The IRS has attempted for many years to categorize rebates as deductions rather than exclusions so that the restrictions of IRC § 162 can be applied. But the courts have allowed exclusion treatment for direct seller-to-buyer rebates.
Though the IRS has had some success in the courts challenging rebates to third parties, recent rulings indicate it is pulling back and may be willing to allow exclusion treatment.
The IRS and the courts agree that rebates paid by nonsellers are not excludable, reasoning that only the seller can agree to a price adjustment.
Although the IRS appears to be moving toward allowing most seller-paid rebates as exclusions, it is now insisting that even accrual taxpayers delay the exclusion until the rebate is paid.
Larry Maples, CPA (inactive), DBA, is a professor of accounting at Tennessee State University in Nashville, Tenn. His e-mail address firstname.lastname@example.org.
Rebates are used in many vendor market channel programs to accomplish objectives such as jump-starting a market, overcoming market barriers and supporting a market until economies of scale can reduce production costs. The income tax treatment of rebates, however, has been a simmering dispute for more than 50 years, leaving uncertainty for both payers and recipients as to characterization and timing.
Recently, the IRS has taken steps to reduce some of the confusion. But a major issue remains unsettled: whether a rebate is a sales price adjustment reducing gross income (exclusion) or a deduction from gross income. This would be a distinction without a difference for federal taxable income, which is reduced either way, except that a deduction is subject to the restrictions of IRC § 162(c) (state sales taxes could also be affected). Thus, rebates that have not qualified as exclusions have been disallowed altogether when the IRS held them to be not ordinary and necessary, or when the payment fit one of the prohibited categories of section 162(c), such as illegal payments or kickbacks.
The rapidly evolving position of the IRS can be viewed through the prism of a series of pronouncements on Medicaid rebates paid by drug manufacturers. In FSA 200101004, the IRS advised that such rebates paid to state agencies were not sales price adjustments. Then in Revenue Ruling 2005-28 and, more recently, in Revenue Ruling 2008-26, the IRS reversed that position using the identical fact pattern. This reversal should not be narrowly interpreted to apply only to Medicaid rebates, because in these more recent rulings the IRS also announced it was suspending an earlier ruling (Revenue Ruling 76-96—see below) that had held that rebates paid by automobile manufacturers were business expenses.
A dictionary definition of a rebate is “a return of a part of a payment.” This basic nonlegal definition implies that payment is returned from seller to buyer. Through the years, the IRS has resisted exclusion treatment for payments that do not literally match this definition, that is, payments not made to the buyer or payments made by non-sellers. The IRS has argued that the intent of such payments cannot be to reach an agreed-upon net selling price because the payment is not between the buyer and seller.
Taxpayers have had a good deal of success in the courts arguing for exclusion treatment for direct payments from seller to buyer. Payments to third parties have been closely scrutinized, but the IRS is currently opening the door. However, neither the courts nor the IRS has allowed exclusion treatment for “rebates” paid by a non-seller.
OPEN DOOR ON SELLER-TO-BUYER PAYMENTS
The Pittsburgh Milk (26 TC 707) case first established in 1956 that direct seller-to-buyer rebates were excludable from gross income. In that case, a dairy wholesaler paid cash rebates to buyers under an informal arrangement to avoid state minimum milk price regulations. The Tax Court held that despite their illegality, the rebates were exclusions because the purpose was to adjust the gross price to a previously agreed net price, and thus the amounts rebated were really only held temporarily as deposits.
The IRS at first declined to acquiesce, but after losing several similar cases agreed not to disagree. But when the prohibitions against deducting certain illegal payments and kickbacks were inserted into the Code, the Treasury issued regulations attempting to also apply that rule to exclusions. The IRS also in 1976, in anticipation of litigation in a similar case involving wholesale liquor, renewed its nonacquiescence to Pittsburgh Milk. These efforts to circumvent the Pittsburgh Milk precedent were defeated in the liquor case, Max Sobel v. Commissioner (69 TC 477, aff’d 46 AFTR2d 80-5799 (9th Cir. 1980)). There, a wholesale liquor dealer violated state minimum pricing regulations by giving a free bottle or credit for each case purchased. The courts held the restrictions on illegal payments applied only to deductions and invalidated the application to exclusions. Although the regulations were not withdrawn, the IRS then once more acquiesced in Pittsburgh Milk and now Max Sobel and issued a revenue ruling (82- 149) holding that illegal rebates paid directly from seller to purchaser are adjustments to the sales price.
