Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 67-47

1967-1 C.B. 9

Sec. 61

IRS Headnote

Sums received by a principal from his exclusive sales agent as a security deposit to insure the agent's performance under the terms of a contract are not includible in the gross income of the principal where he is under an obligation to repay such amounts upon the performance of the terms of the contract. The sales agent may not deduct these payments made during the period of the contract. However, the security deposit or the appropriate part thereof will be includible in the gross income of the principal in any year in which the agent defaults on the contract and the sums are, consequently, appropriated by the principal to cover such default. When such default occurs the sales agent may deduct such sums.

Full Text

Rev. Rul. 67-47

The Internal Revenue Service has been requested to state its position with respect to the treatment for Federal income tax purposes of amounts received by an individual and paid by another as a security deposit which must later be returned to the payer if he does not default on his obligations under the agreement between the individuals.

An individual who owns certain trademarks, copyrights, and secret formulas, and has developed certain methods of operation with respect to a food business, entered into an agreement with another individual, whom he designated as his exclusive sales agent, to sell franchises.

Under the agreement, the agent is required to secure and write two franchise agreements a year for a period of 10 years and thereafter one franchise agreement each year. To secure the performance of his obligations under the agreement, the agent agreed to establish a security deposit with his principal, payable 25 x dollars upon signing of the agreement and 5 x dollars at the end of each calendar year thereafter until a total of 75 x dollars has been established as a security deposit. If, at the end of 10 years after a total of 75 x dollars has been on deposit as security, the agent performs his obligation under the agreement, the principal is required to return the entire security deposit to the agent.

Prior to any default by the agent, the sum is deposited with the principal who is not required to keep such funds in a separate account. However, if the agent defaults upon his obligations under the agreement, he will forfeit all or part of the security deposit made by him.

Provision is also made in the agreement whereby certain franchise fee payments to be received by the principal would be assigned to the agent if, at the time the security deposit is to be returned to him, the principal is unable to repay all or a portion of the security deposit.

Section 61(a) of the Internal Revenue Code of 1954 provides that gross income means all income from whatever source derived, including compensation for services, except as otherwise provided.

In the case of John Mantell v. Commissioner , 17 T.C. 1143, 1148 (1952), acquiescence, C.B. 1952-1, 3, the court held that the sum received by the lessor upon execution of a lease, as security for the lessees' performance of the terms of the lease, was not taxable income upon receipt where the lessor was under obligation to repay it unless in the meantime it should be appropriated to make good a default by the lessees.

A similar result was reached in the case of Bradford Hotel Operating Co. v. Commissioner , 244 F.2d 876 (1957), vacating and remanding 26 T.C. 454 (1956), in connection with a security deposit made under a 35-year lease. In that case the lessor was given the right to commingle and use the security deposit for its own purposes without interest throughout the term of the lease and was obligated to return the security deposit to the lessee immediately upon the expiration of the lease or any extension or renewal thereof provided that the lessee had fulfilled all the obligations of the lease.

Although the above-cited cases concern security deposits made with regard to leased premises as opposed to contracts for service, the principles set forth in those cases are applicable to the facts in this case.

Accordingly, the sums received by the principal from his exclusive sales agent as a security deposit to insure the agent's performance under the terms of a contract, are not includible in the gross income of the principal where he is under an obligation to repay such amounts upon the performance of the terms of the contract. The sales agent may not deduct these payments paid during the period of the contract. However, the security deposit or the appropriate part thereof will be includible in the gross income of the principal in any year in which the agent defaults on the contract and the sums are, consequently, appropriated by him to cover such default. When such default occurs the sales agent may deduct such sums.