IRS Revenue Procedure 92-98

IRS Revenue Procedure 92-98

26 CFR 601.204: Changes in accounting periods and in methods of accounting.

(Also Part 1, Section 446; 1.446-1.)

SECTION 1. PURPOSE

This revenue procedure implements an administrative decision, made by the

Commissioner in the exercise of her discretion under section 446 of the Internal

Revenue Code. Under this revenue procedure, accrual method manufacturers,

wholesalers, and retailers of motor vehicles or other durable consumer goods

may, in certain specified and limited circumstances, include a portion of an

advance payment related to the sale of a multi-year service warranty contract in

gross income generally over the life of the service warranty obligation.

SEC. 2. BACKGROUND

In general, payments received by an accrual method taxpayer for services to

be performed in the future must be included in gross income in the taxable year

of receipt. The Commissioner recognizes that this treatment has resulted in a

significant and unique cash flow problem for certain accrual method taxpayers

that sell multi-year service warranty contracts to customers in connection with

the sale of motor vehicles or other durable consumer goods and immediately pay a

third-party to insure their risks under the contracts.

Accordingly, the Commissioner has made an administrative decision to permit

these taxpayers to adopt or change to a special method of accounting for

advance payments that would alleviate the cash flow problem arising in these

situations but would generally conform economically to the tax treatment of

advance payments under current law. In general, this method of accounting

permits these taxpayers to recognize and include in gross income, generally over

the period of their service warranty contracts, a series of equal payments, the

present value of which equals the portion of the advance payment qualifying for

deferral. This method of accounting is described in further detail in section 5.

SEC. 3. DEFINITIONS

.01 The "service warranty income method" for advance payments is the method

of accounting permitted by this revenue procedure and described in section 5.

.02 The "qualified advance payment amount" is the portion of an advance

payment received by a taxpayer under a multi-year service warranty contract that

is paid by that taxpayer to an unrelated third party within 60 days after

receipt for insurance costs associated with a policy insuring that taxpayer's

obligations under the contract.

.03 The classification of goods as "durable consumer goods" for purposes

[*3] of this revenue procedure depends on the common usage of the goods,

rather than the purchaser's actual intended use of the goods. Thus, a taxpayer

qualifying under this revenue procedure does not have to segregate, as

non-qualifying advance payments, those payments under multi-year service

warranty contracts entered into with a purchaser that will use the underlying

durable consumer goods in its trade or business.

SEC. 4. SCOPE

.01 Except as provided in sections 4.03, 4.04, and 4.05 below, the election

to use the service warranty income method is available to any accrual method

manufacturer, wholesaler, or retailer of motor vehicles or other durable

consumer goods (whether or not it is under examination or before appeals or a

federal court on any tax issue) with respect to qualified advance payment

amounts received on service warranty contracts:

(1) that are fixed-term service arrangements with respect to a motor vehicle

or other durable consumer good purchased by a customer;

(2) that are separately priced, such that customers have the option to

purchase the service warranty contracts for an expressly stated amount separate

from the price of the underlying motor vehicle or other durable consumer

good;

(3) for which the service period begins in the taxable year the advance

payment is received or upon expiration of a fixed-term manufacturer's warranty

beginning in the taxable year the advance payment is received;

(4) for which the taxpayer purchases a policy that constitutes insurance for

federal income tax purposes from an unrelated third party to insure its

obligation under the service warranty contract; and

(5) for which the taxpayer makes payment to the unrelated third party insurer

within 60 days after receipt of the advance payment for the entire amount of the

insurance costs associated with the policy insuring its obligations under the

service warranty contract.

.02 For purposes of section 4.01, a service warranty contract will be treated

as a fixed-term arrangement even if the contract provides for a reasonable

mileage or other usage cap that is generally commensurate with average consumer

mileage or usage over the term of the contract and which causes termination of

the fixed-term arrangement when exceeded. Also for purposes of section 4.01, a

taxpayer has not made payment to an unrelated third party insurer if the

taxpayer and the payee are related persons within the meaning of section

267(b) or section 707(b)(1) of the Code.

.03 A taxpayer is not within the scope of this revenue procedure unless the

taxpayer either (1) has never previously received advance payments under service

warranty contracts prior to the taxable year of an election under this revenue

procedure, or (2) uses the proper method of accounting for advance payments

received under its service warranty contracts. See Schlude v. Commissioner, 372

U.S. 128 (1963), 1963-1 C.B. 99.

.04 A taxpayer also is not within the scope of this revenue procedure unless

the taxpayer uses the proper method of accounting for amounts paid or incurred

for insurance costs that cover the taxpayer's risks under service warranty

contracts. See Rev. Proc. 92-97, page 7, this Bulletin, for a description of

this proper method.

