Although most contracts are created to be as ironclad as possible, many companies allow customers to cancel contracts if they agree to pay a fee associated with prematurely breaking the contract. These fees, which may be called deferred administration fees, deferred termination fees or early termination fees, help deter consumers from moving their patronage to a competitor. Although they’re not precisely the same as revenue created by providing a service, they affect the company’s bottom line in much the same fashion.
Deferred Administration Fees
Deferred administration fees, or deferred admin, are a type of income a company generates through cancellation of its existing contracts. Usually built into contracts with customers, deferred administration fees serve as a deterrent to customers against prematurely ending their contract. Although these fees act as income that boosts a company’s earnings, they also represent the loss of revenue that the company would have later received if all payments associated with the contract were realized if it came to term.
Revenue is ordinary income created by billing a customer for a service, through financing charges and other conventional means of generating a profit. Because they’re ordinary forms of revenue, some companies report revenue separately from deferred administration fees, helping to separate those costs from income that represents unrealized regular income. While this is necessary because of tax purposes, it also helps investors identify the differences between ordinary revenue and early termination fee income. When a company reports unusually high amount of deferred administration fee income in a quarter, it may portend reduced earnings from normal revenue in future quarters.
Taxation of Deferred Administration Fees
There isn’t a blanket rule that guides how the Internal Revenue Service (IRS) treats deferred administration fees. If a fee is assessed as a replacement for ordinary income that would be generated had the contract been realized -- such as early termination fees for cellular contracts -- the administration fees must be taxed as ordinary income. If the fees serve to replenish capital destroyed when a contract is cancelled -- such as those used to reimburse a company for administrative fees when considering a merger -- the IRS allows the company to claim that income as a capital gain.
Burden of Proof
A company that receives deferred administration fees usually must claim the income as ordinary revenue. The IRS requires companies to provide the burden of proof that a termination fee was intended to cover capital destroyed by the early contract termination. In most cases, contractual provisions that define the deferred administration fee must specify the fee represents loss of investment capital, rather than merely income, to be taxed at gains rates.