Revenue Ruling 82-74: Deferring Income for Services

Under Internal Revenue Code (IRC) Section 451(c), businesses have a method to defer income received for future services, aligning tax reporting with when the work is performed. This allows certain taxpayers to postpone recognizing advance payments as income until the tax year after they are received. The goal is to better match income recognition with the period in which the underlying services occur, rather than simply reporting income when the cash is collected.

Eligibility for Income Deferral

To qualify for this income deferral, a business must use an accrual method of accounting. An accrual-basis taxpayer generally recognizes income when the right to receive it is fixed, not necessarily when payment is received. This stands in contrast to cash-basis taxpayers, who report income in the year they receive it.

The deferral method depends on whether a taxpayer has an Applicable Financial Statement (AFS). An AFS is a certified financial statement used for credit purposes or filed with an agency like the Securities and Exchange Commission.

The payment must be for services that will be completed in the tax year following the year of receipt. If the service agreement extends beyond this one-year timeframe, the entire advance payment must generally be included in income in the year it is received.

The method cannot be used for advance payments for:

• Rent
• Certain insurance premiums
• Payments related to financial instruments
• Some warranty contracts

Calculating the Deferrable Amount

The calculation for the deferrable amount depends on whether the taxpayer has an AFS. For a taxpayer with an AFS, the income included for the year of receipt is the same amount recognized as revenue in its AFS for that year. The remainder is deferred and included in income the following tax year.

For a taxpayer without an AFS, income is recognized as it is earned, often on a pro-rata basis. For example, a consulting firm receives a $2,400 payment on September 1 for a 12-month service contract that runs through August 31 of the following year. In the year of receipt, the firm will perform four months of service (September through December). The amount included in the current year’s income would be $800 (4/12 $2,400), and the remaining $1,600 is deferred to the next year.

Adopting the Deferral Method

Adopting this deferral approach is a change in accounting method, which requires formal approval from the IRS. A business cannot simply start deferring advance payments on its tax return without permission. The procedural mechanism for obtaining this consent is filing Form 3115, Application for Change in Accounting Method.

For many changes, including this one, the IRS provides automatic consent if the taxpayer meets the requirements outlined in its procedural guidance. This streamlines the process, as the taxpayer does not have to wait for a specific letter of consent before implementing the change.

A copy of the completed Form 3115 is typically attached to the taxpayer’s timely filed federal income tax return for the year the change is being implemented. Properly completing and filing this form is a necessary step for a business to compliantly shift its income recognition.