.05 This revenue procedure does not apply to any taxpayer that, at the time

for making an election under this revenue procedure, is the subject of a

criminal investigation or proceeding concerning (1) directly or indirectly the

taxpayer's federal tax liability for any year, or (2) the possibility of false

or fraudulent statements made by the [*6] taxpayer with respect to any issue

relating to its federal tax liability for any year.

SEC. 5. DESCRIPTION OF THE SERVICE WARRANTY INCOME METHOD

.01 In general. Taxpayers with an advance payment within the scope of section

4 may elect to include a qualified advance payment amount, increased by an

imputed income amount, in gross income on a level basis over the shorter of (1)

the period beginning in the taxable year the advance payment is received and

ending when the service warranty contract terminates, or (2) a 6-taxable-year

period beginning in the taxable year the advance payment is received. This

method of accounting permits these taxpayers to recognize and include in gross

income, generally over the period of their service warranty contracts, a series

of equal payments, the present value of which equals the qualified advance

payment amounts received by the taxpayer. A taxpayer using the service warranty

income method provided by this section 5 must include in income, in the taxable

year of receipt, the excess of aggregate advance payments received during a

taxable year over aggregate qualified advance payment amounts for the taxable

year.

.02 Simplifying table. An electing taxpayer must use the APPENDIX

table to determine the amount of the gross income (attributable to a qualified

advance payment amount) that must be reported annually under the service

warranty income method.

To use the table for a particular contract, a taxpayer first uses the column

headed by the "Term of Service Agreement in Years." The taxpayer determines

which column to use by ascertaining the length (the number of years) of its

service warranty contract (limited to six years) without regard to whether there

is a period for which there are no obligations under the contract. For example,

if a service warranty contract begins in the third year after payment is

received and ends in the fifth year after payment, the taxpayer uses the column

headed "5." The taxpayer then finds the factor on the row headed by "The

Applicable Interest Rate," which is defined in section 5.04. If the applicable

interest rate in this instance is 8%, the resulting factor would be .2319. This

factor is multiplied by the qualified advance payment amount to determine the

"annual equal payment amount" included in gross income each year for the number

of years headed by the column.

A taxpayer may calculate the aggregate amount to be included in gross

income each year by aggregating the qualified advance payment amounts with

respect to contracts of the same class (i.e., 2-year contracts, 3-year

contracts, etc.). See section 5.08 for examples on using the service warranty

income method.

.03 Special rule for when the taxpayer's trade or business ceases. In the

year in which the taxpayer's trade or business ceases (as defined in section

8.03(2) of Rev. Proc. 92-20, 1992-1 C.B. 685), the remaining qualified advance

payment amounts that have been deferred must be accelerated and included in

gross income, along with appropriate imputed income amounts. These amounts must

be determined using the applicable interest rates specified in section 5.04 and

must be sufficient to ensure that the net present value of all amounts included

in income over the period of deferral equals the qualified advance payment

amounts that would have been reported and included in income upon receipt in the

absence of an election under this revenue procedure. See paragraph (c) of

Example 1 in section 5.08. The Service will compute the amounts to be included

in the year of cessation for [*9] any taxpayer that submits a request for a

ruling pursuant to Rev. Proc. 92-1, 1992-1 C.B. 516 (or its successor). The

Service waives the applicable user fee required under Rev. Proc. 90-17, 1990-1

C.B. 479, for these requests.

.04 Applicable interest rate. The applicable interest rate to be applied to

the qualified advance payment amount received for a particular contract in a

particular taxable year under the service warranty income method is the

applicable federal rate in effect for purposes of section 1274(d) of the Code

(compounded annually) for the month with or within which the taxable year ends.

For purposes of this revenue procedure, the applicable federal rate shall be

rounded to the nearest full percent (or if a multiple of 1/2 of 1 percent, such

rate shall be increased to the next highest full percent).

.05 Effects of the imputed income. Any income imputed on a qualified advance

payment amount under this service warranty income method must not be taken into

account for any purpose under the Internal Revenue Code other than the

determination of a taxpayer's income. Thus, for example, the income imputed on

a qualified advance payment amount may not increase the basis of any

asset held by the taxpayer and may not be recovered as a deduction in any

taxable year. Additionally, any income imputed on a qualified advance payment

amount may not be taken into account, for example, in determining:

(1) the earnings and profits of any corporation under section 312 of the

Code;

(2) the adjustments to a shareholder's stock basis in an S corporation under

section 1367 of the Code;

(3) the adjustments to a partner's interest in a partnership under section

705 of the Code; or

(4) the investment adjustments (or adjustments to an excess loss account)

under section 1.1502-32 of the regulations with respect to the stock of any

consolidated group member owned by another member of the group.

