Accrual basis taxpayers who receive advanced for the sale of goods prior to the actual sale of such goods may, under Reg. §1.451-5, defer recognition of such income until the earliest of:

The year in which the income would be properly accruable under the taxpayer’s method of accounting for tax purposes;
The year in which the income is recognized for financial statement purposes; or
The end of the second year following the year of receipt. [Reg. §1.451-5(b)1, (c)]

But what about a taxpayer who sells gift cards which can be deemed for either goods sold by the taxpayer or services the taxpayer sells? That situation exists in many contexts, as retailers often offer for sale, in addition to products, servicesFor instance, appliance/electronics stores offer, in addition to the goods, various extended warranty, delivery, repair and installation services. In TAM 201610017 the National Office advised that such entities may make use of a partial deferral.

To qualify for this accounting method three conditions must exist:

There must be an agreement between the customer and the taxpayer for future transactions;
The payments must be applied against that agreement; and
The agreement must be for the sale of goods

The TAM first determines whether the sale of gift cards represents an agreement for the future delivery of goods under Reg. §1.451-5(a), determining that it qualifies as such:

The amounts here were received for the sale of gift cards. If the gift cards can be redeemed for goods they are similarly an agreement under the regulation.11 Company’s gift cards are redeemable for goods, warranties, delivery and installation, * * * and other services. The word “can” ordinarily means may, not must. See, Random House Dictionary of the English Language (2d ed. 1987). Reading “can” in § 1.451-5(a)(2)(i) to mean “must” would exclude from the regulation any retailer whose gift cards could be redeemed for non-integral services or other items. Given the ubiquitous sale of warranty and other services with goods purchased from retailers, such a reading of the regulation is too restrictive. The regulation should be interpreted to apply to gift cards, like Company’s, that can be redeemed for goods but can also be redeemed for other items, as well as to gift cards that can only be redeemed for goods.

That is, the mere fact that some of the amounts on gift cards will be used to pay for services does not mean that none of the payments qualify for deferral.

Rather the TAM points the reader to Reg. §1.451-1(a)(3). That provides:

(3) If a taxpayer (described in subparagraph (1) of this paragraph) receives an amount pursuant to, and to be applied against, an agreement that not only obligates the taxpayer to perform the activities described in subparagraph (1)(i) and (ii) of this paragraph, but also obligates the taxpayer to perform services that are not to be performed as an integral part of such activities, such amount will be treated as an “advance payment” (as defined in subparagraph (1) of this paragraph) only to the extent such amount is properly allocable to the obligation to perform the activities described in subparagraph (1) (i) and (ii) of this paragraph. The portion of the amount not so allocable will not be considered an “advance payment” to which this section applies. If, however, the amount not so allocable is less than 5 percent of the total contract price, such amount will be treated as so allocable except that such treatment cannot result in delaying the time at which the taxpayer would otherwise accrue the amounts attributable to the activities described in subparagraph (1)(i) and (ii) of this paragraph.

While noting the regulation contemplates an agreement where the components are fixed ahead of time, the TAM concludes that if the taxpayer can reasonably estimate the amounts that are expected to used to acquire goods as opposed to services, the portion allocable to services may be deferred under the rules of Reg. §1.451-5, with only the portion allocable to services required to be immediately recognized.

The TAM specifically says:

The inclusion in 1.451-5(a)(2)(i), that gift cards “can” be redeemed for goods may only be given effect by inferring a process similar to § 1.451-5(a)(3) and treating the totality of Company’s outstanding gift cards at the end of the taxable year of their sale as if they represented a single agreement, and then estimating amounts properly allocable to the sale of goods, integral services, and the amount not so allocable for these gift cards representing a future sale13. Accordingly, gift cards that can be redeemed for goods and non-integral services are eligible to apply allocation rules similar to those described in § 1.451-5(a)(3) by treating the total of the Company’s outstanding gift cards at the end of the taxable year of their sale as a single agreement and allowing estimates to be used for the application of § 1.451-5(a)(3). Applying this approach to Company’s gift cards, it is eligible to defer amounts received for its gift cards to the extent it can make an appropriate estimate of the amounts that are deferrable under § 1.451-5.

The memorandum does not describe such a “reasonable estimation” methodology for use in the situation that lead to this request for a ruling, noting that this is a fact specific issue.