Purchase-accounting write-down does not reduce taxable advance payment

Plain-English summary

A corporation received an advance payment for a two-year service contract and used Revenue Procedure 2004-34 to defer part of the income. After an unrelated buyer acquired its stock, purchase accounting reduced the deferred-revenue liability to fair value, leaving much of the payment never to appear as revenue in the corporation’s financial statements. Chief Counsel advised that the accounting write-down did not reduce the amount taxable under IRC §§ 61 and 451. The corporation had to include the portion recognized in its applicable financial statement in the short year of receipt and include the entire remaining payment in the next succeeding tax year. On the stated figures, 20x was income in the short year and 100x was income in the following consolidated return.

Ruling snapshot

• Question: Does a post-acquisition financial-accounting write-down reduce the remaining advance payment included in taxable income under Revenue Procedure 2004-34?
• Outcome: Advice given
• Key authorities: IRC §§ 61 and 451; Rev. Proc. 2004-34

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201619009
           Release Date: 5/6/2016
           CC:ITA:B01:JKristall
           POSTN-106723-16

 UILC:     61.00-00, 451.13-00

  date:    March 11, 2016

     to:   Keith G. Medleau
           Office of the Division Counsel
           (Large Business & International)
           CC:LB&I

  from:    Lewis K Brickates
           Chief, Branch 1
           Office of the Associate Chief Counsel
           (Income Tax & Accounting)


subject:   Proper Tax Treatment of Deferred Revenue in a Taxable Stock Acquisition

           This memorandum responds to your request for advice. This advice may not be used
           or cited as precedent

           ISSUE

           What amount of an advance payment does a taxpayer that (1) has deferred
           recognizing revenue into income under Rev. Proc. 2004-34, 2004-1 C.B. 991, and
           (2) subsequently has all of its stock acquired by an unrelated corporation that, for
           financial accounting purposes, writes down the associated deferred revenue liability to
           its fair value as of the date of the acquisition, include in gross income for the next
           succeeding taxable year?

           CONCLUSION

           A taxpayer that (1) has deferred recognizing revenue into income under Rev. Proc.
           2004-34 and (2) subsequently has all of its stock acquired by an unrelated corporation
           that, for financial accounting purposes, writes down the associated deferred revenue
           liability to its fair value as of the date of the acquisition, must include the advance
           payment in its gross income for federal income tax purposes in the year of receipt to
           the extent the payment is recognized in revenues in its Applicable Financial Statement
POSTN-106723-16                             2

(“AFS”) for that taxable year, and must include the remaining amount of the advance
payment in its gross income in the next succeeding taxable year, irrespective of any
write-down of the deferred revenue liability for financial accounting purposes.

FACTS

On May 1, 2015, T, a corporation that files its federal income tax return on a calendar
year basis, received 120x as an advance payment for a 2-year contract to provide
services. For federal income tax purposes, T uses the Deferral Method described in
section 5.02 of Rev. Proc. 2004-34 as its method of accounting for advance payments.
For financial accounting purposes, T recorded 120x as a deferred revenue liability on
its AFS, expecting to report 1/3 of the advance payment in revenues in its AFS for
2015, 1/2 for 2016, and 1/6 for 2017. On August 31, 2015, P, an unrelated
corporation that files its federal income tax return on a calendar year basis, acquired
all of the stock of T, and T joined P’s consolidated group. T’s short taxable year
ended on August 31, 2015, and, as of that date, T had recognized only 1/6 (20x) of the
advance payment in revenues in its AFS. On September 1, 2015, after the stock
acquisition, and in accordance with purchase accounting rules under Generally
Accepted Accounting Principles (GAAP), P wrote down T’s deferred revenue liability to
its fair value of 10x as of the date of the acquisition. That 10x will be recognized in
revenues on T’s AFS in accordance with the method of accounting T uses for financial
accounting purposes. The remaining 90x of the advance payment will never be
recognized in revenues on T’s AFS.

LAW AND ANALYSIS

Section 61(a) of the Internal Revenue Code provides that, except as otherwise
provided in subtitle A, gross income means all income from whatever source derived.
See also § 1.61-1(a) of the Income Tax Regulations. Gross income is an undeniable
accession to wealth, clearly realized, over which a taxpayer has complete dominion.
Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).

