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This month we are going to discuss a very relevant topic in the whole multi-retail arena: gift cards and gift certificates. More and more franchise establishments are using gift cards, and they are becoming increasingly important for specialty shops and restaurants. Gifts cards can be a wonderful way to improve cash flow but there are a number of pitfalls which need to be addressed both legally and tax-wise. As we all know, gift cards and gift certificates create a significant liability on the books until they are cashed. There are very strict financial accounting rules as well as specific tax reporting methods that must be followed.
Let’s first address all of the legal issues which work on a state-by-state basis and follow that with a basic understanding regarding the treatment of gift cards.
Legal Issues
Gift cards attract new customers to stores and restaurants, build brand loyalty and can be marketed as a one-size-fits-all, versatile gift. With all this in their favor, it is no wonder the National Retail Federation estimates U.S. consumers bought about $26 billion worth of gift cards during the 2007 holiday shopping season alone.
The popularity of gift cards has encouraged the development of an increasingly complex web of state laws governing expiration dates and maintenance fees. The cards have also created accounting headaches and are increasingly a topic of discussion among those preparing and auditing a company’s financial statements.
To understand the recent legal developments in the gift card area, I spoke with Ryan Palmer, an attorney in our Franchise, Distribution, and Intellectual property group. He regularly sorts through the patchwork quilt of gift card laws and regulations to help our clients develop compliant multi-jurisdictional programs.
Ryan said gift card laws themselves typically cover two topics: expiration dates and dormancy or maintenance fees. You also have to look at state unclaimed property laws to figure out how to handle cards that have not been redeemed for an extended time period.
It is important for businesses to understand state laws on expiration dates. As Ryan explained, “States that regulate gift cards generally come down one of three ways:
- No expiration dates allowed,
- Expiration dates allowed after a specified time period, or
- Any expiration date allowed as long as it is disclosed on the card or the materials that came with the card.”
Increasingly, expiration dates are becoming a thing of the past. This means laws that require businesses to forfeit unclaimed property to the state after a certain period of time can create a conundrum for a business.
Ryan continued, “Some states have prohibited expiration dates but maintained escheat laws that require businesses to forfeit unredeemed card values after, say, two or three years. It creates an interesting paradox for businesses and consumers. The business has to decide if it will honor the card after the escheat period and the customer has to try to reconcile why his or her gift card that has no expiration date has, in practical terms, expired.” Escheat laws also come in three flavors:
- Those that do not cover gift cards,
- Those that require a retailer to provide the state with a percentage of the unredeemed amount after a specified period of time, and
- Those that require businesses to forfeit the entire value of the card after a specified period of time.
As with expiration dates, Ryan sees the trend with store-issued gift cards moving away from dormancy and maintenance fees, a reaction that he credits to a combination of consumer frustration over the fees and a growing number of laws governing the imposition of these fees. Like expiration dates, Ryan says you can put state laws on fees into three categories:
- A group of states that says you cannot charge any fee whatsoever,
- A more lenient group of states that allows certain fees or fees that do not exceed a specified dollar amount, and
- A group of states that says you can charge whatever you want as long as you disclose the fee.
Lest you think everything about gift cards fits into neat bunches of three, Ryan points out a new state law that many are watching very closely. “California is creating some buzz with Senate Bill 250. It’s really a new breed of gift card law that says any gift card with a value of less than ten dollars is redeemable for its value in cash or by check.” Montana, Vermont, and Washington all have existing laws allowing cash redemption, but California’s legislation is much broader in scope. Vermont, for instance, says that consumers can redeem a card for cash only if its value is under a dollar.
For businesses operating in more than one state, and for those businesses offering gift or loyalty cards through their Web sites, creating a card program that complies with the patchwork quilt of state laws is a growing challenge.
TAX AND FINANCIAL REPORTING ISSUES
For financial reporting purposes, the sale of a gift card is not immediately recognized as income. Income is only recognized when the gift card is redeemed. Under the general tax rules, gift card and certificate income is recognized when the card is sold. However, income from the sale of these cards can be deferred from immediate income recognition for tax reporting purposes if the taxpayer properly follows the deferral rules of Reg. Section 1.451-5 and Rev. Proc 2004-34. Under these rules, unredeemed gift card income can be deferred up to the last day of the second tax year following the year of sale. It is important to note that this deferral method requires the taxpayer to follow the IRS regulations so please consult your accounting firm.
In summary, gift cards are good for business and result in accelerated cash flow. The applicable tax and accounting rules, if correctly followed, can be of real benefit and create some nice tax deferrals.
Next month’s article topic will be new ideas for 2008.
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