Although the IRS conceded the issue on illegal payments, it has continued to monitor seller-to-buyer payments that do not appear to arrive at a specific net selling price. In Foretravel Inc. v. Commissioner (TC Memo 1995-494), the IRS argued unsuccessfully that incentive rebates by a mobile home manufacturer to its dealers were not sales price reductions because the rebate policy could not be reduced to a numerical formula. In the SunMicrosystems (TC Memo 1993-467) and Convergent Technologies (TC Memo 1995-320) cases, computer workstation manufacturers issued stock warrants as buying incentives. Customers sold the warrants to underwriters to reduce the cost of the workstations. The IRS objected to treating the warrants as purchase price adjustments because there was no agreed net price at the time the seller and buyer entered into the agreements. But the Tax Court treated the warrants as exclusions, reasoning that the absence of an advance fixed net price was not crucial, since the agreements provided a mechanism for determining a future price.
Thus, for more than 50 years, the courts have held the door open to exclusion treatment for seller-to-buyer rebates despite repeated IRS attempts to develop a rationale for deduction treatment. It even appears that the original Pittsburgh Milk criterion of an agreed-in-advance net sales price has been expanded in the stock warrant cases.
In Chief Counsel Advice 200834019 (8/22/2008), a taxpayer’s attempt to use the recurring-item exception under IRC § 461(h)(3) to accrue the rebate at sale was denied. To qualify for the rebate, the customer must fill out a form, attach certain items and mail them to a third-party administrator within 30 days. The qualifying customer normally receives a check several months later. The IRS, citing the Supreme Court’s decision in General Dynamics (481 U.S. 239 (1987)), said the taxpayer’s liability for rebates is not fixed until the customer mails the form and attachments.
DOOR CRACKED ON THIRD-PARTY PAYMENTS
Until the recent rulings, neither the IRS nor the courts have been willing to allow exclusion treatment for payments to third parties. The most quoted case is United Draperies (41 TC 457, aff’d 15 AFTR2d 50.1 (7th Cir. 1964)), in which a manufacturer paid rebates to employees of its purchasers based on a percentage of collections from those purchasers. The Tax Court said the kickbacks were not exclusions because the payments were for the referral service provided and were independent of the price agreement between the seller and buyer. On appeal, the Seventh Circuit agreed and pointed out that the seller had a claim of right to the entire sales price.
The IRS applied United Draperies to deny exclusion treatment of rebates from automobile manufacturers to buyers in Revenue Ruling 76-96. The reasoning was that the price was negotiated between the dealer and the customer. Since the manufacturer’s rebate was independent of the price negotiated between the dealer and buyer, the IRS held it could not be an exclusion for the manufacturer. Although this ruling was consistent with United Draperies, the IRS in Revenue Ruling 2005-28 suspended it. This is very interesting because the IRS normally is reluctant to give up a position it has won in the courts. Apparently, the IRS is concerned about consistency in the treatment of taxpayers. The change in position on Medicaid rebates, which also involve payments to third parties, is causing the IRS to reconsider at least automobile rebates and perhaps third-party rebates in general.
In the Medicaid rulings (2005-28 and 2008-26), the IRS set up Pittsburgh Milk as the standard. Thus, rebated amounts that were intended to reduce a list price to an agreed net price should be treated as exclusions. The fact that the rebate is paid to a third party (the state Medicaid agency) is not crucial so long as the purpose and intent is that the rebate is “a factor used in setting the actual selling price.” The existence of the Medicaid rebate agreement guaranteed that the rebate would be a factor.
QUESTIONS AND CONCERNS
Taxpayers paying rebates to third parties have received some good news in the recent rulings. However, there are some unresolved issues. Despite using Pittsburgh Milk as the standard, the rulings do not touch on the fact that the case concerned illegal rebates, whereas the rulings discuss only legal rebates. Will the IRS be willing to stick with the Pittsburgh Milk rationale when illegal rebates are involved? The rulings do not mention Treas. Reg. § 1.61- 3(a), which denies exclusion treatment if such payments would be nondeductible under IRC § 162(c) (illegal payments and kickbacks). Although the Max Sobel line of cases would seem to invalidate that regulation, does the refusal of the IRS to withdraw that regulation mean the Service is not finished with this issue?
