Gift cards can provide many great benefits for restaurant owners. They not only serve as a way to promote the restaurant and bring in new customers, but also provide an increase to the restaurant’s cash flow, often well before the gift card is redeemed. One challenge that many restaurant owners encounter is determining how to properly treat the sale of the gift cards on their income tax returns.

Gift card sales are unique from an income tax standpoint since the receipt of cash may occur years before the customer enters the restaurant to use their gift card. In order to match the receipt of cash with the income tax, the IRS generally requires that income from the sale of gift cards is reported in the year of sale.

This treatment may be very different than how you are recording the gift card sale on your financial statements. Typically, the gift card sale creates a liability for book purposes, and the related income is generally not reported until the card is ultimately redeemed. However, the IRS does not like this treatment, and wants to collect the tax on that income immediately, rather than waiting until the customer ultimately redeems their gift card at a later date.

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That being said, there are still ways to defer the payment of tax on gift card sales to later years, sometimes to as long as nearly three years after the receipt of cash. The IRS has specific rules related to advance payments, in which payment is received in advance of the goods to be provided. Under these rules, gift card income may be reported for tax purposes generally in the same manner as recorded for book purposes, which is typically upon redemption of the gift card. For those gift cards that remain unredeemed for an extended period of time, the income must be reported for tax purposes no later than the last day of the second tax year following the year in which the gift card payment was received.

Because of the substantial benefit of such income deferral, IRS scrutiny of such treatment has increased, and gift card sales have become a “Tier II” issue for tax examinations. Tier I and Tier II issues are those identified by the IRS to require the most attention by an IRS agent during an examination. Therefore, if you are currently using, or considering switching to, an income deferral method for gift cards, you should be aware of the following potential issues:

Using gift card subsidiaries or third party vendors: The IRS has successfully challenged gift card sales made by one business entity that will ultimately be redeemed by another. The IRS believes that such structures do not qualify under the income tax deferral rules. For that reason, the sale of gift cards by a franchisor to be redeemed by its franchisees can be problematic.

Tracking gift card activity: Gift cards must be tracked separately in order to substantiate the date sold, date redeemed, and date expired. Reloadable gift cards make such tracking even more difficult. Restaurants that are not able to accurately track such activity are not eligible for the income deferral.

Providing the appropriate disclosures: To qualify for the income tax deferral, the restaurant must make certain elections and annual disclosures on its income tax returns. Failure to do so may result in loss of the income tax deferral.

With this increased level of IRS scrutiny, it is important to discuss your gift card program with your tax advisor. Ultimately, if your gift card program is structured correctly, and you are able to avoid some of the common pitfalls discussed above, the income tax deferral rules can provide a substantial benefit for your restaurant.

Richard Yelton is a principal at Windham Brannon in Atlanta. His specialties include restaurant and hospitality tax, mergers and acquisitions, and more.