SECTION 5. PERMISSIBLE METHODS

OF ACCOUNTING FOR ADVANCE PAYMENTS

.01 Full Inclusion Method . A taxpayer within the scope of this revenue procedure that includes the full amount of advance payments in gross income for federal income tax purposes in the taxable year of receipt is using a proper method of accounting under § 1.451–1, regardless of whether the taxpayer recognizes the full

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Deferral Method must include in gross income for the taxable year of receipt (or, if applicable, for a short taxable year described in section 5.02(2) of this revenue procedure) all advance payments not previously included in gross income —

(a) if, in that taxable year, the taxpayer either dies or ceases to exist in a transaction other than a transaction to which § 381(a) applies, or

(b) if, and to the extent that, in that taxable year, the taxpayer’s obligation with respect to the advance payments is satisfied or otherwise ends other than in —

(i) a transaction to which § 381(a) applies, or

(ii) a § 351(a) transfer in which (a) substantially all assets of the trade or business (including advance payments) are transferred, (b) the transferee adopts or uses the Deferral Method in the year of transfer, and (c) the transferee and the transferor are members of an affiliated group of corporations that file a consolidated return, pursuant to §§ 1504–1564.

.03 Examples . In each example below, the taxpayer uses an accrual method of accounting for federal income tax purposes and files its returns on a calendar year basis. Except as stated otherwise, the taxpayer in each example has an applicable financial statement as defined in section 4.06 of this revenue procedure. Example 1 . On November 1, 2004, A, in the business of giving dancing lessons, receives an advance payment for a 1-year contract commencing on that date and providing for up to 48 individual, 1-hour lessons. A provides eight lessons in 2004 and another 35 lessons in 2005. In its applicable financial statement, A recognizes ¹ /6 of the payment in revenues for 2004, and ⁵ /6 of the payment in revenues for 2005. A uses the Deferral Method. For federal income tax purposes, A must include ¹ /6 of the payment in gross income for 2004, and the remaining ⁵ /6 of the payment in gross income for 2005.

Example 2 . Assume the same facts as in Example 1, except that the advance payment is received for a 2-year contract under which up to 96 lessons are provided. A provides eight lessons in 2004, 48 lessons in 2005, and 40 lessons in 2006. In its applicable financial statement, A recognizes ¹ /12 of the payment in revenues for 2004, ⁶ /12 of the payment in revenues for 2005, and ⁵ /12 of the payment in gross revenues for 2006. For federal income tax purposes, A must include ¹ /12 of the payment in gross income for 2004, and the remaining ¹¹ /12 of the payment in gross income for 2005.

Example 3 . On June 1, 2004, B, a landscape architecture firm, receives an advance payment for goods and services that, under the terms of the agreement, must be provided by December 2005. On December 31, 2004, B estimates that ³ /4 of the work under the agreement has been completed. In its applicable fi

this revenue procedure. Any amount of the advance payment not included in the taxable year of receipt and the short taxable year must be reported in gross income for the taxable year immediately following the short taxable year.

(3) Inclusion of advance payments in gross income .

(a) Except as provided in paragraph (b) of this section 5.02(3), a taxpayer using the Deferral Method must —

(i) include the advance payment in gross income for the taxable year of receipt (and, if applicable, in gross income for a short taxable year described in section 5.02(2) of this revenue procedure) to the extent recognized in revenues in its applicable financial statement (as defined in section 4.06 of this revenue procedure) for that taxable year, and

(ii) include the remaining amount of the advance payment in gross income in accordance with section 5.02(1)(a)(ii) of this revenue procedure. (b) If the taxpayer does not have an applicable financial statement (as defined in section 4.06 of this revenue procedure), or if the taxpayer is unable to determine, as required by section 5.02(1)(b)(i) of this revenue procedure, the extent to which advance payments are recognized in revenues in its applicable financial statements for the taxable year of receipt (and a short taxable year described in section 5.02(2) of this revenue procedure, if applicable), a taxpayer using the Deferral Method must include the advance payment in gross income for the taxable year of receipt (and, if applicable, in gross income for a short taxable year described in section 5.02(2)) to the extent earned in that taxable year and include the remaining amount of the advance payment in gross income in accordance with section 5.02(1)(a)(ii) of this revenue procedure. The determination of whether an amount is earned in a taxable year must be made without regard to whether the taxpayer may be required to refund the advance payment upon the occurrence of a condition subsequent. If the taxpayer is unable to determine the extent to which a payment (such as a payment for contingent goods or services) is earned in the taxable year of receipt (and, if applicable, in a short taxable year described in section 5.02(2)), the taxpayer may determine that amount —

