Category: Miscellaneous; Accounting Periods
& Methods Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) was engaged in the business of issuing trading stamps for supermarkets. TP's practice was to book revenue for sales of stamps and to accrue an expense related to the estimated cost of redemptions. At present, there is a liability for unredeemed stamps of approximately $800,000 to 900,000, and there have been no stamp redemptions for a period of six to nine years. It is assumed that TP's obligation to redeem the stamps does not expire over time either by operation of some contractual provision or through applicable provisions of law, if any. Clearly TP has a potential increase in taxable income equal to the liability for unredeemed stamps. The question is whether, and if so when, must TP take the liability into income. Discussion Under §1.451-4(a)(2) provides additional special requirements for trading stamp companies. (2) Trading stamp companies. For purposes of this section, a taxpayer will be considered as being in the business of selling trading stamps or premium coupons if-- (i) The trading stamps or premium coupons sold by him are issued by purchasers to promote the sale of their merchandise or services, (ii) The principal activity of the trade or business is the sale of such stamps or coupons, (iii) Such stamps or coupons are redeemable by the taxpayer for a period of at least 1 year from the date of sale, and (iv) Based on his overall experience, it is estimated that not more than two-thirds of the stamps or coupons sold which it is estimated, pursuant to paragraph (c) of this section, will be ultimately redeemed, will be redeemed within 6 months of the date of sale. For purposes of this project, I will assume that TP meets these requirements and is thus qualified to use the methodology set forth in Regulation §1.451-4. Under Regulation §1.451-4(a), the taxpayer is allowed to reduce gross income from stamp sales by the cost of redemptions during the taxable year plus (or minus) reasonable additions (or diminutions) in the provision for future redemptions. Regulation §1.451-4(b) provides that the provision for future redemptions is determined by multiplying the estimated average cost of redeeming each stamp by the reasonable estimate of the number of stamps that will ultimately be presented for redemption. [Emphasis added.] Regulation §1.451-4(b)(2) provides (2) Changes in provision for future redemptions. For purposes of this section, a "net addition to" or "net subtraction from" the provision for future redemptions for a taxable year is computed as follows: (i) Carry over the provision for future redemptions (if any) as of the end of the preceding taxable year, (ii) Compute the provision for future redemptions as of the end of the taxable year in accordance with subparagraph (1) of this paragraph, and (iii) If the amount referred to in subdivision (ii) of this subparagraph exceeds the amount referred to in subdivision (i) of this paragraph, such excess is the net addition to the provision for future redemptions for the taxable year. On the other hand, if the amount referred to in such subdivision (i) exceeds the amount referred to in such subdivision (ii), such excess is the net subtraction from the provision for future redemptions for the taxable year. The point of this passage, of course, is twofold: first, the provision for future redemptions operates just like other accounting reserves with which we are all familiar; second, the taxpayer is obligated to justify the existing liability for future redemptions on an annual basis and to adjust that liability via the reserve account as the facts warrant. This is particularly critical in TP's situation because the regulation makes it extremely clear that TP has a positive duty to re-examine and re-justify the liability for future redemption each and every year. Also, it is important to note in this context the language of Regulation §1.451-4(b)(1) which provides that the estimate of the liability for future redemptions is based on the number of stamps that can reasonably be estimated to ultimately be presented. This passage underscores the basic fact of life for the stamp redemption business that some stamps will never be presented. Moreover, it underscores that the estimation process must take into account a reasonable estimate of actual redemptions, not the redemptions that could theoretically occur. Regulation §1.451-4(c) deals with permissible methodologies of estimation as set forth below. (c) Estimated future redemptions-- (1) In general. A taxpayer may use any method of determining the estimated future redemptions as of the end of a year so long as-- (i) Such method results in a reasonably accurate estimate of the stamps or coupons outstanding at the end of such year that will ultimately be presented for redemption, (ii) Such method is used consistently, and (iii) Such taxpayer complies with the requirements of this paragraph and paragraphs (d) and (e) of this section. (2) Utilization of prior redemption experience. Normally, the estimated future redemptions of a taxpayer shall be determined on the basis of such taxpayer's prior redemption experience. However, if the taxpayer does not have sufficient redemption experience to make a reasonable determination of his "estimated future redemptions", or if because of a change in his mode of operation or other relevant factors the determination cannot reasonably be made completely on the basis of the taxpayer's own experience, the experiences of similarly situated taxpayers may be used to establish an experience factor. (3) One method of determining estimated future redemptions. One permissible method of determining the estimated future redemptions as of the end of the current taxable year is as follows: (i) Estimate for each preceding taxable year and the current taxable year the number of trading stamps or coupons issued for each such year which will ultimately be presented for redemption. (ii) Determine the sum of the estimates under subdivision (i) of this subparagraph for each taxable year prior to and including the current taxable year. (iii) The difference between the sum determined under subdivision (ii) of this subparagraph and the total number of trading stamps or coupons which have already been presented for redemption is the estimated future redemptions as of the end of the current taxable year. (4) Determination of an "estimated redemption percentage." For purposes of applying subparagraph (3)(i) of this paragraph, one permissible method of estimating the number of trading stamps or coupons issued for a taxable year that will ultimately be presented for redemption is to multiply such number of stamps issued for such year by an "estimated redemption percentage". For purposes of this section the term "estimated redemption percentage" for a taxable year means a fraction, the numerator of which is the number of trading stamps or coupons issued during a taxable year that it is reasonably estimated will ultimately be redeemed, and the denominator of which is the number of trading stamps or coupons issued during such year. Consequently, the product of such percentage and the number of stamps issued for such year equals the number of trading stamps or coupons issued for such year that it is estimated will ultimately be redeemed. (5) Five-year rule.