9046 / How are advance payments treated by a taxpayer who uses the accrual method of accounting?

Editor’s Note: The 2017 tax reform legislation modified the treatment of advance payments. See Q for details.

An accrual basis taxpayer who enters into an agreement to provide future services may postpone reporting advance payments under the agreement if the services relate to property the taxpayer owns, leases, builds or installs, but only if the agreement relates to servicing property the taxpayer ordinarily owns, leases, builds or installs in the ordinary course of business without such a service agreement. Recognition of advance payments is not permitted when (1) the taxpayer will perform any part of the service after the end of the tax year immediately following the year of payment or (2) the service will be performed at an unspecified future date that might be after the end of the tax year immediately following the year of payment.¹

Example 1: Scott owns a computer sales business. In 2024, he receives payment for a one-year service contract on a computer that he sold. If Scott normally sells computers without the service contract, he can postpone until 2025 recognition of any income he did not earn in 2024 because, by the terms of the agreement, the services will be performed within one year.

Example 2: Lauren owns a dance studio and, on October 1, 2024, receives payment for a one-year contract for 48 dance lessons. The one-year period begins on October 1. Lauren gives eight dance lessons in 2024. She is required to recognize one-sixth (8/48) of the advance payment in 2024, because she has earned that portion. Further, she is required to recognize the remainder of the income in 2025, even if she does not give all of the lessons in 2025.

The IRS has released guidance that provides a safe harbor for accrual basis taxpayers to treat economic performance as occurring ratably over the life of contracts that provide for services to be provided over time. Under this safe harbor, taxpayers who enter into ratable service contracts are now permitted to expense the cost of regularly provided services as those services are provided over the life of the contract. One example provided in the guidance makes clear that, in the case of ratable service contracts, a payment made in December 2024 for services to be performed in January 2025 can be expensed in 2024, when payment is made. A contract qualifies for treatment as a ratable service contract if (1) it provides for the provision of services on a regular basis (weekly, monthly, etc.), (2) each occurrence of services provides independent value and (3) the contract term is for 12 months or less (excluding extensions).²

If the accrual basis taxpayer must give up certain rights in order to receive the agreed upon amounts, accrual of that income will be prevented. For example, the courts have held that, in the case of an insurance claim resulting from property damage where the insured held two different insurance policies, a clause in policy A that prevented the payout unless the taxpayer agreed to forego his right to the proceeds of policy B prevented accrual. Even though all events that would give rise to the taxpayer’s rights to the amounts receivable under policy A had occurred and the amount could be determined, attachment of the condition prevented accrual of the amounts involved.³ The right to receive an amount must be enforceable by the recipient with no strings attached.