(i) on a statistical basis if adequate data are available to the taxpayer;

(ii) on a straight line ratable basis over the term of the agreement if the taxpayer receives advance payments under a fixed term agreement and if it is not unreasonable to anticipate at the end of the taxable year of receipt that the advance payment will be earned ratably over the term of the agreement; or

(iii) by the use of any other basis that in the opinion of the Commissioner results in a clear reflection of income.

(4) Allocable payments .

(a) General rule . A taxpayer that receives a payment that is partially attributable to an item or items described in section 4.01(3) of this revenue procedure may use the Deferral Method for the portion of the payment allocable to such item or items and, with respect to the remaining portion of the payment, may use any proper method of accounting (including the Deferral Method if the remaining portion of the advance payment is for an item or items described in section 4.01(3) of this revenue procedure with a different deferral period (based on the taxpayer’s applicable financial statement or the earning of the payment, as applicable)), provided that the taxpayer’s method for determining the portion of the payment allocable to such item or items is based on objective criteria.

(b) Advance payments under sec- tion 4.01(3)(i) . An advance payment under section 4.01(3)(i) that is wholly attributable to two or more items described in subparagraphs (a) through (h) of section 4.01(3) of this revenue procedure that have the same deferral period (based on the taxpayer’s applicable financial statement or the earning of the payment, as applicable) is not an allocable payment under section 5.02(4)(a) of this revenue procedure. (c) Allocation deemed to be based on objective criteria . A taxpayer’s allocation method with respect to an allocable payment described in section 5.02(4)(a) of this revenue procedure will be deemed to be based on objective criteria if the allocation method is based on payments the taxpayer regularly receives for an item or items it regularly sells or provides separately.

(5) Acceleration of advance payments . Notwithstanding section 5.02(1) of this revenue procedure, a taxpayer using the

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nancial statement, B recognizes ³ /4 of the payment in revenues for 2004 and ¹ /4 of the payment in revenues for 2005. B uses the Deferral Method. For federal income tax purposes, B must include ³ /4 of the payment in gross income for 2004, and the remaining ¹ /4 of the payment in gross income for 2005, regardless of whether B completes the job in 2005.

Example 4 . On July 1, 2004, C, in the business of selling and repairing television sets, receives an advance payment for a 2-year contract under which C agrees to repair or replace, or authorizes a representative to repair or replace, certain parts in the customer’s television set if those parts fail to function properly. In its applicable financial statement, C recognizes ¹ /4 of the payment in revenues for 2004, ¹ /2 of the payment in revenues for 2005, and ¹ /4 of the payment in revenues for 2006. C uses the Deferral Method. For federal income tax purposes, C must include ¹ /4 of the payment in gross income for 2004 and the remaining ³ /4 of the payment in gross income for 2005. Example 5 . On December 2, 2004, D, in the business of selling and repairing television sets, sells for $200 a television set with a 90-day warranty on parts and labor (for which D, rather than the manufacturer, is the obligor). D regularly sells televisions sets without the warranty for $188. In its applicable financial statement, D allocates $188 of the sales price to the television set and $12 to the 90-day warranty, recognizes ¹ /3 of the amount allocable to the warranty ($4) in revenues for 2004, and recognizes the remaining 2/3 of the amount allocable to the warranty ($8) in revenues for 2005. D uses the Deferral Method. For federal income tax purposes, D must include the $4 allocable to the warranty in gross income for 2004 and the remaining $8 allocable to the warranty in gross income for 2005.

