SECTION 5. DESCRIPTION OF THE

SERVICE WARRANTY INCOME METHOD

.01 In general. Taxpayers with an advance payment within the scope of section 4 of this revenue procedure may elect to include a qualified advance payment amount, increased by an imputed income amount, in gross income on a level basis over the shorter of:

(1) the period beginning in the taxable year the advance payment is received and ending when the service warranty contract terminates; or

(2) a 6-taxable-year period beginning in the taxable year the advance payment is received. This method of accounting permits these taxpayers to recognize and include in gross income, generally over the period of their service warranty contracts, a series of equal payments, the present value of which equals the qualified advance payment amounts received by the taxpayer. A taxpayer using the service warranty income method provided by section 5 of this revenue procedure must include in income, in the taxable year of receipt, the excess of aggregate advance payments received during a taxable year over aggregate qualified advance payment amounts for the taxable year.

.02 Simplifying table.

(1) An electing taxpayer must use the table in the APPENDIX of this revenue procedure to determine the amount of the gross income (attributable to a qualified advance payment amount) that must be reported annually under the service warranty income method.

(2) To use the table for a particular contract, a taxpayer first uses the column headed by the “Term of Service Agreement in Years.” The taxpayer determines

which column to use by ascertaining the length (the number of years) of its service warranty contract (limited to six years) without regard to whether there is a period for which there are no obligations under the contract. For example, if a service warranty contract begins in the third year after payment is received and ends in the fifth year after payment, the taxpayer uses the column headed “5.” The taxpayer then finds the factor in the row headed by “The Applicable Interest Rate,” which is defined in section 5.04 of this revenue procedure. If the applicable interest rate in this instance is 8 percent, the resulting factor would be .2319. This factor is multiplied by the qualified advance payment amount to determine the “annual equal payment amount” included in gross income each year for the number of years at the top of the column.

(3) A taxpayer may calculate the aggregate amount to be included in gross income each year by aggregating the qualified advance payment amounts with respect to contracts of the same class (that is, 2-year contracts, 3-year contracts, etc.). See section 5.08 of this revenue procedure for examples of the service warranty income method.

.03 Special rule for when the taxpayer’s trade or business ceases. In the year in which the taxpayer’s trade or business ceases (as defined in section 5.02(3) of Rev. Proc. 97–37), the remaining qualified advance payment amounts that have been deferred must be accelerated and included in gross income, along with appropriate imputed income amounts. These amounts must be determined using the applicable interest rates specified in section 5.04 of this revenue procedure and must be sufficient to ensure that the net present value of all amounts included in income over the period of deferral equals the qualified advance payment amounts that would have been reported and included in income upon receipt in the absence of an election under this revenue procedure. See the example in section 5.08(1)(c) of this revenue procedure. The Service will compute the amounts to be included in the year of cessation for any taxpayer that submits a request for a ruling pursuant to Rev. Proc. 97–1, 1997–1 I.R.B. 11 (or any successor). The Service waives the applicable user fee required under Rev. Proc. 97–1 for these requests.

August 18, 1997 44 1997–33 I.R.B.

continue to include the annual equal payment amount obtained from the APPENDIX table in gross income for the original length of the cancelled contract. Any amount refunded to the customer reduces income in the year paid. Imputed income amounts added to a qualified advance payment amount are not considered in (and have no effect on) the determination of this reduction of income. Thus, reductions for refunds upon customer cancellation of a multi-year service warranty contract are to be determined in the same manner as if the taxpayer did not make an election under this revenue procedure.

