Are Customer Deposits and Prepayments Taxable When Received?

When is a customer prepayment taxed?

It depends on your accounting method. A corporation on the cash basis is taxed on a customer deposit or prepayment in the year it arrives. A corporation on the accrual basis can elect to include only the part earned, or booked as revenue, by year-end and push the rest to the next tax year, never later (IRS Publication 538). Deferred (unearned) revenue on your balance sheet is not deferred for tax beyond that next year.

The same rule applies to a neocloud (a cloud company built around renting GPU compute) paid up front for a 12-month reserved cluster, and to a cooling or power equipment maker taking a deposit on catalog units with a long backlog.

Gather your accounting method, whether you have audited financial statements (yours or a parent's), and the contract: term, delivery date, invoice due dates, refund and expiry terms. Multi-year prepayments, deliveries more than a year out, contracts that may be leases and method changes need professional judgment.

Is this the right page: catalog goods and capacity, or custom equipment?

This page covers services, reserved capacity and catalog goods. A manufacturing contract not finished in the year it is signed falls under the long-term contract rules instead if the item is unique (built for one customer) or normally takes more than 12 calendar months to make, not counting backlog or queue time; so does a contract to supply and install a central system that becomes part of the building (26 CFR 1.460-2; 1.460-3). Catalog coolant distribution units (CDUs), rear-door heat exchangers, UPS units and standard pad-mount transformers usually stay here; for the rest, see long-term contracts for custom equipment.

Are customer deposits taxable income when received?

Usually yes, unless the accrual-basis deferral below applies. A payment for goods, services, software or similar items that is earned in a later year is an "advance payment", and the default rule taxes it in the year received (26 USC 451(c)).

"Received" includes an amount that is due and payable, not just cash in the bank (26 CFR 1.451-8(a)(14)). An annual invoice issued on December 15 and due January 15 is not received in December. Contract and invoice terms can move the tax year.

Can a cash-basis company defer a prepayment?

No. On the cash method, income is taxed when actually or constructively received (credited to you or available without restriction) (Publication 538). The one-year deferral in section 451(c) is written for accrual-method taxpayers only.

A C corporation can generally use the cash method only if its average annual gross receipts for the three prior tax years are no more than $32,000,000, counting companies under common control together (26 USC 448(c); Rev. Proc. 2025-32, section 4.30). Moving to accrual is a method change; see switching from cash to accrual accounting.

How is deferred revenue taxed on the accrual basis?

Deferred revenue can wait one tax year, no longer. An accrual-basis corporation that elects deferral includes the part of the prepayment recognized by year-end, and the whole rest in the next tax year (26 CFR 1.451-8(c) and (d)). What counts as "recognized" depends on whether you have an applicable financial statement (AFS). Deferral works only if you can tell how much of each prepayment was booked as revenue, or earned, by year-end. Prepaid credits whose sale date or use you do not track are taxed in full when received (26 CFR 1.451-8(c)(1), (c)(3) and (d)(2)).

With audited financial statements

An AFS is a financial statement certified as prepared under US GAAP or IFRS that is audited and used for credit, for reporting to shareholders, or another substantial non-tax purpose, or that is filed with a government agency (26 CFR 1.451-3(a)(5)). Unaudited statements sent to investors are not an AFS. A US subsidiary included in its parent's audited consolidated statements, including a foreign parent's IFRS statements, uses those statements as its AFS, so the parent's revenue timing sets the subsidiary's tax timing (26 CFR 1.451-3(a)(5) and (h)(1)). This page explains why an audit changes the answer, not the audit itself.

Without audited financial statements

You include what is earned by year-end under the all events test (your right to the money is fixed and the amount is known), applied as if the payment had not been received yet. If you cannot otherwise tell how much is earned, a fixed-term deal reasonably expected to be earned evenly can be spread straight-line over the term (26 CFR 1.451-8(d)(3)). For goods, the right to payment is usually fixed at shipment or delivery under the contract, so a deposit on units not yet shipped is usually not yet earned.

A customer prepaid two or three years of reserved capacity: is it all taxed in year two?