--(i) One permissible method of determining the "estimated redemption percentage" for a taxable year is to-- (a) Determine the percentage which the total number of stamps or coupons redeemed in the taxable year and the 4 preceding taxable years is of the total number of stamps or coupons issued or sold in such 5 years; and (b) Multiply such percentage by an appropriate growth factor as determined pursuant to guidelines published by the Commissioner. (ii) If a taxpayer uses the method described in subdivision (i) of this subparagraph for a taxable year, it will normally be presumed that such taxpayer's "estimated redemption percentage" is reasonably accurate. (6) Other methods of determining estimated future redemptions. (i) If a taxpayer uses a method of determining his "estimated future redemptions" (other than a method which applies the 5-year rule as described in subparagraph (5)(i) of this paragraph) such as a probability sampling technique, the appropriateness of the method (including the appropriateness of the sampling technique, if any) and the accuracy and reliability of the results obtained must, if requested, be demonstrated to the satisfaction of the district director. (ii) No inference shall be drawn from subdivision (i) of this subparagraph that the use of any method to which such subdivision applies is less acceptable than the method described in subparagraph (5)(i) of this paragraph. Therefore, certain probability sampling techniques used in determining estimated future redemptions may result in reasonably accurate and reliable estimates. Such a sampling technique will be considered appropriate if the sampling is-- (a) Taken in accordance with sound statistical sampling principles, (b) In accordance with such principles, sufficiently broad to produce a reasonably accurate result, and (c) Taken with sufficient frequency as to produce a reasonably accurate result. In addition, if the sampling technique is appropriate, the results obtained therefrom in determining estimated future redemptions will be considered accurate and reliable if the evaluation of such results is consistent with sound statistical principles. Ordinarily, samplings and recomputations of the estimated future redemptions will be required annually. However, the facts and circumstances in a particular case may justify such a recomputation being taken less frequently than annually. In addition, the Commissioner may prescribe procedures indicating that samples made to update the results of a sample of stamps redeemed in a prior year need not be the same size as the sample of such prior year. It is reasonably apparent from the foregoing that the taxpayer has wide latitude in determining the methodology upon which the estimate for future redemptions will be based. It is equally clear, however, that the IRS expects the taxpayer to take a scientific approach based on hard data from some source. Finally, it is abundantly clear that the IRS will carefully scrutinize whatever the taxpayer does. Incidentally, the IRS issued additional guidance for estimation methodologies in the form of Revenue Procedure 72-36, 1972-2 CB 771. The procedure is 40 pages in length and filled with extremely technical statistical methodologies for estimating future redemption obligations. I will be happy to supply a copy of this document should you or TP wish to consider its information value. After attempting to read the document, I can only say that insofar as I understood what I read, I did not see anything that might be directly helpful in TP's circumstances. Finally, Regulation §1.451-4(d) provides a consistency requirement as between financial reporting and tax reporting, and Regulation §1.451-4(e) provides significant tax return information requirements for taxpayers using the provisions of Regulation §1-451-4. Based on the foregoing information several things are immediately clear. 1. TP has a duty to evaluate the reserve account annually. 2. TP must justify the reserve account not based on the cost of redeeming stamps that might theoretically be presented but rather based on the stamps that can realistically be expected to be presented for redemption. 3. TP must justify all estimates based on hard data of some kind, either from TP's own experience or from the experience of similarly situated firms. Without personal knowledge of TP's business, I am forced to rely on common sense which would lead me to speculate that as time passes, the number of stamps that will never be presented for redemption increases. It seems to me that the passage of time must necessarily increase the number stamps lost, destroyed, discarded, or forgotten. If that is indeed the case, TP should have taken the reserve into income gradually over a period of years. Now given a period of six to nine years of zero redemptions, it would seem to me that there is a fairly high likelihood that there will be no significant additional redemptions ever. It appears to me that based on the language of the regulations, TP has an obligation to either justify the reserve with hard data or to reduce the reserve to some nominal sum immediately. I believe that if TP's returns were examined, the IRS could reasonably be expected to take such a position unless TP could produce compelling evidence that the amount of stamps that will never be presented does not increase over time. Given the "no-redemption" history, it seems unlikely that TP would be able to produce such evidence. As a practical matter, I can imagine that TP will be extremely reluctant to virtually eliminate the reserve all at once. If so, I would suggest embarking on a good faith effort to take the reserve account into income in as few years as TP will agree to. |
