Rev. Rul. 72-519

Advice has been requested whether, under the circumstances described below, amounts received by a corporation are security deposits or advance payments, when they are includible in gross income.

Situation 1.

Corporation X supplies motor fuel to dealers who operate automobile service stations under a "meter purchase plan." Under the plan, the fuel is stored in tanks on the dealers' premises but remains the property of X and is included in its inventory until it is withdrawn from the storage tanks. Ordinarily, the fuel is withdrawn from the storage tanks when it is delivered to a motorist via a fuel pump at which time it passes through a meter and registers on the totalizers of the fuel pump. X bills the dealers monthly based on the meter readings.

Each dealer entering into a "meter purchase plan" with X must, pursuant to the agreement, make a "deposit" with X. X treats the "deposit" as a security deposit. The purpose of the deposit is to protect X's title to and interest in the fuel stored on the dealer's premises and to guarantee the faithful performance of the agreement. Its purpose is not to secure the dealer's payment for the fuel. The agreement does not place any restrictions on the use of the deposit by X. The deposit is held by X as long as its relationship with the dealer continues under the "meter purchase plan." When the relationship is terminated, the deposit is either refunded in cash or refunded by way of an off-setting credit against any amount owed by the dealer.

Situation 2.

Corporation Y is a water company and uses an accrual method of accounting. It has no reservoirs. It purchases all the water it provides to customers from state owned reservoirs. Its only processing is that of filtration and purification. Its purchased water on hand at the close of its taxable year is inventoried. Prior to providing water to a new customer, the customer is required to make a "deposit" with Y determined either by the size of the meter installed or equal to two months water usage. The cost to the company of one month's water for any given customer is always less than the amount of the "deposit." Upon receiving the "deposit," Y issues a non-transferable, nonassignable receipt to the customer. The receipt places no restrictions on the use by Y of the "deposit," and states that the purpose of the "deposit" is to guarantee payment of any and all indebtedness for water supplied which may become due to Y by the customer. When a customer terminates his contract with Y, the "deposit" is applied against any unpaid balance in the customer's account, with any excess being paid to the customer. Y pays annual interest on the "deposit." The "deposit" is not to secure any property interest of Y with respect to its meter or other property on the customer's premises.

In cases involving the rental of property, it has been held that payments received by a lessor to secure the lessee's performance of covenants contained in a lease, and which are to be refunded at the expiration of the lease, are not taxable income even though the lessor had the use of the money. If the sum is received, however, as advance rent for a subsequent period of the lease, it is taxable income when received even though under certain conditions a refund may be required. See Hirsch Improvement Co. v. Commissioner, 143 F. 2d 912 (1944), certiorari denied, 323 U.S. 750 (1944).

If an amount is received as security for the lessee's performance but, if any or all of it remains during the final period of the lease, it is to be applied to rent, it is necessary to determine whether the amount was primarily a security deposit or primarily a prepayment of rent. This is determined by reference to the intentions and acts of the parties as ascertained from the lease agreement and related circumstances. See John Mantell v. Commissioner, 17 T.C. 1143 (1952), and Gilken Corporation v. Commissioner 10 T.C. 445 (1948), affirmed, 176 F.2d 141 (1949). If the amount is intended primarily to secure only payment of rent due rather than other covenants, this indicates it should be considered to be advance rent. See J. and E. Enterprises, Inc. v. Commissioner T.C. Memo. 1967-191.

Although the above-cited cases concern security deposits made with regard to rental agreements, the principles set forth are applicable to the situations in the instant case. That is, when the purpose of the deposit is to guarantee the customer's payment of amounts owed to the creditor, such a deposit is treated as an advance payment, but when the purpose of the deposit is to secure a property interest of the taxpayer the deposit is regarded as a true security deposit.

In Situation 1, although the "deposit" received by X may be offset against the amount due X by a dealer terminating the "meter purchase plan," the purpose of the "deposit" is to protect X's title to and interest in the fuel prior to its sale to the dealer and to guarantee the faithful performance of the agreement. Its purpose is not to secure payment of the amount due X by the dealer for fuel. Accordingly, the amount received by X is a security deposit and not an advance payment for goods.

In Situation 2, the agreement provides that the "deposit" is received as security for the payment of amounts owed to Y for water and is to be applied against the customer's ending balance when the contract is terminated. The fact that Y pays annual interest on the "deposit" does not outweigh its primary characteristics as an advance payment. See Commissioner v. Lyon, 97 F.2d 70 (1938). Accordingly, the amount received by Y is an advance payment for water.

Section 1.451-5 of the Income Tax Regulations provides in part that advance payments may be included in income in the taxable year of receipt or in the taxable year in which properly accruable under the taxpayer's method of accounting if the method is not at variance with the method used by the taxpayer for purposes of all reports to shareholders and for credit purposes except in the case of inventoriable goods.

Section 1.451-5 of the regulations further provides that if a taxpayer receives "substantial" advance payments with respect to an agreement for the sale of goods properly includible in his inventory and has on hand goods in sufficient quantity to satisfy the agreement in such year, then all advance payments received with respect to such agreement by the last day of the second taxable year following the year in which such substantial advance payments are received and not previously included in income in accordance with the taxpayer's accrual method of accounting, must be included in income in such second taxable year. Accordingly, in the instant case, provided that all the requirements of section 1.451-5 of the regulations are complied with, an advance payment is treated as a payment for the water delivered in the month in which the deposit is credited against the customer's account, that is, the month in which the water delivery is terminated. However, the advance payment must be included in Y's gross income no later than the second taxable year following the year of receipt in accordance with the provisions of section 1.451-5(c)(1)(i) of the regulations. Y must take into account in the taxable year the advance payment is includible in gross income the actual or estimated cost and expenditures necessary to satisfy such payment in accordance with the provisions of section 1.451-5(c)(1)(ii) of the regulations.

Any change from Y's present treatment of "deposits" (which is to include each such amount in income at termination of a customer's contract to the extent of the customer's outstanding balance) to including such "deposits" in income at a different time (e.g., upon receipt) is a change in method of accounting to which the provisions of sections 446 and 481 of the Internal Revenue Code of 1954 and the regulations thereunder apply.