Example 6 . E, in the business of photographic processing, receives advance payments for mailers and certificates that oblige E to process photographic film, prints, or other photographic materials returned in the mailer or with the certificate. E tracks each of the mailers and certificates with unique identifying numbers. On July 20, 2004, E receives payments for 2 mailers. One of the mailers is submitted and processed on September 1, 2004, and the other is submitted and processed on February 1, 2006. In its applicable financial statement, E recognizes the payment for the September 1, 2004, processing in revenues for 2004 and the payment for the February 1, 2006, processing in revenues for 2006. E uses the Deferral Method. For federal income tax purposes, E must include the payment for the September 1, 2004, processing in gross income for 2004 and the payment for the February 1, 2006, processing in gross income for 2005. Example 7 . F, a hair styling salon, receives advance payments for gift cards that may later be redeemed at the salon for hair styling services or hair care products at the face value of the gift card. The gift cards look like standard credit cards, and each gift card has a magnetic strip that, in connection with F ’s computer system, identifies the available balance. The gift cards may not be redeemed for cash, and have no expiration date. In its applicable financial statement, F recognizes advance payments for gift cards in revenues when redeemed. F is not able to determine the extent to which advance payments are recognized in revenues in its applicable financial statement for

the taxable year of receipt and therefore does not meet the requirement of section 5.02(1)(b)(i) of this revenue procedure. Further, F does not determine under a basis described in section 5.02(3)(b) of this revenue procedure the extent to which payments are earned for the taxable year of receipt . Therefore, F may not use the Deferral Method for these advance payments.

Example 8 . Assume the same facts as in Example 7, except that the gift cards have an expiration date 12 months from the date of sale, F does not accept expired gift cards, and F recognizes unredeemed gift cards in revenues in its applicable financial statement for the taxable year in which the cards expire. Because F tracks the sale date and the expiration date of the gift cards for purposes of its applicable financial statement, F is able to determine the extent to which advance payments are recognized in revenues for the taxable year of receipt. Therefore, F meets the requirement of section 5.02(1)(b)(i) of this revenue procedure and may use the Deferral Method for these advance payments.

Example 9 . G, a video arcade operator, receives payments in 2004 for game tokens that are used by customers to play the video games offered by G . The tokens cannot be redeemed for cash. The tokens are imprinted with the name of the video arcade, but they are not individually marked for identification. For purposes of its applicable financial statement, G completed a study that determined that for payments received for tokens in the current year, x percent of tokens are expected to be used in the current year, y percent of tokens are expected to be used in the next year, and z percent of tokens are expected to never be used. Based on the study, in its applicable financial statement G recognizes in revenues for 2004 x percent (tokens expected to be used in 2004) and z percent (tokens expected never to be used) of the payments received in 2004 for tokens; G recognizes in revenues for 2005 the remaining y percent of the payments received in 2004 for tokens. G uses the Deferral Method. Using the study, G determines the extent to which advance payments are recognized in revenues in its applicable financial statement for the taxable year of receipt and therefore meets the requirement of section 5.02(1)(b)(i) of this revenue procedure. Under section 5.02(3)(a) of this revenue procedure, G must include advance payments in gross income in accordance with its applicable financial statement in the taxable year of receipt, provided that any portion of the payment not included in income in the taxable year of receipt is included in gross income for the next succeeding taxable year. Thus, for federal income tax purposes, G must include x percent and z percent of the advance payments in gross income for 2004, and y percent of the advance payments in gross income for 2005.

Example 10 . Assume the same facts as in Exam- ple 9, except that G does not have an applicable financial statement (as defined in section 4.06 of this revenue procedure). G completed a study on a statistical basis, based on adequate data available to G, and concluded that for payments received in the current year, x percent of tokens are expected to be used in the current year, y percent of tokens are expected to be used in the next year, and the remaining z percent of tokens are expected to never be used. Based on the study, G treats as earned for 2004 x percent (for tokens expected to be used in that year) as well as z percent (for tokens that are expected to never be

used). G uses the Deferral Method. Using the study, G determines the extent to which advance payments are earned in the taxable year of receipt and therefore meets the requirement of section 5.02(1)(b)(ii) of this revenue procedure. Because G does not have an applicable financial statement, G may determine the extent to which a payment is earned in the taxable year of receipt on a statistical basis under section 5.02(3)(b)(i) of this revenue procedure, provided that any portion that is not included in the taxable year of receipt is included in the next succeeding taxable year. Thus, for federal income tax purposes, G must include x percent and z percent of the advance payments in gross income for 2004, and y percent of the advance payments in gross income for 2005.

