You do. If you just create a CM, yes it will make the funds refundable, and show the customer at 0 balance after refunding. However the original payment can still be applied to an invoice even though a refund was done off a credit (without invoicing it from the SO)

I just did a test transaction.

Sales order for 100, prepaid $50.

Created credit memo for item "refund" for $50, and refunded the $50. Customer balance at 0

If I go back to the open SO and invoice it, there is a $50 credit open still. 

Doing a Credit only doesn't change anything with the original payment. 

If I instead go to the original SO with Prepayment, add the refund item line, invoice, credit and refund, customer is at 0 balance, and the original prepayment is no longer available since it was "invoiced" and used

@capandhitch2  RE: However the original payment can still be applied to an invoice even though a refund was done off a credit (without invoicing it from the SO)

I played with it and I see what you mean. This is a very convoluted thing.

I still don't really understand your solution to add data to the SO and then invoice it. It seems to use that solution the customer would need to proceed with the sale. Correct?

However, it appears that a way to handle this case, whether or not there will ever be a sale/invoice, is to skip the credit memo and instead:

1. Create a refund check from your bank account and use the A/R account in the detail area of the check. Add the customer name into the Customer:Job field on the check.

2. Open the Receive Payments window and select the 'invoice' listed there that is actually the check you just wrote.

3. Open the Discounts and Credits window and apply the prepayment amount, which will be listed as a credit.

The payment seems locked/married to the SO when its a prepayment. Adding an item to the SO (our generic item called "Refund for prepayment"), changing the other SO items to qty 0, and invoicing the Refund line for the prepayment amount, applying the prepayment to the invoice, then doing a CM off of it keeps it all tied together. 

Ill play around with your method. Sounds like it would work. However, I know our staff sometimes forgets to do that final step of applying the "check" in the receive payments window after. That results in the customer showing a 0 balance, however next time the customer has an invoice it will pop up message about a credit being available. One of our issues is not all of our sales staff are not accountants and don't grasp the last step. We have to use Enterprise due to having 250,000 sku's.