.06 Special rules for customer cancellations of service warranty contracts

and terminations of service warranty contracts because of mileage or usage

limitations.

(1) Customer cancellations. If a customer cancels a service warranty contract

during the taxable year of sale and, in that year, receives a refund of amounts

paid, the amount refunded is not included in the taxpayer's income for the

year of the sale. If a customer cancels a service warranty contract

after the year in which the taxpayer sold the contract, the taxpayer must

continue to include the annual equal payment amount obtained from the APPENDIX

table in gross income for the original length of the cancelled contract. Any

amount refunded to the customer reduces income in the year paid. Imputed income

amounts added to a qualified advance payment amount are not considered in (and

have no effect on) the determination of this reduction of income. Thus,

reductions for refunds upon customer cancellation of a multi-year service

warranty contract are to be determined in the same manner as if the taxpayer did

not make an election under this revenue procedure.

(2) Terminations. If a contract terminates because of a mileage or usage

limitation during or after the year in which the taxpayer sold the contract, the

taxpayer must continue to include the annual equal payment amount obtained from

the APPENDIX table in gross income for the original length of the terminated

contract. See paragraph (b) of Example 1 in section 5.08.

.07 Short taxable years. If a taxpayer using the APPENDIX table has a short

taxable year during the term of its service warranty contract, the

applicable table factor for the short period must be multiplied by a fraction,

the numerator of which is the number of months in the short period, and the

denominator of which is 12. After a short taxable year for which the table

factor adjustment of the preceding sentence has been made, the taxpayer must

continue to determine its gross income on a prior year's qualified advance

payment amount using the applicable table factor for each 12-month taxable year

(or that table factor multiplied by an appropriate fraction for any other short

periods), until the number of months for which the qualified advance payment

amount is taken into account (determined as if the qualified advance payment

amount is first taken into account in the first month of the year in which the

advance payment is received) is equal to the number of months in the original

contract term (as determined under section 5.02). If less than 12-months'

inclusion remains for the final year, the applicable table factor for that year

may be determined as if it were a short period containing the number of months

remaining on the contract not yet taken into account. See Example 2 in section

5.08.

.08 Examples of the service warranty income method.

(1) Example 1. (a) A, a calendar year accrual basis taxpayer, elects under

this revenue procedure to use the service warranty income method of accounting

for its qualified advance payment amounts on service warranty contracts. A sold

5 service warranty contracts on January 1, 1992, for $ 800 each. A also sold 5

service warranty contracts on December 31, 1992, for $ 800 each. All the

service warranty contracts sold by A in 1992 carry a term of 5 years and run

concurrently with the manufacturer's warranties. Further, A pays, within 60

days of the receipt of each advance payment, $ 600 per contract to an unrelated

third party to insure (in an arrangement that constitutes insurance) its

obligations under the service warranty contracts. The applicable interest rate,

determined in accordance with section 5.04 of this revenue procedure, is 10

percent.

A aggregates all its qualified advance payment amounts on its 5-year service

warranty contracts, thus determining that $ 6,000 of qualified advance payment

amounts were received in 1992 with respect to the class of 5-year service

warranty contracts. Applying the "10% and [*14] 5-year" table factor of

.2398 found in the APPENDIX to this revenue procedure, A determines that it must

report income of $ 1,439 in 1992 through 1996 under the election provided in

this revenue procedure. In addition, A must include in gross income in 1992 the

$ 2,000 payment received for services that is not deferred under this revenue

procedure. Gross income is reported by A as follows:

Description of Item 1992 1993 1994 1995 1996

Deferred Income $ 1,439 $ 1,439 $ 1,439 $ 1,439 $ 1,439

Gross Income $ 3,439 $ 1,439 $ 1,439 $ 1,439 $ 1,439

Non-deferred Income $ 2,000

Assuming that A is an S corporation with a single shareholder and that A

reported no income other than that arising from the above service warranty

transactions, the shareholder would report the following section 1367

adjustments to stock basis:

Description of Item 1992 1993 1994 1995 1996

Deferred Income $ 1,200 $ 1,200 $ 1,200 $ 1,200 $ 1,200

Section 1367 Adj. $ 3,200 $ 1,200 $ 1,200 $ 1,200 $ 1,200

Non-deferred Income $ 2,000

The stock basis adjustment for the deferred advance payment amount is determined

by ratably spreading the stock basis adjustment over the term of the service

warranty contract. Since the service warranty contract is treated as sold at

the beginning of the taxable year, the stock basis adjustment each year would be

$ 1,200 ($ 6,000/5). The aggregate imputed income of $ 1,195 ($ 239 x 5) on the

$ 6,000 of aggregate qualified advance payment amounts for 1992 is not taken

into account at any time by the shareholder in determining its basis in the A

stock.

