Is Deferred Revenue Taxable? Rules for Advance Payments

When a business receives money for a product or service it has not yet delivered, it records this as deferred revenue. From an accounting standpoint, this is a liability on the balance sheet, representing an obligation to the customer. The revenue is considered “unearned” until the company fulfills its promise. Only then is the amount recognized as revenue on the income statement, which aligns with the principles of accrual accounting.

The tax treatment of these advance payments, however, often diverges from accounting rules. While an accountant sees a liability, tax authorities may see immediate income. This difference stems from the distinct objectives of financial accounting, which focuses on a company’s financial health, and tax law, which is structured to collect revenue for government operations.

The General Rule for Taxing Advance Payments

For federal income tax purposes, the default principle is that advance payments are included in a business’s gross income in the year they are received. This is true regardless of when the products are delivered or services are rendered, and it applies even if the payment is not yet considered “earned” for financial accounting. This immediate inclusion of income is based on the tax concept that if a taxpayer receives income under a “claim of right” and without restriction as to its disposition, it is taxable in that year.

This means a business that receives a payment in December for a service to be performed next March must report that entire payment as income on the current year’s tax return. The logic is that the business has the cash in hand and can use it freely, making it part of the income for that period. This approach ensures that income is taxed when the taxpayer has the resources to pay the tax.

The Deferral Method Exception

An exception to the general rule of immediate taxation is the Deferral Method. Available to businesses using an accrual method of accounting, this option allows taxpayers to postpone recognizing certain advance payments until the year following the year of receipt. The rules for this method were codified in the Internal Revenue Code by the Tax Cuts and Jobs Act of 2017.

Eligibility for this method is specific. It applies to advance payments received for a range of items, including:

• Services
• The sale of goods
• The use of intellectual property like trademarks and copyrights
• Subscriptions for publications or software

A business receiving a prepayment for a one-year software license or for a custom manufacturing project could use this method to better align its tax liability with its accounting revenue.

Certain types of payments are explicitly excluded from this deferral treatment. These ineligible payments include rent and insurance premiums. For these specific items, the general rule of inclusion in the year of receipt applies, even for accrual-basis taxpayers. The distinction between eligible and ineligible payments requires businesses to carefully categorize the nature of their advance payments.

Applying the Deferral Method

The mechanics of the Deferral Method center on a one-year postponement. A business can defer including an advance payment in its taxable income, but only to the extent that the revenue is also deferred for financial reporting purposes. Any portion of the payment that is recognized as revenue in the business’s financial statements in the year of receipt must also be included in taxable income for that same year.

Consider a calendar-year business that sells a 12-month software subscription for $12,000, receiving the full payment on July 1 of Year 1. For its financial statements, the company recognizes $1,000 in revenue each month. By the end of Year 1, it will have recognized $6,000 (for July through December). Under the Deferral Method, the business would include this $6,000 in its taxable income for Year 1. The remaining $6,000, which is deferred for accounting purposes, can also be deferred for tax purposes and will be included in its taxable income for Year 2.

The limitation of this method becomes clear with multi-year contracts. Imagine the same business receives a $2,400 payment on May 1 of Year 1 for a 24-month service contract. For its financial statements, it recognizes $100 per month. In Year 1, it would recognize $800 in revenue (for May through December). Because the deferral is limited to only the next succeeding tax year, the entire remaining balance of $1,600 must be included in taxable income for Year 2, even though a portion of that revenue will not be “earned” for accounting purposes until Year 3.

How to Adopt the Deferral Method

Adopting the Deferral Method is not automatic; it requires a formal election because it is considered a change in accounting method. A business that has been following the general rule of including all advance payments in the year of receipt cannot simply start deferring them on its tax return. Instead, it must file IRS Form 3115, Application for Change in Accounting Method.

For this specific change to the Deferral Method, the process falls under the automatic consent procedures of the IRS. This means that prior permission from the IRS is not required before making the change, as long as the form is completed correctly and filed with the tax return for the year of the change.

The automatic consent procedure simplifies the process, but it does not reduce the importance of accurate filing. Failure to file this form can result in the IRS disallowing the deferral during an audit, forcing the business back to the default method of recognizing all advance payments as income in the year they are received.