Manufacturer's Minimum Rebate Guarantee Is Not Deductible in Year Made

(Parker Tax Publishing June 2021)

The IRS National Office advised that an accrual method taxpayer's liability to pay sales incentives to third party distributors was incurred, and thus deductible, in the year the distributors earned the sales incentives rather than in in the year in which the taxpayer promised to pay the incentives. The National Office noted that the taxpayer's liability to pay the guaranteed minimum was contingent on distributors selling at least one unit in the year following the year the taxpayer's promise to pay the incentive was made and was also contingent on not selling sufficient units to earn incentives that exceeded the guaranteed minimum. TAM 202121010.

Background

A taxpayer manufactured and distributed units of a product to third party distributors for resale to retail customers. In order to encourage additional sales, the taxpayer introduced a sales incentive program. Under the program, the taxpayer made an irrevocable promise in Year 1 to pay participating distributors an allocated share of a guaranteed minimum sales incentive payment if the participating distributors, in the aggregate, did not earn sales incentive payments in Year 2 that equaled at least the guaranteed minimum amount. The taxpayer effectuated the incentive program by posting two short announcement letters to a portal website. The taxpayer usually posted the letters near the end of its fiscal year-end. Although the letters indicated that the taxpayer would provide additional details about the program, including how the individual incentives would be calculated and a mechanism to allocate the guaranteed minimum payment among the distributors at a later date, the taxpayer never published any additional details or information about the program.

The taxpayer set the guaranteed minimum payment amount to be "somewhat below" the total incentive payments the taxpayer expected to pay the distributors. The taxpayer did not develop a mechanism to allocate the guaranteed minimum payment among the distributors because the participating distributors always qualified to receive sales incentive payments in excess of the guaranteed minimum amount. In addition, there was no evidence indicating that the participating distributors relied on the announcement letters to purchase any additional units before the fiscal year-end announcement period. The taxpayer was unable to confirm or track whether any participating distributors opened or viewed the announcement letters, and the taxpayer received no inquiries or communication from the distributors regarding the announcement letters.

The taxpayer treated the amount of the guaranteed minimum payment as a reduction to its gross receipts in the tax year the taxpayer issued the announcement letters. An IRS field office proposed to disallow the taxpayer's reduction to its gross receipts for the amount of the guaranteed minimum payment because, under Code Sec. 461, all events had not occurred to establish the fact of this liability in Year 1.

Code Sec. 461(h) and Reg. Sec. 1.461-1(a)(2)(i) provide that, under an accrual method of accounting, a liability is generally taken into account in the tax year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability (collectively, the all events test). Code Sec. 461(h)(1) provides that the all events test is not met any earlier than when economic performance occurs. However, under the recurring item exception in Reg. Sec. 1.461-5(b)(1), a liability is treated as incurred for a tax year if: (1) at the end of the tax year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (2) economic performance occurs on or before the earlier of (i) the date that the taxpayer files a return for the tax year, or (ii) the 15th day of the 9th calendar month after the close of the tax year; (3) the liability is recurring in nature; and (4) either the amount of the liability is not material or accrual of the liability in the tax year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the tax year in which economic performance occurs.

The taxpayer argued that its liability to pay the guaranteed minimum payment was fixed and determinable in Year 1 when it issued the announcement letters. The taxpayer viewed its situation as indistinguishable from United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), in which the Supreme Court allowed a Nevada casino operator to deduct amounts guaranteed for payment of slot machine jackpots that had not yet been won by casino patrons. The Court found that the last event that created the casino's liability was the last play of a slot machine before the end of the fiscal year. At that point, Nevada law made the amount shown on the jackpot payoff indicators incapable of being reduced. According to the taxpayer, the event triggering the obligation pay the guaranteed minimum payment - a sale by a distributor during the qualifying period in Year 2 - was no different than when a patron won a jackpot in the year following the year in which the casino was allowed a deduction for the jackpot amount in Hughes Properties. The taxpayer added that the event triggering its obligation to pay the guaranteed minimum payment was inevitable and that the Court in Hughes Properties held that a liability incurred by a taxpayer at the end of a tax year was deductible in that year if payment of the liability was inevitable, even though some act remained to be completed in the following year. The taxpayer further contended that its commitment to make the guaranteed minimum payment was enforceable under state law as a unilateral contract, making the taxpayer's liability to pay the guaranteed minimum payment irrevocable.