(b) If one of the service warranty contracts described in paragraph (a)

terminates because of a mileage or usage limitation in 1994, there is no effect

on the amounts that A must include in gross income each year. Under section

5.06 of this revenue procedure, A would continue to report the amounts of gross

income set forth in paragraph (a) even if one or more of its service warranty

contracts is terminated.

advance payment amount in gross income in 1992 and the $ 1,439 annual equal

payment amount in gross income in 1992 and 1993, as in paragraph (a)

above. However, in 1994, A must accelerate and include in gross income the

remaining advance payment amount plus an appropriate imputed income amount.

To calculate this amount, A must first determine the portion of the qualified

advance payment amount and the portion of imputed income included in each annual

equal payment amount. For 1992, the annual equal payment amount included in

income, $ 1,439, is entirely from the qualified advance payment amount because

no income is imputed to the taxpayer in the first taxable year. Thus, the $

6,000 deferred qualified advance payment amount is reduced for A's inclusion of

$ 1,439 in 1992 leaving $ 4,561 of deferred qualified advance payment amount

remaining.

For 1993, A multiplies the applicable interest rate of 10% and the 1992

remaining qualified advance payment amount of $ 4,561. That product, $ 456,

constitutes the imputed income portion of the 1993 annual equal payment amount

of $ 1,439. The difference between $ 1,439 and $ 456 ($ 983) is the portion of

the annual equal payment amount that constitutes the qualified advance payment

amount. The $ 983 reduces the qualified advance payment amount

remaining after 1992 to $ 3,578.

When A's business ceases in 1994, A must include in gross income the

qualified advance payment amount remaining after 1993 and an appropriate imputed

income amount. The appropriate imputed income amount is the product of the

qualified advance payment amount remaining after 1993 and the applicable

interest rate ($ 3,578 x 10%), which is $ 358. Thus, in 1994, A includes in

gross income $ 3,936 ($ 3,578 + $ 358).

(2) Example 2. X, a calendar year accrual basis taxpayer, elects under this

revenue procedure to use the service warranty income method of accounting for

its qualified advance payment amounts on service warranty contracts, X sold 5

service warranty contracts on January 1, 1992, for $ 800 each. X also sold 5

service warranty contracts on December 31, 1992, for $ 800 each. All the

service warranty contracts sold by X in 1992 carry a term of 5 years and run

concurrently with the manufacturer's warranties. Further, X pays, within 60

days of the receipt of each advance payment, $ 600 per contract to an unrelated

third party to insure (in an arrangement that constitutes insurance) its

obligations under the service warranty contracts. The applicable

interest rate, determined in accordance with section 5.04 of this revenue

procedure, is 10 percent.

X aggregates all its qualified advance payment amounts on its 5-year service

warranty contracts, thus determining that $ 6,000 of qualified advance payment

amounts were received in 1992 with respect to the class of 5-year service

warranty contracts. Applying the "10% and 5-year" table factor of .2398 found

in the APPENDIX to this revenue procedure, X initially determines that it has

annual equal payment amounts of $ 1,439 includible in gross income in 1992

through 1996 under the election provided in this revenue procedure. In

addition, X must include in gross income in 1992 the $ 2,000 payment received

for services that is not deferred as a qualified advance payment amount by this

revenue procedure.

After making the initial determinations above, X experiences a short taxable

year of 7-months beginning on January 1, 1994, and ending on July 31, 1994.

After the 7-month short period, X's taxable year ends on July 31. When X

experiences the 7-month short period, X must multiply the APPENDIX table factor

[*19] by a fraction, the numerator of which is the number of the months in the

short period, and the denominator of which is 12. This adjusted factor of .1399

(7/12 x .2398) is applied to the qualified advance payment amount of $ 6,000.

The product, $ 839, is included in X's gross income for the short taxable year.

Because X's contracts had a term of 5 years or 60 months (and are assumed under

this revenue procedure to have begun at the beginning of the 1992 taxable year),

there are 5 additional months in the taxable year ending July 31, 1997, for

which a portion of the annual equal payment amount must be taken into account.