The other concern is timing. The IRS has opened the door for exclusion treatment, at least for legal rebates. But what if the rebate is paid in the year following the sale? Will the IRS allow the rebate to be matched with the sale? In this respect, the language of Revenue Ruling 2008-26 should be closely compared with its nearly identical predecessor, Revenue Ruling 2005-28. The facts and analysis are the same, but when the latest ruling states the timing rule, it replaces the word “incurred” with “paid.” Thus, the IRS will not allow a match of the rebate with the associated sale. The deduction is not allowed until payment.
This change of language apparently signals the IRS’s intent to apply the economic performance requirement of IRC § 461(h) to rebates treated as exclusions. Treas. Reg. § 1.461-4(g)(3) provides that economic performance to pay a rebate occurs only on payment unless the recurring- item exception applies. Despite criticism from commentators who believe it is inappropriate to apply the economic performance rule to exclusions, this latest language change demonstrates the renewed resolve of the IRS. The IRS has the latitude to require payers to wait for a deduction until the rebate is paid because the fountainhead case, Pittsburgh Milk, did not address the issue of payments made after the year of sale. But the net-selling-price rationale of that case would be better served with a simple matching rule.
In a letter ruling (200826006) issued a month or so after Revenue Ruling 2008-26, the IRS explicitly applied the economic performance cash payment rule to rebates. An accrual-method retailer reduced gross receipts by the amount of its estimated rebate payment, which meant that at year-end, unpaid rebates had been used to reduce income. The IRS ruled that the retailer must wait until payment to reduce income and stated, “….subparagraph (g)(3) [of Reg. 1.461-4] applies to all rebates, refunds and payments or transfers in the nature of a rebate or refund regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to costs of goods sold.”
CLOSED DOOR ON NON-SELLER PAYMENTS
The courts have generally not allowed a non-seller to exclude a rebate, reasoning that only the seller can agree to a price adjustment. There is a line of cases on insurance agents who had agreed to give certain customers illegal discounts/rebates to induce them to purchase policies. The Tax Court initially allowed an agent to exclude such payments, reasoning he never had a claim of right to a full commission he had partially bargained away. But beginning with its decision in James Alex v. Commissioner (70 TC 322 (1978), aff’d 46 AFTR2d 80-5802 (9th Cir. 1980)), the Tax Court has said such payments are not excludable because an agent is the agent of the seller and cannot make a price adjustment without the seller’s authority. The Ninth Circuit agreed, adding that only a seller can qualify for exclusion treatment under Pittsburgh Milk. These decisions are doubly bad news for non-sellers because not only are the payments not exclusions, they also are not deductions under IRC § 162(c)(2). But not all non-seller rebates are illegal. In Robert E. Corrigan v. Commissioner (TC Memo 2005-119), the Tax Court did not allow a stockbroker who rebated part of his commission to a customer to exclude it from income. But the court allowed an employee business expense deduction because the payments were not illegal.
Taxpayers could have success under the claim-of-right doctrine if they actually contract away their right to receive a portion of a commission. The Tenth Circuit in Mickey L. Worden v. Commissioner (72 AFTR2d 93-5998) reversed the Tax Court, allowing an exclusion to an insurance agent whose contract with an insurance company allowed him to remit only the net premium and whose contracts with clients allowed him to collect only the net premium.
CPAs should closely monitor at least three aspects of future IRS guidance:
1. Will the IRS follow through on the suspension of Revenue Ruling 76-96 by reversing that ruling? Will it apply the principles of the recent Medicaid ruling more broadly?
2. Will the IRS stick to its guns and force payers to delay exclusions until the rebate is paid, that is, apply the economic performance standard to rebates? If so, this controversial position could spawn a court test.
3. Will the IRS apply the exclusion rule of Revenue Ruling 2008-26 to illegal payments? The focus on Pittsburgh Milk in that ruling would seem to imply that the answer is “yes.” But the only examples in that ruling are legal payments.
Pay Now or Defer, Nov. 05, page 91
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