In ILM 201619009, the Service ruled that a taxpayer that receives an advance payment for a contract and then has all of its stock acquired by an unrelated corporation and writes down the associated deferred revenue liability to its fair value as of the acquisition date must include the advance payment in its gross income in the year of receipt to the extent the payment is recognized in revenues in its applicable financial statement (AFS) for the tax year. The taxpayer must include the remaining amount of the advance payment in its gross income in the next succeeding tax year, regardless of any write-down of the deferred revenue liability for financial accounting purposes.

Facts

Taxpayer, a corporation that files its federal income tax return on a calendar-year basis, received an advance payment for a two-year contract to provide services on May 1, 2015. Taxpayer uses the deferral method in Revenue Procedure 2004-34, 2004-1 C.B. 991, as its accounting method for advance payments. Taxpayer recorded the advance payment as a deferred revenue liability on its AFS for financial accounting purposes, 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.

An unrelated corporation acquired Taxpayer on August 31, 2015, and Taxpayer's short tax year ended on that date. As of August 31, 2015, Taxpayer had only recognized 1/6 of the advance payment in revenues in its AFS.

After the acquisition, the unrelated corporation wrote down Taxpayer's deferred revenue liability to its fair value as of the acquisition date and that amount will be recognized in revenues on Taxpayer's AFS in accordance with Taxpayer's accounting method used for financial accounting purposes. A certain amount, however, will never be recognized in revenues on Taxpayer's AFS.

Analysis

The Service ruled that the advance payment was an accession to wealth that Taxpayer must include in its income under Section 61 under its proper accounting method. The Service determined that the advance payment satisfied the definition of "advance payment" in Revenue Procedure 2004-34 and later factual developments occurring after the year-end, such as the unrelated corporation's write-down of Taxpayer's deferred revenue liability, do not affect this determination.

The Service noted that, at the end of Taxpayer's short tax year on August 31, 2015, Taxpayer had reported 1/6 of the payment in revenues on its AFS and the unrelated corporation wrote down Taxpayer's deferred revenue liability to its fair value as of September 1, 2015, the first day of Taxpayer's next succeeding tax year. Accordingly, the Service ruled that Taxpayer is eligible for deferral and must take 1/6 of the advance payment into income for its short tax year ending August 31, 2015, under Section 451 and Revenue Procedure 2004-34. Taxpayer must include the remainder of the advance payment in its income for its next succeeding tax year, even though a certain amount will never be recognized in revenues in Taxpayer's AFS.

Additionally, the Service concluded that Revenue Procedure 2004-34 does not allow Taxpayer to exclude from gross income any part of the advance payment and GAAP purchase accounting rules do not override Section 61, which requires Taxpayer to include in gross income the entire amount of the advance payment because it is an accession to wealth.

Implications

EY agrees with the Service's conclusion under the facts set forth above. That is, the write-down of the deferred revenue liability to a reduced amount for book purposes does not affect the taxpayer's accrual of the advance payment income under Revenue Procedure 2004-34, which does not require accelerated recognition of the advance payment at issue. EY understands that some practitioners have asserted a position contrary to the result in the ILM. Further, if the taxpayer's facts instead were that the deferred revenue liability was written down to zero, we believe that the result would be the same from the standpoint of the application of Revenue Procedure 2004-34. We understand that this approach is consistent with the informal, unpublished view of certain IRS National Office personnel. These issues recently were discussed at the Federal Bar Association Federal Tax Conference and ABA Tax Section meetings in Washington, DC.

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