Gift cards have become an increasingly important source of revenue for many retailers. In response to what the Internal Revenue Service (the "Service") referred to as numerous "variations and problems" involving the recognition of revenue and expenses related to gift card sales, on May 23, 2007, the Service’s Large and Mid- Size Business Division ("LMSB") issued an Industry Director Directive (LMSB-04- 0507-039) intended to provide guidance to examiners in the classification and examination of taxpayers who receive gift card income.

In the directive, LMSB identifies two categories of issues related to gift card sales. The memorandum directs examiners to contact the relevant Technical Advisor within the Service in the event that an issue belonging to the first category arises within the context of an examination or if the examiner becomes aware of a significant issue concerning gift card sales which is not represented in the second category.

The first category includes compliance problems with the rules for deferral of gift card income as established by Treas. Reg. § 1.451-5. The regulation provides for deferral of advance payments from the sale of a gift card until the last day of the second taxable year after the sale. In order for deferral to be appropriate, the taxpayer must have sufficient goods on hand to satisfy the requirements of the unredeemed gift cards and also must attach an information schedule to the taxpayer’s return detailing gift card income from the current taxable year that is being deferred and gift card income from a prior year that is being reported in the current taxable year. The directive indicates that generally strict compliance with the information schedule provisions will be required. Often this schedule is omitted because taxpayers are unaware of the differences between financial and tax reporting requirements for gift card revenue.

The first category also includes issues that arise from a change in the taxpayer’s method of accounting for gift card income. A change in a taxpayer’s method of accounting for income from gift cards that involves a change to or from the deferral method described above requires the taxpayer to file Form 3115. The directive emphasizes that gift certificates and gift cards are considered the same "item" for accounting method purposes for taxpayers that may be switching from the use of gift certificates to gift cards.

Finally, the first category includes issues involving the use of estimates to report the amount of unredeemed gift cards. The Service has taken the position that a taxpayer who utilizes the deferral method provided for in Treas. Reg. § 1.451-5 must specifically track unredeemed gift card amounts; estimates are not sufficient for purposes of the information schedule required by the regulation.

The second category of issues related to gift card sales identified by LMSB includes matters such as separate gift card companies, gift cards versus gift certificates, reloadable gift cards, deposits, gift cards as refunds, dormancy fees, escheatment to states, bulk sales discounts, expiration dates, and charitable contributions of gift cards.

Pillsbury Winthrop Shaw Pittman’s tax lawyers have extensive experience in the tax accounting issues faced by retailers and are available to assist with accounting method changes as well as issues that arise upon audit.

About Pillsbury's Gift and Prepaid Cards Practice

Pillsbury provides ongoing counsel to retailers and financial institutions on regulatory compliance with federal and state laws related to gift cards, prepaid cards and stored value cards, for both closed and open universe programs. We counsel on the unclaimed property requirements related to gift and prepaid cards, as well as state laws regarding expiration dates, fees and other terms and conditions. We also advise on the licensing requirements triggered by gift cards.

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