Yes, whatever has not been recognized in the year of receipt is taxed in the next tax year, even if the books spread it over three. The regulation's own example: a 3-year contract with one-twelfth recognized in the first year puts the other eleven-twelfths in the second year (26 CFR 1.451-8(c)(10)).

Is reserved GPU capacity a service or a lease of servers?

It matters because rent is not an advance payment and gets no one-year deferral (26 USC 451(c)(4)(B)). Advance rent is income when received under any accounting method (26 CFR 1.61-8(b)). The exceptions are software and intellectual property, and use of property that is ancillary to services (26 CFR 1.451-8(a)(1)).

Capacity on servers the provider operates and also uses for other customers points toward a service. A so-called service contract is treated as a lease when the facts point that way: customer possession, customer control, a significant customer economic or possessory interest, no provider risk if performance fails, no concurrent use for other customers, and a price close to the servers' rental value (26 USC 7701(e)). No single factor decides it.

A lease with total rent over $250,000 that has prepaid, deferred, or rising or falling rent may fall under section 467, which has its own timing rules (26 USC 467; 26 CFR 1.467-1(c)). That needs a review. Export-control and customer-identification rules for compute sold abroad are outside this page.

Deposits on catalog equipment with a long backlog: does a later delivery change anything?

Usually not. A deposit on catalog goods is an advance payment, so under the deferral method it is taxed no later than the year after receipt, even if delivery is two years out. The regulation's example: a website designer paid in July for a site finished about 18 months later includes the payment in the year after receipt (26 CFR 1.451-8(c)(10)).

Two refinements can apply:

• Specified goods exception. It applies only to a company with an AFS. The payment must arrive in a tax year earlier than the year before the contract's stated delivery month and year; the seller must not have enough similar goods, on hand or available from its normal supply, during the receipt year; and the AFS must book all revenue in the year of delivery (26 CFR 1.451-8(a)(1)(ii)(H) and (a)(15)). Such a payment is then not an advance payment. It falls under the general all events test and case law, and the IRS warns it "could be includible in the year of receipt" (Publication 538). A company can instead elect to treat all such payments as advance payments (26 CFR 1.451-8(f)).
• Advance payment cost offset method. An optional method for inventory sales that can reduce the amount taxed before delivery by costs already incurred on the goods (26 CFR 1.451-8(e)).

Are refundable deposits taxable?

A true security deposit is not income when received. The Supreme Court held that deposits a utility had to return, where the customer decided whether to apply them to bills, were not income because the company lacked "complete dominion" over them (Commissioner v. Indianapolis Power & Light Co.).

A nonrefundable deposit, or one the contract applies to the price, is an advance payment. A security deposit becomes income when you keep it: forfeited on cancellation, or applied to an unpaid invoice. When a forfeit ends your obligation to deliver, any deferred balance is taxed that year (26 CFR 1.451-8(c)(4)). Drafting deposit terms is a legal question.

What if prepaid credits expire unused, or you refund a customer?

Credits that expire unused are income no later than the year after receipt, the same as used credits. Without an AFS, a company with adequate data may count credits expected never to be used as earned in the year of sale on a statistical basis (26 CFR 1.451-8(d)(3) and (d)(8)).

A refund is deducted when paid. A credit against future services counts as paid as those services are provided (26 CFR 1.461-4(g)(3)). One exception: a company that uses the recurring item exception can deduct a recurring type of refund in the earlier year if the refund and its amount were fixed by year-end and it is paid within 8½ months after year-end, or by the filing date if sooner (26 CFR 1.461-5). A book reserve for expected refunds or service credits does not lower taxable income: for tax, AFS revenue is added back up for refunds (26 CFR 1.451-3(b)).

How do you start deferring, and why does taxable income differ from book income?

A new company, or one receiving advance payments for the first time, elects deferral by filing a return that uses it, for each category of advance payments (26 CFR 1.451-8(g)). A company already including prepayments in full, or switching from cash to accrual, changes its accounting method with Form 3115; the automatic procedure is in Rev. Proc. 2025-23, section 16.08. Once made, the election stays until the IRS consents to revoke it (26 USC 451(c)(2)).

