Deferred Revenue in General
The treatment of deferred revenue for financial accounting or GAAP purposes and income tax purposes can be materially different and, therefore, can result in unexpected consequences for taxpayers unfamiliar with the rules.
As a general matter, when a company receives an advance payment for services, it recognizes that payment into income for financial accounting or GAAP purposes as it performs such services and the income is “earned.” For income tax purposes, however, the advance payment must generally be recognized into taxable income in the taxable year of receipt, unless the taxpayer uses the accrual method of tax accounting and elects to defer a portion of the taxable-income recognition under Section 451(c).
Section 451(c) permits accrual method taxpayers to recognize advance payments into taxable income as such payments are recognized into income for financial accounting or GAAP purposes, provided that no advance payment can be deferred beyond the tax year that follows the year of receipt. The following example helps illustrate this rule.
Example 1
An accrual-method, calendar-year taxpayer (T) receives a $360 payment for monthly subscription services on February 1, 2024 that will last through January 31, 2027 (i.e., a three-year agreement with subscription services worth $10 per month). Under Section 451(c), T will recognize $110 of the payment in its 2024 taxable income and the remaining $250 in its 2025 taxable income (i.e., 11 months in 2024 at $10 per month and the balance in 2025 because the income cannot be deferred more than one tax year after the year of receipt).
For certain short tax years, there is a special rule. If a taxpayer has a short taxable year of 92 days or fewer, it must recognize the income earned for financial reporting purposes during the short taxable year into taxable income for such tax year. However, the taxpayer can defer the remainder of the revenue deferred under Section 451(c) attributable to its taxable year preceding the short taxable year to its taxable year succeeding its short taxable year.
In the M&A Context
M&A transactions complicate the tax treatment of deferred revenue.
First, many M&A transactions result in shortened taxable years, thereby shortening the period of income tax deferral.
Second, Treasury Regulations Section 1.451-8 requires taxpayers to accelerate advance payments that have not been previously included in income if (1) the taxpayer ceases to exist (including, for example, if the taxpayer becomes a disregarded entity for income tax purposes); or (2) the taxpayer’s obligation with respect to performance on the deferred revenue is satisfied or otherwise ceases to exist in a transaction other than (a) certain tax-free entity combinations (e.g., a tax-free liquidation or tax-free merger) or (b) certain tax-free contributions of assets within a consolidated group. Such acceleration events are also common in M&A transactions.
C Corporations
C corporations are generally required to use the accrual method of tax accounting (except for smaller businesses), so most can defer recognition of prepayments under Section 451(c), and most C corporation acquisitions are not acceleration events. The relevant implications are best illustrated in the following example.
Example 2
Assume the same facts as Example 1 but that (1) T is a C corporation for tax purposes and files its tax return on a calendar year basis; and (2) P is the parent corporation of a consolidated income tax group that also files its consolidated tax return on a calendar year basis.
Situation A – Acquisition in Year of Advance Payment
On August 31, 2024, P purchases 100% of the stock of T and makes an election for T to join in filing as a member of P’s consolidated income tax group beginning September 1, 2024. T will need to file a short-period income tax return for its taxable year ending August 31, 2024 and then file as a member of P’s consolidated income tax group for the remainder of the 2024 tax year.
As a result, (1) T must include the $70 that it recognized for financial reporting purposes before P’s purchase as taxable income in its taxable year ending August 31, 2024; and (2) P includes the remaining $290 in the taxable income of its consolidated income group for its taxable year ending December 31, 2024 (comprising the remainder of the income earned in 2024 and the amounts that otherwise would have been deferred by T until 2025).
Situation B – Acquisition in Year Succeeding Advance Payment
Now assume that P purchases 100% of the stock of T on August 31, 2025 and elects for T to join P’s consolidated income tax group beginning September 1, 2025. As a result, (1) T includes the entire $110 earned for financial purposes in 2024 on its 2024 income tax return; (2) T reports the remaining $250 of the advance payment on its short-period income tax return for 2025; and (3) P includes any new deferred revenue attributable to advance payments received by P during 2024 that had not yet been earned at the time of the sale for financial reporting purposes in its 2025 consolidated income tax return.
Situation C – Acquisition Causing Short Taxable Year
To illustrate the impact of the short-taxable-year rule, assume that instead P acquires 100% of T’s stock on January 31, 2025. Since T’s tax year succeeding the tax year in which it receives the advance payment is less than 92 days, (1) T recognizes the amount that was earned for financial reporting purposes during such short tax year on its January 31, 2025 income tax return (i.e., $10); and (2) the remaining $240 of taxable income related to deferred revenue is picked up in the succeeding taxable year (i.e., P’s 2025 consolidated income tax return).
One important note is that the examples above do not illustrate the impact of any deductions related to the cost to perform on the deferred revenue. Such costs are generally incurred as the deferred revenue is recognized for GAAP purposes (i.e., over the term of the agreement) and may also be deductible for tax purposes as they are incurred to offset income inclusion in a post-closing period. This generally results in less post-closing income inclusion for low-margin businesses.
Flow-through entities
Flow-through entities such as partnerships and S corporations that are smaller and/or closely held may be more likely than C corporations to use the cash method of tax accounting. Further, many M&A transactions involving flow-through entities are also structured as asset acquisitions for income tax purposes and therefore more often result in acceleration events for deferred revenue. However, the buyers and sellers in flow-through M&A transactions always need to consider the implications of deferred revenue when applicable.
Example 3
Assume the same facts as Example 1 but that (1) T is a partnership for tax purposes and files its tax return on a calendar year basis; and (2) P is the parent corporation of a consolidated income tax group that also files its consolidated tax return on a calendar year basis.
Situation A – Acquisition of 100% of T
On August 31, 2024, P purchases 100% of T’s partnership interests. As a result, T’s tax year ends on August 31, 2024, and thereafter T will be a disregarded entity of P for income tax purposes.
Because T ceases to exist for income tax purposes, T must include the entire $360 prepayment (the $70 earned for financial reporting purposes and the remainder) into income for its tax year ending August 31, 2024. P does not have any taxable income inclusion with respect to the $360 prepayment.
Note that if instead T were taxed as an S corporation and if the parties made a Section 338(h)(10) election for the acquisition of T, the practical result would be the same.
Situation B – Acquisition of 50% of T
Now assume that P purchases 50% of T’s partnership interests on August 31, 2024. This does not cause T’s tax year to end or result in any acceleration event because T remains in existence for income tax purposes. Therefore, the acquisition has no impact on T’s income tax treatment of its deferred revenue. If instead, P had acquired T either via merger or another transaction that resulted in P being treated as a continuation of T as a partnership for income tax purposes, the result would be the same.
Practical Considerations
As illustrated in the foregoing examples, the tax treatment of deferred revenue or advance payments is complex and can have unexpected consequences in the M&A context. Identifying the magnitude during the diligence process is the first step in properly managing the tax consequences of deferred revenue.
It is crucial for taxpayers and their advisers to understand and fully consider these consequences on the buy-and-sell side of M&A transactions, taking into consideration the cost to perform on any deferred revenue, the length of such prepaid agreements, and the proper allocation of the related tax obligations.
Parties should work to ensure that the tax treatment of deferred revenue or advance payments aligns with the economics of the deal and that such treatment is properly accounted for in purchase agreements.
You can subscribe to future advisories and other Alston & Bird publications by completing our publications subscription form.
If you have any questions, or would like additional information, please contact one of the attorneys on our Tax Team.