(2) Terminations. If a contract terminates because of a mileage or usage limitation during or after the year in which the taxpayer sold the contract, the taxpayer must continue to include the annual equal payment amount obtained from the APPENDIX table in gross income for the original length of the terminated contract. See paragraph (b) of Example 1 in section 5.08 of this revenue procedure. .07 Short taxable years. If a taxpayer using the table in the APPENDIX of this revenue procedure has a short taxable year during the term of its service warranty contract, the applicable table factor for the short period must be multiplied by a fraction, the numerator of which is the number of months in the short period, and the denominator of which is 12. After a short taxable year for which the table factor adjustment of the preceding sentence has been made, the taxpayer must continue to determine its gross income on a prior year’s qualified advance payment amount using the applicable table factor for each 12-month taxable year (or that table factor multiplied by an appropriate fraction for any other short periods), until the number of months for which the qualified advance payment amount is taken into account (determined as if the qualified advance payment amount is first taken into account in the first month of the year in which the advance payment is received) is equal to the number of months in the original contract term (as determined under section 5.02 of this revenue procedure). If less than 12-months’ inclusion remains for the final year, the applicable table factor for that year may be determined as if it were a short period containing the number of months remaining on the contract not yet taken into ac

(a) A, a calendar year accrual basis taxpayer, elects under this revenue procedure to use the service warranty income method of accounting for its qualified advance payment amounts on service warranty contracts. A sold 5 service warranty contracts on January 1, 1997, for $800 each. A also sold 5 service warranty contracts on December 31, 1997, for $800 each. All the service warranty contracts sold by A in 1997 carry a term of 5 years and run concurrently with the manufacturer’s warranties. Further, A pays, within 60 days of the receipt of each advance payment, $600 per contract to an unrelated third party to insure (in an arrangement that constitutes insurance) its obligations under the service warranty contracts. The applicable interest rate, determined in accordance with section 5.04 of this revenue procedure, is 10 percent.

A aggregates all its qualified advance payment amounts on its 5-year service warranty contracts, thus determining that $6,000 of qualified advance payment amounts were received in 1997 with respect to the class of 5-year service warranty contracts. Applying the “10% and 5-year” factor of .2398 found in the table in the APPENDIX of this revenue procedure, A determines that it must report gross income of $1,439 ($6,000 x .2398) in 1997 through 2001 under the election provided in this revenue procedure. In addition, A must include in gross income in 1997 the $2,000 payment received for services that is not deferred under this revenue procedure. Gross income is reported by A as follows:

Assuming that A is an S corporation with a single shareholder and that A re

Description of Item 1997 1998 1999 2000 2001 Non-deferred Income $2,000 Deferred Income ________________________________________________1,439 $1,439 $1,439 $1,439 $1,439 Gross Income ________________________________________________________________________________________________$3,439 $1,439 $1,439 $1,439 $1,439

Description of Item 1997 1998 1999 2000 2001 Non-deferred Income $2,000 Deferred Income ________________________________________________1,200 $1,200 $1,200 $1,200 $1,200 Gross Income ________________________________________________________________________________________________$3,200 $1,200 $1,200 $1,200 $1,200

count. See Example 2 in section 5.08 of this revenue procedure.

.08 Examples of the service warranty income method.

(1) Example 1.

ported no income other than that arising from the above service warranty transactions, the shareholder would report the following § 1367 adjustments to stock basis:

The stock basis adjustment for the deferred advance payment amount is determined by ratably spreading the stock basis adjustment over the term of the service warranty contract. Since the service warranty contract is treated as sold at the beginning of the taxable year, the stock basis adjustment each year would be $1,200 ($6,000/5). The aggregate imputed income of $1,195 ($239 x 5) on the $6,000 of aggregate qualified advance payment amounts for 1997 is not taken into account at any time by the shareholder in determining its basis in the A stock.

(b) If one of the service warranty contracts described in paragraph (a) terminates because of a mileage or usage limitation in 1999, there is no effect on the amounts that A must include in gross income each year. Under section 5.06 of this revenue procedure, A would continue to report the amounts of gross income set forth in section 5.08(1)(a) of this revenue procedure even if one or more of its service warranty contracts is terminated.

(c) If A’s business ceases in 1999, A must include the $2,000 non-qualified advance payment amount in gross income in 1997 and the $1,439 annual equal payment amount in gross income in 1997 and 1998, as in section 5.08(1)(a) of this revenue procedure above. However, in 1999, A must accelerate and include in gross income the remaining advance payment amount plus an appropriate imputed income amount.