Thus, X includes $ 600 (5/12 x .2398 x $ 6,000) in gross income. Gross income

is reported by X in each taxable year as follows:

Description of Item 1992 1993 7-month Yr. End Yr. End

Short Yr. 7/31/95 7/31/96

Non-deferred income $ 2,000

Deferred Income $ 1,439 $ 1,439 $ 839 $ 1,439 $ 1,439

Gross Income $ 3,439 $ 1,439 $ 839 $ 1,439 $ 1,439

Description of Item Yr. End 7/31/97

Non-deferred Income

Deferred Income $ 600

Gross Income $ 600

SEC. 6. MANNER OF MAKING METHOD CHANGE

For a taxpayer that is within the scope of this revenue procedure and that

previously received advance payments (see section 4.03), an election to use the

service warranty income method under this revenue procedure will result in a

change in method of accounting. This change in method of accounting for advance

payments is to be made using a cut-off method under which the taxpayer retains

its former method of accounting for advance payments received on all service

warranty contracts sold prior to the first day of the first taxable year for

which the taxpayer makes an election under this revenue procedure (i.e., the

year of change). The taxpayer begins the use of the service warranty income

method described in this revenue procedure with respect to all qualified advance

payment amounts received in the year of change and thereafter. Because the

change in accounting method under this revenue procedure is made using a cut-off

method, no omissions or duplications are created, and no adjustment under

section 481(a) of the Code is necessary or permitted. Thus, taxpayers are

precluded from taking a net section 481(a) adjustment into account in

any taxable year.

SEC. 7. PROCEDURES

.01 Upon adoption or change to method. A qualifying taxpayer may elect to

adopt or change to the service warranty income method in any taxable year ending

on or after June 12, 1992, by attaching a statement to its timely filed original

federal income tax return (including extensions) for the year of adoption or

year of change.

.02 If, however, on or before December 31, 1992, a taxpayer files or has

filed its original federal income tax return for its first taxable year ending

on or after June 12, 1992, the taxpayer may attach a statement to an amended

return for that year, provided the amended return is filed no later than March

1, 1993.

.03 The statement referred to in section 7.01 or 7.02 should be identified at

the top as follows: "ELECTION OF THE SERVICE WARRANTY INCOME METHOD UNDER REV.

PROC. 92-98." The statement should set forth:

(1) a paragraph stating that the taxpayer is electing the service warranty

income method for all advance payments (as defined in this revenue procedure)

received in the current taxable year and to be received in subsequent taxable

years;

(2) a paragraph stating that the taxpayer agrees to all the terms

and conditions of this Rev. Proc. 92-98, and specifically stating that the

dealer agrees to include in gross income all imputed income amounts necessary at

the applicable interest rate determined in accordance with section 5.04 so that

the net present value of gross income inclusions in taxable years to which

qualified advance payment amounts are being deferred equals the amount of

qualified advance payment amounts received in earlier taxable years;

(3) a description of the service warranty contracts sold during the taxable

year the service warranty income method is elected;

(4) the aggregate amount of the qualified advance payment amounts received

for each class (i.e., 3-year contracts, 4-year contracts, etc.) of service

warranty contracts sold during the taxable year of election;

(5) the future value factors that are to be applied to the aggregate

qualified advance payment amounts for each class of service warranty contracts

sold during the election year; and

(6) the signature by or on behalf of the taxpayer making the election by an

individual with the authority to bind the taxpayer in such matters. For

example, an officer must sign on behalf of a corporation, a general

partner on behalf of a partnership, a trustee on behalf of a trust, or an

individual on behalf of a sole proprietorship. See section 10.07 of Rev. Proc.

92-20. If the taxpayer is a member of a consolidated group, the statement

submitted on behalf of the taxpayer must be signed by a duly authorized officer

of the common parent. See section 1.1502-77 of the regulations and section

10.08 of Rev. Proc. 92-20.

.04 Annual reporting requirement. Upon election of the service warranty

income method of accounting, a taxpayer must satisfy the annual reporting

requirement set forth in this section. For each taxable year after election of

the service warranty income method, the taxpayer must attach a statement to its

timely filed original federal income tax return setting forth:

(1) a description of the service warranty contracts sold during the taxable

year;

(2) the aggregate amount of the qualified advance payment amounts received

for each class of service warranty contracts sold during the taxable year; and

(3) the future value factors that are to be applied to the aggregate

qualified advance payment amounts for each class of service warranty contracts

sold during the taxable year.

SEC. 8. EFFECT OF AND REVOCATION OF ELECTION

The election of the service warranty income method under this revenue

procedure constitutes the adoption of (or a change in) a method of accounting.

Because the service warranty income method constitutes a method of accounting,

an electing taxpayer must use this method for all its qualified advance payment