On multi-year deals, taxable income runs ahead of book income in year two and behind it later. Form 1120 reconciles the gap on Schedule M-1, or on Schedule M-3 when total assets are $10,000,000 or more at year-end (Instructions for Form 1120). If, in a year after the payment was received, a buyer writes down your deferred revenue in purchase accounting, the write-down counts as revenue that year (26 CFR 1.451-8(c)(5)). A company that ceases to exist, other than in a section 381(a) transaction such as a tax-free merger or a subsidiary's liquidation into its parent, includes every deferred balance in its final year (26 CFR 1.451-8(c)(4)).

Rev. Proc. 2004-34, the older deferral procedure, is obsolete for tax years beginning on or after January 1, 2021 (T.D. 9941).

How does Canada treat the same deposit?

Canada taxes the amount when received but allows a yearly reserve with no one-year cap. A corporation includes amounts received for goods or services not yet provided at year-end (Income Tax Act, s. 12(1)(a)), then deducts a reasonable reserve for what it expects to deliver after year-end (s. 20(1)(m)). The reserve is added back the next year (s. 12(1)(e)) and can be claimed again while delivery is still ahead.

For a Canadian corporation's own return, see how Canadian corporations are taxed.

Example

All figures are illustrative, in US dollars, for calendar-year corporations.

A neocloud sells a prepaid reserved cluster

A Delaware C corporation after its Series A uses accrual with the one-year deferral and has audited statements for investors. On October 1, 2026, an inference customer prepays $2,400,000 for a 12-month reserved cluster.

• The books show $600,000 of revenue for 2026 and $1,800,000 for 2027. The tax return is the same.
• If the deal were 24 months for $4,800,000, the books would show $600,000, $2,400,000 and $1,800,000 for 2026 to 2028. Tax: $600,000 in 2026 and $4,200,000 in 2027.
• On the cash basis, the full prepayment is 2026 income either way.

Equipment makers take deposits on catalog units

A cooling maker on accrual without audited statements takes a $900,000 deposit (30% of $3,000,000) in December 2026 for catalog CDUs that ship in May 2027. Because the units are catalog items built in 8 weeks, this is not a long-term contract. With the deferral method, $0 is income in 2026 and the full $3,000,000 sale is income in 2027. On the cash basis, the $900,000 is 2026 income.

A transformer maker with audited statements takes a $1,500,000 deposit in November 2026 on catalog transformers. The contract says March 2028 because of the backlog. Because each is a catalog item that takes 6 months to build, the backlog does not make this a long-term contract. The deposit arrives before 2027, the year before the stated delivery, so the specified goods exception can apply:

• If it applies (no such transformers on hand or available from its normal supply in 2026, and its statements book all revenue in the year of delivery): the deposit is not an advance payment and could be taxed in 2026.
• If it does not apply, or the maker elects to treat such payments as advance payments: the deferral method makes the $1,500,000 2027 income, a year before delivery. The cost offset method can lower that amount.

Security deposits, expiring credits and a refund

The neocloud holds a $250,000 security deposit, returned at contract end if bills are paid. It is not income unless kept.

In late December 2026 it sells $500,000 of prepaid GPU-hour credits that expire in 12 months, none used before year-end. All $500,000 is 2027 income, used or expired.

A $100,000 cash refund for a 2027 outage, paid in February 2028, is a 2028 deduction, or a 2027 one under the recurring item exception if the refund was fixed by the end of 2027. A book reserve for refunds not yet owed is never deducted.

Different for you?

• Custom or long-build equipment, or supply-and-install work past year-end: see long-term contracts for custom equipment.
• On the cash basis and want to defer: see switching from cash to accrual accounting.
• Sales tax on prepaid GPU compute, hosting or colocation invoices: see sales tax on colocation, hosting and GPU compute.
• Sales tax on equipment, installation or maintenance: see sales tax on servers, installation and maintenance and sales tax on installed cooling and power equipment.
• Prepaid software subscriptions and sales tax: see sales tax on SaaS and software.
• A customer cancels and you keep the units: see writing off unsold or obsolete inventory.
• You own servers that others rent: see renting out GPU servers.
• Corporate rate, losses and estimated tax: see how C corporations are taxed.
• Multi-year prepayments, a possible lease of servers, a delivery date two years out, or a group with audited consolidated statements: these turn on contract terms and elections that are hard to undo; see data center and AI infrastructure services.