Revenue Code 456: Electing to Defer Prepaid Dues

Internal Revenue Code Section 456 provides a tax accounting method for organizations that receive membership dues in advance. While the accrual method of accounting normally recognizes revenue when it is earned, this code section allows qualifying organizations to defer this prepaid income. The purpose of this election is to better align the recognition of income with the period in which the associated services or membership privileges are provided to members.

Qualifying for the Deferral

To be eligible for the income deferral under Section 456, an entity must qualify as a “membership organization.” This is defined as a corporation or association that operates on a membership basis and does not have capital stock. A defining characteristic is that no part of the organization’s net earnings can be distributed to any member or shareholder. This structure is common for entities like automobile clubs and professional associations.

The income eligible for deferral must be “prepaid dues income,” which is any amount received for services or membership privileges the organization is obligated to provide in the future. A requirement is that this liability must extend beyond the end of the taxable year in which the payment is received. The liability to provide services cannot extend for more than 36 months from the date of receipt. For example, if an auto club receives payment for a 24-month membership, it can defer that income because the service obligation falls within the 36-month window.

This deferral applies only to income from dues for services or privileges. If a portion of a member’s payment is for something else, like rent for exhibit space, that portion is not considered prepaid dues income. The organization must use an accrual method of accounting for its subscription income to make this election. If an organization has more than one trade or business, it must make a separate election for each one.

How to Make the Election

Adopting the deferral method is a change in accounting method and requires a formal election by filing Form 3115, Application for Change in Accounting Method. This form requires information about the organization, its current method of accounting for dues, and the proposed deferral method. The organization must describe its business operations and the nature of the membership liabilities.

A statement must be attached to Form 3115 that provides specific details about the election. This includes a description of the services provided to members and the length of the membership periods. The organization must also state that it will report the income ratably over the period of the liability.

For an existing organization, the election is considered an automatic consent change, meaning prior permission from the IRS is not needed. The organization must attach the completed Form 3115 to its timely filed income tax return for the year of the change. This simplifies the process for many taxpayers.

Once the election is made, the organization implements the new accounting method. The income is recognized proportionally over the life of the membership. For instance, if a member pays $360 for a 36-month membership, the organization would recognize $10 of income each month. This ratable inclusion of income continues for the duration of the liability.

Ceasing the Election

An election to defer prepaid dues remains in effect for all subsequent tax years unless it is formally ended. An organization may voluntarily stop using this accounting method but must obtain consent from the IRS. To do this, the organization must file another Form 3115, requesting to change its accounting method back to its prior system.

The election also terminates if the organization’s liability to provide services ends, for example, if the organization dissolves or ceases its operations. In such a scenario, any prepaid dues income that was deferred in prior years and has not yet been included in gross income must be recognized immediately. This remaining balance is included in the organization’s gross income for the final taxable year.