Retail gift cards raise tax and unclaimed property audit risks and present planning opportunities. As discussed in a prior Tax Alert, the IRS designated the tax treatment of amounts received from gift card sales as a “Tier II” issue. This indicates that the IRS plans to increase the audit resources it devotes to examining retailers’ tax reporting of gift card sales. (See, Williams Mullen Tax Alert, Retail Gift Cards and Store Credits — A Tax and Unclaimed Property Risk, February 2010)

IRS Field Attorney Advice on Gift Card Subsidiaries

A recent IRS Field Attorney Advice illustrates the use of a gift card subsidiary to avoid the application of unfavorable state unclaimed property laws. In FAA 20100901F (Mar. 5, 2010), the IRS addressed a retailer’s use of a disregarded entity to sell gift cards and administer a gift card program. The gift card subsidiary was structured in a manner that allowed the retailer to treat the gift card sales proceeds as advance payments. As advance payments, the retailer could defer the recognition of income recognition until the year in which a customer actually redeemed the gift card.

Advance Payment Regime

The IRS permits accrual method taxpayers that sell gift cards to treat such sales as “advance payments.” As advance payments, retailers selling gift cards can defer income from the sales until the year that customers redeem the gift cards for merchandise. A retailer using a gift card subsidiary will sell the gift cards at its retail outlets, but process the sale through and forward the proceeds to its subsidiary. In effect, the gift card subsidiary is selling the gift cards at its parent’s retail store. When a gift cardholder eventually redeems the gift card’s balance, the subsidiary forwards the redeemed value of the gift card to the retailer. In turn, the retailer pays its subsidiary a fee for processing the transaction.

The IRS contends that advance payment treatment is only available if the gift card issuer is the same entity that provides the merchandise when customers redeem the gift cards. The IRS takes the position that the gift card subsidiary's sales proceeds from the gift card sales are not advance payments because the retailer, rather than its subsidiary, is the entity providing the merchandise.

In its March 2010 Field Attorney Advice, the IRS informed a revenue agent that the retailer did not run afoul of the advance payment regime even though the retailer used a gift card subsidiary to sell gift cards and administer the retailer’s gift card program. The retailer organized its gift card subsidiary as a single member limited liability company disregarded for tax purposes. The IRS concluded that the subsidiary, as an unincorporated division of the retailer, was the same entity as the retailer for purposes of the advance payment regime. Therefore, the retailer could defer income recognition until the customers redeemed the gift cards.

Use of Disregarded Subsidiary in Favorable Jurisdictions

Many states with significant budget deficits are looking for alternative sources of revenue. Several states (including Texas, New York, North Carolina and South Carolina) have enacted or considered laws mandating that unused gift card balances “escheat” to the state as unclaimed or abandoned property after a period of years, after a period of inactivity, or when the gift card expires. Other states take a more lenient approach to retailers, allowing retailers to retain the unused credit balances. If a retailer is concerned about the “escheatment” of unused gift card balances to the state, it should consider organizing a gift card subsidiary (structured as a disregarded entity) in a state with favorable unclaimed property laws. This will give the retailer the ability to select a more favorable venue for the application of unclaimed property law while taking advantage of the favorable tax treatment afforded by advance payment tax regime.

Review of Income Tax and Unclaimed Property Implications

To ensure the most favorable treatment for unused balances on gift cards, retailers should consider both state and federal laws applicable to them and seek counsel when necessary. For more information on this topic, please contact a member of the firm’s Tax Law Practice Group or Retail Industry Service Group