Example 11 . H is in the business of compiling and providing business information for a particular industry in an online format accessible over the internet. On September 1, 2004, H receives an advance payment from a subscriber for 1 year of access to its online database, beginning on that date. In its applicable financial statement, H recognizes ¹ /3 of the payment in revenues for 2004 and the remaining ² /3 in revenues for 2005. H uses the Deferral Method. For federal income tax purposes, H must include ¹ /3 of the payment in gross income for 2004 and the remaining 2/3 of the payment in gross income for 2005. Example 12 . On December 1, 2004, I, in the business of operating a chain of “shopping club” retail stores, receives advance payments for membership fees. Upon payment of the fee, a member is allowed access for a 1-year period to I ’s stores, which offer discounted merchandise and services. In its applicable financial statement, I recognizes ¹ /12 of the payment in revenues for 2004 and ¹¹ /12 of the payment in revenues for 2005. I uses the Deferral Method. For federal income tax purposes, I must include ¹ /12 of the payment in gross income for 2004, and the remaining 11/12 of the payment in gross income for 2005. Example 13 . In 2004, J, in the business of operating tours, receives payments from customers for a 10-day cruise that will take place in April 2005. Under the agreement, J charters a cruise ship, hires a crew and a tour guide, and arranges for entertainment and shore trips for the customers. In its applicable financial statement, J recognizes the payments in revenues for 2005. J uses the Deferral Method. For federal income tax purposes, J must include the payments in gross income for 2005.

Example 14 . On November 1, 2004, K, a travel agent, receives payment from a customer for an airline flight that will take place in April 2005. K purchases and delivers the airline ticket to the customer on November 14, 2004. K retains a portion of the customer’s payment (the excess of the customer’s payment over the cost of the airline ticket) as its commission. Because K is not required to provide any services after the ticket is delivered to the customer, K earns its commission when the airline ticket is delivered. The customer may cancel the flight and receive a refund from K only to the extent the airline itself provides refunds. K does not have an applicable financial statement (as defined in section 4.06 of this revenue procedure), but, in its unaudited financial statements, K recognizes its commission in revenues for 2005. The commission is not an advance payment as defined in section 4.01 of this revenue procedure because the payment is not earned by K, in whole or

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in part, in a subsequent taxable year. Thus, K may not use the Deferral Method for this payment.

Example 15 . L, a professional sports franchise, is a member of a sports league that enters into contracts with television networks for the right to broadcast games to be played between teams in the league. The money received by the sports league under the contracts is divided equally among the member teams. The league entered into a 3-year broadcasting contract beginning October 1, 2004. L receives three equal installment payments on October 1 of each contract year, beginning in 2004. In its applicable financial statement, L recognizes ¹ /4 of the first installment payment in revenues for 2004 and ³ /4 in revenues for 2005; L recognizes ¹ /4 of the second installment in revenues for 2005 and ³ /4 in revenues for 2006; L recognizes ¹ /4 of the third installment in revenues for 2006 and ³ /4 in revenues for 2007. L uses the Deferral Method. Under section 4 of this revenue procedure, each installment payment constitutes an “advance payment.” For federal income tax purposes, L must include ¹ /4 of the first installment payment in gross income for 2004 and ³ /4 in gross income for 2005; ¹ /4 of the second installment in gross income for 2005 and ³ /4 in gross income for 2006; and ¹ /4 of the third installment in gross income for 2006 and ³ /4 in gross income for 2007.

Example 16 . M is in the business of negotiating, placing, and servicing insurance coverage and administering claims for insurance companies. On December 1, 2004, M enters into a contract with an insurance company to provide property and casualty claims administration services for a 4-year period beginning January 1, 2005. Pursuant to the contract, the insurance company makes four equal annual payments to M ; each payment relates to a year of service and is made during the month prior to the service year (for example, M is paid on December 1, 2004, for the service year beginning January 1, 2005). In its applicable financial statement, M recognizes the first payment in revenues for 2005; the second payment in revenues for 2006; the third payment in revenues for 2007; and the fourth payment in revenues for 2008. M uses the Deferral Method. Under section 4 of this revenue procedure, each annual payment constitutes an “advance payment.” For federal income tax purposes, M must include the first payment in gross income for 2005; the second payment in gross income for 2006; the third payment in gross income for 2007; and the fourth payment in gross income for 2008.

