Vendor Allowances for Defective Merchandise Reduce Inventory Cost

In a recent chief counsel advice, the IRS held that certain allowances resellers receive from vendors for defective merchandise should be treated as reducing the cost of inventory under Treas. Reg. § 1.471-3(b).

The IRS is closely scrutinizing the various types of vendor allowances to determine if they constitute gross income, expense reimbursement, trade discounts or other discounts under Treas. Reg. § 1.471-3(b). This has been designated a Tier III issue (the highest compliance risk for a particular industry) by the IRS. If the allowances are properly treated as a trade discount, then the issue becomes whether the allowances should reduce the cost of all merchandise purchased from the vendor or only the cost of the defective merchandise.

A discount that is always allowed regardless of time of payment is a trade discount. The IRS treats the purchaser as paying a net price after the trade discount (Revenue Ruling 84-41). The CCA cites Pittsburgh Milk Co. (26 TC 707 (1956)) for the proposition that if the purpose and intent of the allowance is to reach an agreed-upon sales price, then the allowance is a sales (purchase) price adjustment. Interestingly, the IRS fought this precedent for years on the seller side, preferring to treat allowances granted by the seller as deductions subject to the restrictions under IRC § 162, such as economic performance. (See “Tax Treatment of Rebates May Be Clearing Up,” JofA, Oct. 08, page 42, for how the IRS is relaxing its position on the seller side.) In the CCA, the taxpayer received a “returned/ defective merchandise vendor allowance” when it purchased merchandise from certain vendors. The allowance was stated as a percentage of total purchases and normally required no actual return of the merchandise. The agreement did not require the allowance to be repaid or reduced if the defective rate was less than the estimated rate.

The CCA concluded that the allowances received were not part of total sales under Treas. Reg. § 1.61-3(a) but should reduce the cost of inventory under Treas. Reg. § 1.471-3(b). Even though the allowances were sometimes characterized as compensation for defective goods, they were really reductions in invoice cost because they were fixed allowances not dependent on proving the actual defective rate.

The IRS also held that since the allowances were not tied to specific items of inventory but were related to all items purchased from a particular vendor, the discount should reduce the cost of all the merchandise from that vendor.

Finally, the CCA said that resellers are not required to capitalize the cost of defective merchandise as an indirect cost of nondefective goods under Treas. Reg. § 1.263A-1(e)(3)(ii)(Q). The CCA found that the terms “spoilage,” “rework labor” and “scrap” in this regulation were intended to require manufacturers, not resellers, to capitalize such costs.

  Chief Counsel Advice 200945034 (11/6/2009)

By Larry Maples, CPA, DBA, professor of accounting, Tennessee State University, Nashville, Tenn.