To calculate this amount, A must first determine the portion of the qualified advance payment amount and the portion of

1997–33 I.R.B. 45 August 18, 1997

imputed income included in each annual equal payment amount. For 1997, the annual equal payment amount included in income, $1,439, is entirely from the qualified advance payment amount because no income is imputed to the taxpayer in the first taxable year. Thus, the $6,000 deferred qualified advance payment amount is reduced for A’s inclusion of $1,439 in 1997 leaving $4,561 of deferred qualified advance payment amount remaining.

For 1998, A multiplies the applicable interest rate of 10% by the 1997 remaining qualified advance payment amount of $4,561. That product, $456, constitutes the imputed income portion of the 1998 annual equal payment amount of $1,439. The difference between $1,439 and $456 ($983) is the portion of the annual equal payment amount that constitutes the qualified advance payment amount. The $983 reduces the qualified advance payment amount remaining after 1997 to $3,578.

When A’s business ceases in 1999, A must include in gross income the qualified advance payment amount remaining after 1998 and an appropriate imputed income amount. The appropriate imputed income amount is the product of the qualified advance payment amount remaining after 1998 and the applicable interest rate ($3,578 x 10%), which is $358. Thus, in 1999, A includes in gross income $3,936 ($3,578 + $358).

(2) Example 2. X, a calendar year accrual basis taxpayer, elects under this revenue procedure to use the service warranty income method of accounting for its qualified advance payment amounts on service warranty contracts. X sold 5 service warranty contracts on January 1, 1997, for $800 each. X also sold 5 service warranty contracts on December 31, 1997, for $800 each. All the service warranty contracts sold by X in 1997 carry a term of 5 years and run concurrently with the manufacturer’s warranties. Further, X pays, within 60 days of the receipt of each advance payment, $600 per contract to an unrelated third party to insure (in an arrangement that constitutes insurance) its obligations under the service warranty contracts. The applicable interest rate, determined in accordance with section 5.04 of this revenue procedure, is 10 percent.

7-month Short Yr. End Yr. End Description of Item 1997 1998 Yr. 7/31/00 7/31/01 Non-deferred Income $2,000 Deferred Income ________________________________________________1,439 $1,439 $ 839 $1,439 $1,439 Gross Income ________________________________________________________________________________________________$3,439 $1,439 $ 839 $1,439 $1,439

Description of Item Yr. End

7/31/02 Non-deferred Income Deferred Income ________$ 600 Gross Income ________________$ 600

X aggregates all its qualified advance payment amounts on its 5-year service warranty contracts, thus determining that $6,000 of qualified advance payment amounts were received in 1997 with respect to the class of 5-year service warranty contracts. Applying the “10% and 5-year” factor of .2398 found in the table in the APPENDIX of this revenue procedure, X determines that it has annual equal payment amounts of $1,439 includible in gross income in 1997 through 2001 under the election provided in this revenue procedure. In addition, X must include in gross income in 1997 the $2,000 payment received for services that is not deferred as a qualified advance payment amount by this revenue procedure.

After making the initial determinations above, X experiences a short taxable year of 7 months beginning on January l, 1999, and ending on July 31, 1999. After the 7month short period, X’s taxable year ends on July 31. When X experiences the 7month short period, X must multiply the factor in the table in the APPENDIX of this revenue procedure by a fraction, the numerator of which is the number of the months in the short period, and the denominator of which is 12. This adjusted factor of .1399 (7/12 x .2398) is applied to the qualified advance payment amount of $6,000. The product, $839, is included in X’s gross income for the short taxable year. Because X’s contracts had a term of 5 years or 60 months (and are assumed under this revenue procedure to have begun at the beginning of the 1997 taxable year), there are 5 additional months in the taxable year ending July 31, 2002, for which a portion of the annual equal payment amount must be taken into account. Thus, X includes $600 (5/12 x .2398 x $6,000) in gross income. Gross income is

reported by X in each taxable year as follows: