Rev. Rul. 79-195

ISSUE

When must a correspondence school on an accrual method of accounting include tuition amounts represented by student promissory notes in gross income for federal income tax purposes?

FACTS

The taxpayer, a correspondence school (the "School"), computes its taxable income on an accrual method of accounting. The School offers home study courses consisting of several lessons to be completed by a student over a period of 36 months.

The School participates in a federally insured student loan program, under which the federal government guarantees payment of student loans made by participating financial and educational institutions. A student who has enrolled in a course with the School and has executed a tuition contract signs and delivers to the School a non-negotiable interest-bearing promissory note. Pursuant to the terms of the tuition contract and promissory note, the student is not required to begin making principal payments and interest thereon until nine months after the student graduates or ceases to carry at least one-half of a normal full-time academic workload. All payments on a student note are to be made directly to the School.

Under the terms of the tuition contract, the School's right to receive a tuition payment is conditioned upon the School rendering the educational instruction on a lesson-by-lesson basis and the student's completion of a lesson. If a student terminates a course before completion, only the tuition for the lessons completed is due, and the student's note is reduced accordingly. If the student terminates a course before completing any lessons, there is no tuition charge and the student's note is cancelled.

The School obtains most of the working capital required for its operations through financing arrangements in which blocks of federally insured student notes are warehoused with banks or other financial institutions. The financial warehousing transactions are effected primarily through "sale and repurchase agreements" whereby the School agrees to "sell" a student note at its face value to a financial institution that qualifies as an eligible lender under the federal student loan program, and to "repurchase" the same note from the institution at the same price (adjusted for prepaid student payments, if any) when the student completes or cancels the course. In effect, the student's note is placed with a financial institution temporarily for the time the student is in school and is returned to the School prior to the note's maturity. During this period, the financial institution is entitled to the interest on the student's note.

LAW AND ANALYSIS

Section 451(a) of the Internal Revenue Code of 1954 provides that 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.

Section 1.451-1(a) of the regulations provides, in part, that under an accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.

All the events that fix the right to receive income referred to in section 1.451-1(a) of the regulations occur when either (1) the required performance takes place, or (2) payment is due, or (3) payment is made. Rev. Rul. 74-607, 1974-2 C.B. 149.

With respect to (1) above, performance occurs when the School renders the educational instruction for a lesson and the student completes the lesson.

With respect to (2) and (3) above, payment is not due nor made pursuant to the terms of the tuition contract and nonnegotiable promissory note until nine months after the student graduates or ceases to carry at least one-half of a normal full-time academic workload. Nor does the receipt by the School of the promissory note itself constitute payment as it merely represents evidence of a student's indebtedness, the existence of this indebtedness being conditioned on the student's completion of one lesson and its ultimate amount being conditioned on the number of lessons completed by the student. See Schlude v. Commissioner, 372 U.S. 128 (1963), in which the Government conceded in its brief, as noted on page 133 (footnote 6) of the opinion, that the taxpayer, a dance studio using the accrual method of accounting, does not realize income for the taxable year in which (1) no dance lessons were rendered, (2) payment for such future lessons was not contractually due, and (3) payment was not made in cash or by negotiable note.

Whether a transfer of student notes pursuant to a "sales and repurchase" agreement is in substance a sale or a loan of the notes turns on the facts, with characterization of the transaction depending on whether there is a relinquishment of substantial incidents of ownership and a shifting of the economic risk of loss. All payments on the notes are made to the School. Abatement of tuition price and the corresponding reduction in the student's note, resulting from the noncompletion of lessons, is borne by the School. The School is obligated to repurchase the notes from the financial institution for the same amount (adjusted for prepaid student payments forwarded to the financial institution, if any) it received on the original transfer. The financial institution has no risk of loss with respect to the student notes, may not sell the notes, and does not acquire ownership of the notes. Accordingly, the arrangement between the School and the financial institution is a loan with the notes being used for collateral security rather than a sale of the notes. Compare Rev. Rul. 74-27, 1974-1 C.B. 24.

HOLDING

The School's right to receive a tuition payment is conditioned upon the School rendering the educational instruction for a lesson and the student's completion of the lesson. As payment is neither due nor made, all the events that fix the School's right to receive the tuition payment for a lesson under section 1.451-1(a) of the regulations occur when the student completes a lesson. Therefore, tuition income is realized by the School as each lesson is completed by the student.