When you bill in advance, the payment you collect is not yet revenue and not yet fully yours. Until you deliver the goods or perform the service, that money is a contract liability on your balance sheet, and separate rules from the IRS, the FTC, the card networks, and contract law each govern when you owe tax on it, how quickly you must ship or refund it, and when you can keep it if the deal falls apart. Missing any of those rules can trigger chargebacks, penalties, or lawsuits.
What the Advance Invoice Has to Say
An advance invoice needs to separate what the customer is paying now from the total project cost. At minimum, include the legal names and addresses of both parties, a description of the goods or services the payment covers, and the specific amount due as the advance. Label the line item precisely. “Deposit,” “retainer,” or “first installment” are not interchangeable, because the label — combined with the underlying contract terms — affects how the payment is treated for tax and refund purposes.
Also include the billing period or milestone the payment is tied to, payment terms and accepted methods, any applicable tax identification numbers, and the due date. The record needs to be clear enough that neither party can later dispute what the money was for.
Card Network Rules for Prepayment Charges
Visa’s merchant rules generally prohibit processing a transaction until the merchandise ships or the service is provided. The exception is when the cardholder has agreed to an advance payment and you have disclosed that clearly.1Visa. Visa Core Rules and Visa Product and Service Rules Mastercard has similar restrictions. Repeated violations don’t just risk chargebacks on individual transactions; they can get your merchant account terminated.
If you bill in advance for goods that won’t ship for weeks, your checkout process and invoice should clearly state that the charge is a deposit or prepayment, not a completed sale. Use billing descriptors the customer will recognize on their bank statement. Vague descriptors are one of the fastest routes to a chargeback, because customers who don’t recognize a charge dispute it reflexively.
Deferred Revenue Under ASC 606
When you receive an advance payment, you don’t book it as revenue. Under ASC 606, a payment received before you transfer goods or services to the customer is recorded as a contract liability. You’ll see this called “deferred revenue” or “unearned revenue” — all three terms describe the same thing: money you’ve collected but haven’t yet earned.
Revenue is recognized only when you satisfy the performance obligation. If a client pays $12,000 in January for a full year of monthly consulting, you recognize $1,000 of revenue each month and carry the remaining balance as a liability. This prevents your financial statements from overstating income in the period you collect cash.
When You Owe Federal Tax on the Money
The accounting treatment and the tax treatment don’t always line up. What you report to the IRS depends on whether you use the accrual method or the cash method.
Accrual-Method Taxpayers
Under Section 451(c) of the Internal Revenue Code, accrual-method taxpayers have two options. The default is full inclusion: you report the entire advance payment as gross income in the year you receive it, regardless of when you deliver.2Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion
The alternative is the deferral method. If you elect it, you include in gross income only the portion of the advance payment that you recognize as revenue on your financial statements for that year. The remaining portion gets included in the following tax year, not when you actually earn it, but the very next year. The deferral is limited to one year. If a customer prepays for a three-year service contract, you cannot spread the income over three years under this election. Year one takes whatever your financial statements show; everything else hits year two.2Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion
Some categories are excluded from the deferral election entirely, including rent, insurance premiums, payments related to financial instruments, and payments for warranty contracts where a third party is the primary obligor.2Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion
Cash-Method Taxpayers
The cash-method rules are simpler and less forgiving. You include advance payments in gross income in the year you receive them, full stop. The IRS treats income as “constructively received” when it is credited to your account or made available without restriction, so you can’t delay depositing a check until January to push income into the next tax year.3Internal Revenue Service. Publication 538 – Accounting Periods and Methods Cash-method taxpayers have no deferral election for advance payments.
Deposit or Advance Payment
The IRS draws a sharp line between a refundable deposit and an advance payment, and the distinction controls when you owe tax on the money. Under the “complete dominion” test, if you have no obligation to return the funds — or the obligation exists only in narrow circumstances like significant delivery delays — the payment is an advance payment includable in gross income. If the agreement gives the customer an unconditional right to a refund, the payment is a deposit and stays off your income until you either earn it or the refund obligation expires.
The label on the invoice matters less than the actual contract terms. Calling something a “deposit” while your agreement says it is nonrefundable will not change how the IRS classifies it. Tax timing follows economic substance, not the heading on the invoice.