Example 17 . N is a cable internet service provider that enters into contracts with subscribers to provide internet services for a monthly fee (paid prior to the service month). For those subscribers who do not own a compatible modem, N provides a rental cable modem for an additional monthly charge (also paid prior to the service month). Pursuant to the contract, N will replace or repair the cable modem if it proves defective during the contract period. In December 2004, N receives payments from subscribers for January 2005 internet service and cable modem use. In its applicable financial statement, N recognizes the entire amount of these payments in revenues for 2005. N uses the Deferral Method. Because a subscriber’s use of a cable modem is ancillary to the provision of internet services by N, and because the cable modem warranty is ancillary to the use of the cable modem, the payments are advance payments within the meaning of section 4.01(3)(i) of this revenue procedure.

Further, because the deferral period for each item is the same in N ’s applicable financial statement, N is not required to allocate the advance payments (see section 5.02(4)(b) of this revenue procedure). For federal income tax purposes, N must include the advance payments in gross income for 2005.

Example 18 . On January 1, 2005, O enters into, and receives advance payments pursuant to, a 5-year license agreement for its computer software. Under the contract, the licensee pays O both the first-year (2005) license fee and the fifth-year (2009) license fee upon commencement of the agreement. The fees for the second, third, and fourth years are payable on January 1 of each license year. In its applicable financial statement, O recognizes the fees in revenues for the respective license year. O uses the Deferral Method. For federal income tax purposes, O must include the first-year license fee in gross income for 2005, the second-year and the fifth-year license fee in gross income for 2006, the third-year license fee in gross income for 2007, and the fourth-year license fee in gross income for 2008.

Example 19 . On July 1, 2004, P, in the business of selling and licensing computer software (off the shelf, fully customized, and semi-customized) and providing customer support, receives an advance payment for a 2-year “software maintenance contract” under which P will provide software updates if it develops an update within the contract period, as well as online and telephone customer support. In its applicable financial statement, P recognizes ¹ /4 of the payment in revenues for 2004, ¹ /2 in revenues for 2005, and the remaining ¹ /4 in revenues for 2006, regardless of when P provides updates or customer support. P uses the Deferral Method. For federal income tax purposes, P must include ¹ /4 of the payment in gross income for 2004 and ³ /4 in gross income for 2005.

Example 20 . Assume the same facts as in Exam- ple 19, except that P changes its taxable period to a fiscal year ending March 31 so that P has a short taxable year beginning January 1, 2005, and ending March 31, 2005. In its applicable financial statement, P recognizes ¹ /4 of the payment in revenues for the taxable year ending December 31, 2004; ¹ /8 in revenues for the short taxable year ending March 31, 2005; ¹ /2 in revenues for the taxable year ending March 31, 2006; and ¹ /8 in revenues for the taxable year ending March 31, 2007. Because the taxable year ending March 31, 2005, is 92 days or less, section 5.02(2) of this revenue procedure applies. For federal income tax purposes, P must include ¹ /4 of the payment in gross income for the taxable year ending December 31, 2004, ¹ /8 in gross income for the short taxable year ending March 31, 2005, and the remaining ⁵ /8 in gross income for the taxable year ending March 31, 2006.

Example 21 . Assume the same facts as in Exam- ple 19, except that P ceases to exist on December 1, 2004, in a transaction other than a transaction to which § 381(a) applies. For federal income tax purposes, P must include the entire advance payment in gross income for 2004.

Example 22 . On July 1, 2004, Q, in the business of selling and licensing computer software (off the shelf, fully customized, and semi-customized) and providing customer support, receives an advance payment of $100 for a 2-year software license agreement that includes a 1-year “software maintenance contract” under which Q will provide software up

dates if it develops an update within the contract period, as well as online and telephone customer support. In its applicable financial statement, Q allocates $20 of the payment to the maintenance contract and $80 to the license agreement, based on objective criteria. With respect to the $20 allocable to the maintenance contract, Q recognizes ¹ /2 ($10) in revenues for 2004 and the remaining ¹ /2 ($10) in revenues for 2005 regardless of when Q provides updates or customer support. With respect to the $80 allocable to the license agreement, Q recognizes ¹ /4 ($20) in revenues for 2004, ¹ /2 ($40) in revenues for 2005, and the remaining ¹ /4 ($20) in revenues for 2006. Q uses the Deferral Method. For federal income tax purposes, Q must include $30 in gross income for 2004 ($10 allocable to the maintenance contract and $20 allocable to the license agreement) and the remaining $70 in gross income for 2005.