The proliferation of electronic gift cards raises critical income tax and unclaimed property issues for retailers’ gift card policies. These issues also affect the issuance of merchandise credit or customer refunds in electronic form. Federal income tax law has not caught up with the proliferation of gift cards: the IRS is still assessing how retailers’ should report income from gift card sales. In addition, revenuestarved states are enacting laws to make unused gift card balances escheat to the state as unclaimed property.
Retailers’ issuance of gift cards raises the following income tax and unclaimed property issues:
- The proper income tax treatment of gift card sales as an advance payment;
- The use of special-purpose subsidiaries to issue retail gift cards;
- The bulk sale of gift cards to third-party vendors; and
- Whether unused balances are unclaimed property that escheats to the state.
Federal Taxation and IRS Audits of Retailers’ Gift Card Sales
Retailers issue gift cards both in original sales and as store credits for merchandise returns, in lieu of cash refunds. Either way, a significant portion of gift card value is never redeemed. Many retailers treat the unused gift card value as additional revenue.
Aware of this widespread practice, the IRS is subjecting retailers’ treatment of unused credit balances to close scrutiny. In its 2009 Public Report, the Large and Midsize Business Subgroup of The Internal Revenue Service Advisory Counsel explains that the IRS is seeking guidance on the proper treatment by retailers of their gift card sales proceeds. Furthermore, the IRS designated the tax treatment of gift card sales and merchandise credits as a “Tier II” issue under the IRS’s Large and Mid-Size Business Division (the “LMSB”). This designation means the IRS intends to devote increased attention and greater audit resources to the treatment of unused store credit balances.
Generally, the IRS permits accrual method taxpayers that sell gift cards to treat the gift card sales as “advance payments.” An advance payment is a payment that a taxpayer receives in the current year for goods or services in a subsequent year. The principal tax benefit of treating the sale as an advance payment is the deferral of income from the sale. The taxpayer not only defers income for tax purposes, but also defers reporting the income in its gross receipts for financial accounting purposes until a subsequent year. In the case of an accrual method retailer, that subsequent year is when a customer uses the gift card or merchandise credit. Treasury Department regulations now set out the requirements a retailer must satisfy to treat the sale of a gift card as an advance payment. IRS guidance supplements those regulations.
Retailers can easily run afoul of the advance payment regulations by using subsidiaries to process or third-party vendors to distribute gift cards. Some retailers that sell gift cards at their retail outlets process the sale through, and forward the proceeds to, related subsidiaries. As a gift cardholder redeems the gift card’s value, the subsidiary returns the redeemed value to the retailer that provided the goods or services to the gift cardholder. In return, the retailer pays its subsidiary a fee to process the transaction. Retailers that employ subsidiaries in this manner should expect the LMSB to disallow their advance-payment treatment of the gift card sale. The LMSB contends that advance-payment treatment is only available if the gift card issuer is the same entity that provides the goods or services when customers redeem the gift cards. The LMSB takes the position that the subsidiary’s proceeds from gift card sales are not advance payments because the retailer, not the subsidiary, provides goods or services to the gift card holders.
The LMSB has also denied advance-payment treatment to retailers’ bulk sales of gift cards to third-party vendors. As supermarket checkout displays attest, many retailers sell their gift cards to third-party vendors, who then resell the retailer’s gift cards. Under these circumstances, the LMSB contends that the retailer's sale is complete upon its bulk sale of the gift cards to the third-party vendor. Therefore, the IRS disallows the retailer’s use of advance-payment treatment to defer reporting the sale for income tax purposes.
A further issue arises when retailers issue gift cards for merchandise credits or customer refunds. Under the regulations and IRS guidance, the deferral period is limited; the taxpayer cannot defer income recognition indefinitely. Where a retailer issues merchandise credits or customer refunds on gift cards, when does the limited deferral period begin? When the retailer makes the initial sale? Or not until the retailer issues the credit or refund? To complicate matters further, customers often fail to present a sales receipt for the credit or refund.
No receipt makes it difficult, if not impossible, for retailers to know when the original sale took place.
State Treatment of Unused Gift Card Balances as Unclaimed Property
In addition to income tax issues, retailers must also be wary of state laws on unclaimed property. Many states deem gift cards’ unused credit balances to be unclaimed property that escheats to the state after a specified period. Taking a more lenient approach to retailers, other states allow retailers to pocket the unused credit balances. For example, Virginia exempts from its unclaimed property laws gift cards that are redeemable for merchandise. In contrast, Texas takes unused gift card balances by escheat, if the retailer imposes certain terms on the gift cards, such as expiration dates or certain types of service fees. To ensure that retailers properly relinquish to state treasuries the unused balances of gift cards and merchandise credits, many states resort to unclaimed property audits of retailers’ gift card records. We expect unclaimed property audits to increase as more states view unclaimed property remittances as a significant revenue source.
Interaction Between Federal Tax Law and State Unclaimed Property Law
Retailers’ treatment of unused balances on gift cards create both federal and state law issues. Retailers that attempt to avoid certain states’ unfavorable unclaimed property laws may unwittingly encounter federal tax issues with advance-payment treatment. For example, some retailers might form a gift card-processing subsidiary in a state with favorable unclaimed property laws only to run afoul of the federal rules on advance payments. It will often be difficult for retailers to reconcile the state law implications of their actions with federal tax laws. To ensure the most favorable treatment for unused balances on gift cards and merchandise credit cards, retailers must consider both state and federal laws and seek legal counsel, where needed.
Review of Policies and Financial Reporting Implications
Williams Mullen recommends that its retail clients comprehensively examine their gift card policies, including income tax reporting of gift card sales, and review their compliance with states’ unclaimed property laws. Retail clients should likewise examine their financial reporting of gift card transactions. Those who are public companies in particular should assess whether they must claim income from unused gift card balances or disclose income tax or unclaimed property liabilities due to unused gift card balances.