In general, § 451 provides that the amount of any item of gross income is included in
gross income for the taxable year in which received by the taxpayer, unless, under the
method of accounting used in computing taxable income, the amount is to be properly
accounted for as of a different period.

Rev. Proc. 2004-34 permits certain taxpayers using an overall accrual method of
accounting to defer including advance payments in income in some circumstances.
An advance payment for purposes of Rev. Proc. 2004-34 is a payment received by a
taxpayer if –

   (1) Including the payment in gross income for the taxable year of receipt is a
       permissible method of accounting for federal income tax purposes;
POSTN-106723-16                              3

   (2) The payment is recognized by the taxpayer (in whole or in part) in revenues in
       its AFS (as defined in section 4.06 of Rev. Proc. 2004-34) for a subsequent
       taxable year; and

   (3) The payment is for one of several listed items, including services.

A taxpayer within the scope of Rev. Proc. 2004-34 may elect to use the Deferral
Method under which the taxpayer 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) of Rev. Proc. 2004-34) to the extent recognized in
revenues in its AFS for that taxable year. The taxpayer must include the remaining
amount of the advance payment in gross income for the next succeeding taxable year.

Income is computed based on all of a taxpayer’s transactions during a taxable year.
To require taxpayers to reflect events occurring after the end of the taxable year would
be disruptive and would violate the spirit of the annual accounting system. Healy v.
Commissioner, 345 U.S. 278, 284-85 (1953). See also Burnet v. Sanford & Brooks
Co., 282 U.S. 359, 363 (1931) (“[Tax is assessed] on the basis of . . . all the taxpayer's
transactions during a fixed accounting period, either the calendar year, or, at the
option of the taxpayer, the particular fiscal year which he may adopt”).

In this case, the advance payment T received was an accession to wealth that T must
include in its income under § 61 under its proper method of accounting. The advance
payment T received satisfied the definition of an advance payment in section 4.01 of
Rev. Proc. 2004-34 because as of the end of T’s short taxable year ending August 31,
2015, 100x would be recognized in T’s AFS for a subsequent taxable year under T’s
method of accounting. Subsequent factual developments occurring after year-end,
such as P’s write-down of T’s deferred revenue liability, do not affect this
determination.

For T’s short taxable year ending August 31, 2015, T had reported 1/6 (20x) of the
payment in revenues on its AFS. P wrote down T’s deferred revenue liability to its fair
value of 10x as of September 1, 2015, the first day of T’s next succeeding taxable
year. T is eligible for deferral and under T’s deferral method must take 1/6 (20x) of the
advance payment into income for its short taxable year ending August 31, 2015, in
accordance with § 451 and Rev. Proc. 2004-34. The remainder (100x) of the advance
payment must be included in income for T’s next succeeding taxable year in
accordance with section 5.02 of Rev. Proc. 2004-34, even though 90x of the 100x will
never be recognized in revenues in T’s AFS. This follows from the language of
section 5.02(1)(a)(ii) of Rev. Proc. 2004-34, which requires a deferring taxpayer to
“include the remaining amount of the advance payment in gross income for the next
succeeding taxable year.” Indeed, § 451 and Rev. Proc. 2004-34 provide rules only
for determining the taxable year(s) during which T must include the entire 120x in
gross income. Rev. Proc. 2004-34 neither authorizes nor permits T to exclude from
gross income any part of the 120x of advance payments T received under the service
POSTN-106723-16                             4

contract. In addition, GAAP purchase accounting rules do not override the mandate
under § 61 that T include in gross income the entire 120x accession to wealth it
received under the service contract.

Accordingly, 20x must be included in income on T’s short-year return for its taxable
year ending August 31, 2015, and 100x must be included in income for T as part of
P’s consolidated return for the taxable year ending December 31, 2015, irrespective of
P’s write-down of the deferred revenue liability.

Please contact Jason Kristall at (202) 317-7003 if you would like further assistance or
have any questions about the contents of this memorandum.