Penalties for Getting the Timing Wrong
Two penalty tiers apply. The accuracy-related penalty under Section 6662 adds 20% to the underpayment amount for negligence, substantial understatements, and similar errors.4Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
If the IRS determines that the underreporting was fraudulent, the penalty jumps to 75% of the underpayment attributable to fraud under Section 6663. The burden then shifts uncomfortably: once the IRS proves any portion of an underpayment is due to fraud, the entire underpayment is presumed fraudulent, and you have to prove by a preponderance of evidence which portions were not.5Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty
Shipping and Refund Deadlines for Prepaid Goods
If you sell physical goods ordered by mail, internet, or phone, the FTC’s Merchandise Rule imposes hard deadlines. You must have a reasonable basis to believe you can ship within the timeframe stated in your advertising. If you state no timeframe, the default is 30 days from receipt of a properly completed order. For orders where the buyer applies for credit at the time of purchase, the default is 50 days.6eCFR. 16 CFR Part 435 – Mail, Internet, or Telephone Order Merchandise
If you can’t meet the deadline, you must notify the customer and offer a choice: consent to the delay, or cancel and receive a full refund. Store credit, vouchers, and future purchase credits are not acceptable substitutes for a cash refund.7Federal Trade Commission. Business Guide to the FTC’s Mail, Internet, or Telephone Order Merchandise Rule
Refund timing is strict. For payments made by cash, check, or money order, send the refund within seven working days of the date the buyer’s right to a refund kicks in. For credit card payments where you are the creditor, credit the account within one billing cycle.6eCFR. 16 CFR Part 435 – Mail, Internet, or Telephone Order Merchandise
Cooling-Off Rule for In-Person Sales
A separate federal rule applies to certain in-person sales made outside the seller’s normal place of business. Under the FTC’s Cooling-Off Rule, consumers who buy goods or services worth $25 or more at locations like trade shows, conventions, or during in-home sales presentations have three business days to cancel and receive a full refund. The seller must provide a cancellation form and inform the buyer of this right at the time of sale.
The rule does not cover purchases made online, by mail, or by phone, and it excludes categories like insurance, securities, and automobiles sold at temporary locations. If your business collects advance payments at trade shows or through door-to-door sales, build the three-day cancellation window into your process and avoid spending the customer’s money before it closes.
Refunds If the Deal Falls Apart
There is a common misconception that U.S. law automatically requires businesses to refund unearned advance payments if a contract falls apart. Unlike the European Union, which provides a broad statutory right to withdraw from many consumer transactions, U.S. contract law generally leaves refund rights to the terms of the agreement and the type of transaction involved.
Sales of Goods Under the UCC
For sales of goods, the Uniform Commercial Code provides the clearest protection. When a seller fails to deliver or repudiates the contract, the buyer can cancel and recover whatever portion of the price has been paid.8Legal Information Institute. UCC 2-711 – Buyer’s Remedies in General The buyer can also purchase substitute goods elsewhere and recover the difference. The UCC gives a prepaying buyer a statutory path to get the money back plus consequential losses.
Unjust Enrichment
For service contracts and situations where the UCC doesn’t apply, the common law doctrine of unjust enrichment fills some of the gap. A party who receives a benefit at another’s expense without adequate legal justification can be required to pay it back. A company that collects an advance and never performs is the textbook example. Courts don’t need a written contract to apply this remedy; unjust enrichment exists precisely for situations where the formal agreement has broken down or was never properly formed.
Non-Refundable Deposits and Liquidated Damages
Clauses labeling advance payments “non-refundable” or setting a fixed amount the seller may keep on cancellation are enforceable, but only if the amount is a reasonable estimate of the actual harm caused by the cancellation. Courts treat unreasonable forfeiture clauses as unenforceable penalties rather than valid liquidated damages.9U.S. Department of Justice. Civil Resource Manual 74 – Liquidated Damages Provisions A wedding venue keeping a $500 deposit when it could have rebooked the date will have a harder time defending that clause than one that demonstrably turned away other clients.
A Separate Rule for Attorney Retainers
If you are paying an attorney in advance, the rules are stricter than for ordinary businesses. ABA Model Rule 1.15 requires attorneys to deposit advance fees into a client trust account, kept separate from the lawyer’s operating funds. The lawyer can withdraw money from the trust only as fees are earned or expenses are actually incurred.10American Bar Association. Rule 1.15 – Safekeeping Property Nominal or short-term amounts go into pooled IOLTA accounts, where the interest benefits legal aid programs rather than the individual client.11American Bar Association. Interest on Lawyers’ Trust Accounts
Every state has adopted some version of Rule 1.15, and mixing client funds with business accounts, even temporarily, is one of the most common grounds for professional discipline. If you hire a lawyer on retainer, the advance fee belongs in the trust account until it is earned. If it doesn’t go there, that’s a red flag.