Sale Proceeds.”
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