Analysis

In TAM 202121010, the IRS National Office advised that the taxpayer's liability to pay sales incentives was not accelerated by the taxpayer's promise to pay a guaranteed minimum sales incentive because the taxpayer's liability to pay the guaranteed minimum was contingent on distributors selling at least one unit in Year 2 and also on not selling sufficient units to earn incentives that exceeded the guaranteed minimum.

The National Office found that the taxpayer's liability was in effect a rebate. The taxpayer paid the incentives during the first 8 1/2 months of Year 2. Therefore, the National Office said, the economic performance requirement would be met if the liability were fixed at the end of Year 1. However, in order to apply the recurring item exception, all events must have occurred that establish the fact of the liability at issue -- the guaranteed minimum amount promised in Year 1. The National Office agreed with the field office that the requirements that the distributors sell at least one unit in Year 2 and not sell sufficient units to earn incentives that exceeded the guaranteed minimum were conditions precedent to the taxpayer's liability for purposes of Code Sec. 461. Since the last event necessary to establish the taxpayer's liability occurred in Year 2, the taxpayer could not establish the fact of its liability in Year 1.

The National Office disagreed with the taxpayer's assertion that its situation was analogous to Hughes Properties. The National Office noted that in Hughes Properties, the last event necessary to establish the liability was the last play of the slot machine at year end because, even if the jackpot was not won with that play, Nevada law had the effect of irrevocably setting aside the amount of the jackpot by that play, which the casino eventually was required to pay. The National Office noted that, in the taxpayer's case, one of the two last events necessary to establish the liability was when a distributor made a sale during the qualifying period in Year 2. According to the National Office, in the taxpayer's case the contingencies determined the existence of the liability as of the end of tax Year 1, whereas in Hughes Properties the only contingencies related to the identity of the winners of the jackpot.

The National Office also found that the taxpayer's situation was distinguishable from Rev. Rul. 2011-29, in which the IRS ruled that, by the end of a particular year, a taxpayer had established the fact of its liability for a minimum amount of bonuses payable to a group of eligible employees in the following year, even though the identity of the particular employees to which the bonuses would be paid was unknown until after the end of the tax year. In Rev. Rul. 2011-29, the IRS determined that the fact of the taxpayer's liability for the minimum amount of bonuses was established by the end of the year in which the services were rendered by the employees. The National Office explained that, unlike Rev. Rul. 2011-29, in the taxpayer's case, the promise to pay was not unconditionally fixed by the end of Year 1 because participating distributors had not rendered any services or provided any other consideration to the taxpayer by the end of Year 1. Rather, the taxpayer's promise to pay the guaranteed minimum payment became unconditionally fixed when the participating distributor made a sale during the qualifying period in Year 2 and when participating distributors did not earn sales incentives during the qualifying period equaling at least the guaranteed minimum amount, which could only be determined in Year 2.

The National Office found that even if the taxpayer's assertion about state law was correct regarding partial performance in a unilateral contract, the facts did not indicate that distributors relied on the offer to purchase any additional units from the taxpayer in Year 1. The National Office found that the timing of the taxpayer's issuance of the announcement letters meant that the distributors would have little or no time to make an informed decision to buy any additional units prior to the taxpayer's fiscal year-end. The National Office noted that in fact, the taxpayer was unable to confirm or track whether any participating distributors opened or viewed the announcement letters, and the taxpayer received no inquiries or communication from the distributors regarding the announcement letters. This indicated to the National Office that the distributors did not act upon the taxpayer's offer by the fiscal year end. Thus, the National Office found that the taxpayer's offer for a unilateral contract could only be accepted when the participating distributor sold the product during the qualifying period in tax Year 2.

For a discussion of the all events test under Code Sec. 461, see Parker Tax ¶241,740.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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