The IRS recently issued guidance clarifying how retailers are supposed to treat gift card transactions. Previously, this was a contentious issue between the IRS and the retail industry.

The problem arose because of complicated corporate structures of many large retailers. In these situations, there would often be one corporate subsidiary that would issue gift cards. These cards could be redeemed at the retailer’s stores, which were usually organized as many separate corporations and which might be owned by franchisees or other unrelated parties. In these situations, the IRS position was that the income to the retailer was immediately taxable on sale of the card, but the offsetting cost of honoring the card could not be deducted until the card was presented. So, if a card was purchased in December but not redeemed until January, the income was taxable one year but the cost was not deductible until the next.

In its new guidance, Rev. Proc. 2011-18, the IRS has agreed to allow the retailer to defer the income from sale of the card until the next year, so long as the retailer does not book the revenue for financial accounting purposes in the year of sale. However, under the guidance, the retailer must pay tax on the income in the year following the sale even if the card hasn’t yet been presented by that time. In other words, the maximum deferral of tax is one year. Also, the retailer has to go through some formalities to adopt this as a method of tax accounting.

In additional guidance, Rev. Proc. 2011-17, the IRS also explained what to do when a retailer issues a gift card in exchange for returned merchandise. The IRS will allow this to be treated as a cash refund to the customer (resulting in an immediate deduction) and a sale of the gift card (income from which may be eligible for deferral as described above).

Some retailers may take more aggressive positions than allowed by the IRS guidance. Treasury Regulations allow, in some cases, income from the sale of gift cards that are redeemed for goods (not services) to be deferred until the second year following the sale, if not previously booked as revenue by the retailer. The IRS still contends that these regulations are inapplicable where the entity that sells the card is different from the entity that redeems it. Retailers may also assert that their gift card receipts are in trust for the card holders, so that the retailer has no income until and unless the cards are actually redeemed, which may in some cases be several years in the future if at all. Although there is case law that supports this view, it is likely to be vigorously contested by the IRS.

Content for this post was provided by Howard Weinman, a tax partner in the Washington, DC office of Crowell & Moring.

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