Tax File Memorandum

FACTS:

Peaceful, an accrual basis taxpayer, provides a full line of funeral services and sells goods related to those services. Peaceful has attempted to design an approach that allows customers to prepay for their funeral goods and services.

ISSUE:
The amount prepaid under Peaceful’s program constitutes prepaid income that must be included in Peaceful’s income (and therefore subject to tax) in the year in which it is received.

CONCLUSION:
Peaceful should go ahead and pay the audit based on the facts. The IRS is correct according to the tax code and laws.

ANALYSIS:
Prepaid income tax is a form of prepaid expense. The most common reason why prepayment on income taxes occurs is due to over-estimation of tax deposits. In this situation, taxes are estimated from the financial of the previous year. These estimated taxes are paid. Then, when the year-end taxes are found to be less than the taxes paid earlier, prepayment on income taxes has occurred. This prepayment can create one of two results: a tax refund or the credit written off towards the tax liability of the next period.

According to the Perry Funeral Home, Inc. v. Commissioner, TC Memo 2003-340 , Code Sec(s) 451. PERRY FUNERAL HOME, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Case, Time for reporting income—accrual method—refundable deposit vs. advance payments—pre-need funeral contracts. Accrual-method funeral home corp. properly reported monies received for Massachusetts regulated pre-need funeral service contracts in year services were actually rendered, rather than in payment year as IRS contended: following Supreme Court precedent, payments were refundable deposits, not advance payments, where contracts contained open-ended cancellation and refund rights that left taxpayer without complete dominionand control over funds. Notably, under contracts’ plain language and pursuant to Massachusetts regs], customers controlled whether or when refund would be made; and fact that cancellation/refund rights were rarely exercised was irrelevant.

Because Peaceful were receiving prepaid income they will have to pay taxes on the prepaid sales that were being made within 1 year of the sale. The Internal Revenue Code imposes a Federal tax on the taxable income of every corporation. Sec. 11(a). Section 61(a) specifies that gross income for purposes of calculating such taxable income means “all income from whatever source derived”. Encompassed within this broad pronouncement are all “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 [47 AFTR 162] (1955). Stated otherwise, gross income includes earnings unaccompanied by an obligation to repay and without restriction as to their disposition. James v. United States, 366 U.S. 213, 219 [7 AFTR 2d 1361] (1961).

Section 451(a) provides the following general rule regarding the year in which items of gross income should be included in taxable income:
The amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period. Consistent with the principle of section 451, section 446(a) and (b) directs that taxpayers are to compute taxable income using the method of accounting regularly employed for keeping their books, with the exception that “if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.” In general, the accrual method is designated a permissible method of accounting for purposes of section 446. Sec. 446(c)(2). Under the accrual method, income is to be included for the taxable year when all events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.

References:

Secs. 1.446-1(c)(1)(ii), 1.451- 1(a), Income Tax Regs. Typically, all events that fix the right to receive income have occurred upon the earliest of the following to take place: The income is (1) actually or constructively received; (2) due; or (3) earned by performance. Schlude v. Commissioner, 372 U.S. 128, 133 [11 AFTR 2d 751] (1963); Johnson v. Commissioner, 108 T.C. 448, 459 (1997), affd. in part, revd. in part and remanded on another ground 184 F.3d 786 [84 AFTR 2d 99-5306] (8th Cir. 1999). [pg. 1971] As caselaw applying the above standards has evolved, it has become well established that amounts constituting advance payments for goods or services are includable in gross income in the year received. Schlude v. Commissioner, supra; AAA v. United States, 367 U.S. 687 [7 AFTR 2d 1618] (1961); Auto. Club of Mich. v. Commissioner, 353 U.S. 180 [50 AFTR 1967] (1957); RCA Corp. v. United States, 664 F.2d 881 [48 AFTR 2d 81-6164] (2d Cir. 1981); see also Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 207 & n.3 [65 AFTR 2d 90-394] (1990).

In contrast, amounts properly characterized as loans, deposits, or trust funds are not includable upon receipt. Commissioner v. Indianapolis Power & Light Co., supra at 207-208; Johnson v. Commissioner, supra at 467-475; Oak Indus., Inc. v. Commissioner, 96 T.C. 559, 563-564 (1991); Angelus Funeral Home v. Commissioner, 47 T.C. 391, 397 (1967), affd. 407 F.2d 210 [23 AFTR 2d 69-673] (9th Cir. 1969). The rationale underlying this distinction is that money received in the capacity solely of a borrower, depository, agent, or fiduciary, because it is accompanied by an obligation to repay or restriction as to disposition, is not income at all. See Commissioner v. Indianapolis Power & Light Co., supra at 208 n.3; Johnson v. Commissioner, supra at 474-475. Hence, no question of the timing of income accrual is presented. See Commissioner v. Indianapolis Power & Light Co., supra at 208 n.3; Johnson v. Commissioner, supra at 474-475