Tax Considerations for Gift Card Issuers – Restaurants and Retail

Gift Card Revenue

Gift cards are an effective strategy for increasing cash flow and attracting new customers. Convenient for purchasers and redeemers alike, they essentially provide restaurants and retailers with free advertising through word of mouth and customer referrals.

While gift cards are very popular in today’s restaurant and retail world, they are also a very hot area of scrutiny with the IRS. Calculation of the gift card income adjustment under IRS audits is becoming more commonplace, as they analyze how companies recognize such earnings. Great emphasis is laid on the use of correct methods and procedures.

Businesses issuing a gift card receive an “advance payment” for the obligation to provide goods or services at a future time. Under Section 1.451-5(b), accrual-based taxpayers are entitled to adopt an accounting method to defer income recognition on the sale of gift cards that are unredeemed as of the company’s calendar or fiscal year-end. A taxpayer generally may not defer advance payments with respect to an agreement for the sale of goods beyond the end of the second taxable year following the year the taxpayer receives a substantial advance payment such as a gift card sale (hence, a two-year deferral). The regulations provide that the term “agreement” includes a gift certificate as well as any agreement obligating a taxpayer to sell goods in a future tax year and which also contains an obligation to perform services that are to be performed as an integral part of such sales (this is referred to as “integral services”). Therefore, a taxpayer may use the two-year deferral method for sales of gift cards that are redeemable for goods or integral services.

One-Year Deferral

The One-Year Deferral Method is a general rule defined under Internal Revenue Code 2004-34 and allows a taxpayer to defer advance payments in the year they are received whether integral or non-integral goods or services are provided. Deferred payments must be included in the subsequent year’s income. This method can be applied to many types of advance payments (goods, services, gift cards, etc.). Under this method related groups of restaurants, management companies, and franchisors/franchisees would be eligible.

Two-Year Deferral

The Two-Year Deferral is also defined under Internal Revenue Code 2004-34, but has further requirements for eligibility. In order to qualify:

  • The taxpayer must have inventory on the hand at the time the gift card is sold (sale of goods or integral services.).
  • The card must be sold and redeemed by the same taxpayer.
  • A disclosure is required on the tax return (Regulation 1.451.5).

Accounting for Gift Cards

When it comes to gift card revenue, keeping a carry-forward schedule with proof of timing differences is recommended to minimize IRS scrutiny. This avoids double revenue recognition and is concrete evidence in the event of an IRS audit. Management must also be aware of changes in revenue recognition regulations and update company policies accordingly.

Electing to Change Methods

Once a gift card accounting method has been elected and applied, taxpayers are required to use the same one going forward. If a taxpayer wishes to change methods, he/she must file Form 3115 Application for Change in Accounting Method with the federal income tax return for the year of change.

Unclaimed Property Gift Cards

Many taxpayers do not know the rules regarding unclaimed gift cards. If a certain amount of time lapses and gift cards are not redeemed (a dormancy period), many states will require companies to turn over a portion or all of their value. Because unclaimed property is treated differently across state lines, this raises issues for restaurants or retailers operating in multiple states. For example, Massachusetts gift cards must state the date of issuance and expiration and must be valid for at least 7 years. If the requirements are met, the company may keep the unredeemed value upon expiration.

Please contact us with any questions if your restaurant or retail business sells and redeems gift cards.


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