Understanding Taxation of Deferred Revenue: Deferred Income Tax & Its Tax Year

Understanding Taxation of Deferred Revenue:  Deferred Income Tax & Its Tax Year
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The Importance of Understanding the Rules on Taxation on Deferred Revenues

Electrician’s Mate 2nd Class Nathan Hansen, left, helps Operations Specialist 1st Class Paul Lutton prepare his tax return aboard the Nimitz-class aircraft carrier USS John C. Stennis (CVN 74)

Certain transactions pose some elements of difficulty when discerning the taxation of deferred revenue.

In considering the recognition of income in a transaction in which not all conditions have been met, the matter of determining the point in time as to when the deferred revenue is recognized will depend on the actual date of delivery and/or payment.

The aspect of deferred income tax will likewise come into focus in conjunction with this, inasmuch as late or non-payment of taxes entails penalties. In a worst-case scenario, deferment of revenue may be construed as intentional or a form of tax evasion or an attempt to evade tax and will, therefore, be subject to both criminal and civil penalties. See “Penalty for Failure to Report Income on a Tax Return”.

IRS taxation laws and the SEC’s standards of accounting have two different views on when deferred revenue should be recognized; hence, it is important to look closely into each agency’s rules.

Internal Revenue Services (IRS) Basis for Revenue Recognition

The IRS guidelines in recognizing income for purposes of taxation on deferred revenue states that income is recognized if all conditions or events have transpired to constitute a sale. This denotes that the signing of a contract cannot be constituted as a sale transaction unless the delivery of goods or services has been rendered. In which case:

  • The signed contract and the receipt of goods delivered clearly establish the fact that the recipient of the goods or services will pay at the agreed time, regardless if full payment has yet to be received by the seller. Under taxation rules, this can be construed as a consummated sale.

  • Hence the point in time by which income will be recognized is during the tax year that the agreement or contract was signed, along with the acceptance of the delivered goods or services by the buyer.

  • The deferred revenue initially recognized as liability will remain as such until the payment has been completed. This is only as far as accounting for cash is concerned and without prejudice to the recognition of the deferred revenue.

  • The deferral of payment does not denote the deferral of revenue if a signed contract or agreement clearly states that the buyer is bound by a promise to pay at a specified time.

  • In the absence of an agreement or contract that will establish a promise to pay or any document that will bind the buyer to pay, the IRS will consider the seller as shrewd enough to deliver the goods only if full payment was received.

Securities and Exchange Commissions’ (SEC) Views on Deferred Revenues

800px-Leverage Ratios

The SEC on the other hand requires a more conservative approach, in which income should be recognized only if the company is fully assured of its realization, and this denotes that full payment has been received. In which case:

  • Partial or down payment cannot be considered as income inasmuch as the amount may represent only a partial recovery of the cost of goods sold.

  • Income is still not assured, since the buyer may still default in remitting the full payment on the agreed and specified date.

  • The public should not be misled into believing that income has been gained when, in fact, only a partial recovery of the cost of goods sold is included in the financial condition of the company.

  • Reporting income in conformity with GAAP principles does not necessarily mean that the income reported for the SEC’s or investor’s purposes is the taxable income.

Please proceed to the next page regarding specific transactions: taxation on deferred revenue beyond the taxable year.

Determining the Tax Year of a Deferred Income

435px-Form 1040, 2005

There are certain transactions in which the elements of agreement, delivery, and payment are not the basis for determining the tax year of a deferred revenue. Find examples below:

Sale of Property under the 1031 Exchange—Although this taxation rule has been superseded by another rule for Capital Gains Tax, the same will be discussed for those transactions falling under the 1031 category or those that occurred prior to the revision of the Capital Gains Tax.

A 1031 exchange is one where a property held for investment was sold but the proceeds from said sale remain intact and are held under escrow by the real estate agent. The sales proceeds will be released from escrow only if they will be used to buy a replacement property of the “like-kind” and with relatively the same value as the property sold. This way, no income will be recognized and only the payment of the Capital Gains Tax is deferred.

In the event that the replacement property purchased has a lower value, which will leave an excess in the amount held in escrow by the real estate agent, said excess will be reported by the latter to the IRS for taxation purposes. The excess represents income on the part of the seller that was deferred pending the purchase of a “like kind” property. In our example, however, the replacement property purchased was not a “like kind;” hence the seller will be required to pay the corresponding Capital Gains Tax on the excess within 30 days after the prescribed period for 1031 exchange transactions.

For more information about the latest rules on Capital Gains Tax on sale of real estate, readers may refer to a separate article entitled: “IRS Tax Information when Flipping a House”.

Contributions to Pension Fund

Generally, the employers’ contributions to a pension fund are considered part of the employees’ compensations and are therefore taxable. Contributions to pension funds are exempt from federal income tax only if the funds were deducted from the employee’s salary and set aside as a retirement fund qualified as exempt by the IRS, i.e. 401k.

In a 401K retirement agreement, the employee who partially pre-withdraws from his pension fund prior to his retirement, will have to pay taxes for the amount withdrawn within the tax year it was received. In addition, applicable taxes will be computed from the date the portion was credited as a retirement fund.

This condition precludes the employee from assigning his earnings as contributions to his retirement with the intention of avoiding withholding taxes. Since retirement contributions are considered deferred income on the part of the employee, the amount becomes taxable if used for other purposes.

Change of Accounting Method to Recognize Taxation of Deferred Income

In case an entity was audited by its external auditor as non-compliant with taxation rules by not using the “unearned revenue or deferred revenue” method of accounting, the entity has to notify the IRS of any changes in the accounting method and seek its approval by using IRS Form 3115, Application for Change in Accounting Method.

  • The IRS will evaluate the merits involved in changing the accounting method used before the next tax return is prepared.

  • Failure to do so will deem the use of the wrong accounting method as intentional or as an attempt to evade taxes if the wrong method is discovered by the IRS.

  • A voluntary change in the wrong accounting method used lessens the adverse impact since it is deemed as unintentional. Otherwise, the penalty for tax evasion or even attempts at tax evasion will include the filing of criminal charges.

Based on the explanations furnished, learners as well as taxpayers will have more awareness that taxation on deferred income is not limited to the context of unearned revenues in businesses.

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