Editor: Mindy Cozewith, CPA, M. Tax.
With the passing of April 15, many practitioners will shift their attention to taxpayers under extension, many of which will use the recurring-item exception to deduct expenditures paid subsequent to year end but prior to the filing of the tax return. In recent guidance, the IRS has been scrutinizing the timing of the deduction of rebate payments (expenditures generally eligible for the recurring-item exception) and focusing on whether the related liability is actually fixed by year end and therefore eligible to be deducted even if paid within 8½ months of year end.
Background
Under an accrual method of accounting, a liability is incurred and generally taken into account for federal income tax purposes in the tax year in which:
- All the events have occurred that establish the fact of the liability;
- The amount of the liability can be determined with reasonable accuracy; and
- Economic performance has occurred with respect to the liability (Regs. Sec. 1.461-1(a)(2)(i)).
Economic performance occurs for a rebate liability when the taxpayer makes a payment to the person to whom the liability is owed (Regs. Sec. 1.461-4(g)(3)). Accordingly, taxpayers cannot deduct rebates in any tax year prior to the tax year in which they actually pay the rebate, unless they qualify for the recurring-item exception.
Under the recurring-item exception, economic performance is treated as having been met for the year the rebate liability is fixed and determinable, as long as:
- Payment is made on or before the earlier of the date the taxpayer files a timely tax return (including extensions) for the tax year the rebate liability is fixed and determinable or 8½ months after the close of that tax year; and
- The rebate liability is recurring in nature (Regs. Secs. 1.461-5(b)(1)(ii), (b) (1)(iii), and (b)(3)).
Under the recurring-item exception, the amount of the liability must not be material, or accrual of the liability in the tax year must result in better matching of the liability against the income to which it relates. The matching requirement of the recurring- item exception is deemed satisfied with respect to rebates, and the exception applies to rebate liabilities without regard to materiality (Regs. Secs. 1.461-5(b)(1) (iv) and (b)(5)(ii)).
It is tempting to immediately dismiss the all-events test for rebate payments, move immediately to the economic performance issue, and conclude that since economic performance occurs as rebate payments are made, any rebate payments made within 8½ months of year end are currently deductible under the recurring-item exception. This simple analysis can lead to an incorrect answer. The all-events test, although relatively benign in its language, is heavily dependent on an analysis of the facts and circ*mstances.
For example, in CCA 200826006, the IRS held that the taxpayer’s “net” method of accounting for cash rebates (i.e., the reduction of gross receipts by the amount of estimated rebate payments) was not permitted under Regs. Sec. 1.461-4(g) (3). The IRS determined that under Regs. Sec. 1.461-4(g)(3), the taxpayer could not treat its liability for a cash rebate as incurred prior to payment of the rebate. While neither the taxpayer nor the IRS addressed the taxpayer’s potential eligibility for the recurring-item exception under Regs. Sec. 1.461-5, it is possible the taxpayer may have been allowed a deduction in the current year for rebates that were paid by the due date of the tax return or within 8½ months of year end, whichever was earlier, depending on the facts and circ*mstances and whether the taxpayer’s liability was fixed by year end.
In CCA 200834019, the IRS addressed the eligibility of the taxpayer’s cash rebate payments for the recurring-item exception. Because the taxpayer’s liability to pay the rebates did not become fixed until the customer subsequently complied with the cash rebate program’s requirements, the IRS held that the taxpayer, an accrual-method retailer of consumer products, could not treat its liability to pay cash rebates as incurred on the date it sold a product by adopting the recurring-item exception.
Details Behind the Ruling
Under the facts of CCA 200834019, the taxpayer offered cash rebates in conjunction with the sale of a product and contracted with a third-party administrator to process the rebates. Under the cash rebate program, a customer would pay full price for an item and receive a rebate form. To be entitled to a cash rebate, the customer had to complete the rebate form, cut out and attach a copy of the UPC code from the item, attach a copy of the sales receipt, and mail the rebate request to the third-party administrator within 30 days of the date of purchase. Based on these facts, the IRS determined that the taxpayer’s liability to pay a cash rebate was not fixed prior to the time the customer complied with the requirements of the cash rebate program.
Furthermore, because the recurringitem exception is available only for qualifying payment liabilities that are fixed and determinable by the end of the taxpayer’s tax year, the IRS ruled that the taxpayer
may not treat its cash rebate liability as incurred on the date of the sale of the product to which the liability relates by adopting the recurring item exception of § 461(h)(3) because that liability is not fixed until the customer later complies with the rebate requirements.
In other words, a liability must be fixed and determinable before the recurring item exception can be used. The fact that payment is made within 8½ months of year end does not fix the liability for such payment at year end. See also Bigler, T.C. Memo. 2008-133 (a remanufacturer of automobile parts could not offset amounts invoiced to customers by estimated credits to the customers for returns of automobile part cores), and Rev. Rul. 2007-3 (the recurring-item exception does not apply if the fact of the liability is not established by year end).
The IRS’s determination that a customer’s compliance with the cash rebate program requirements was the event necessary to fix the taxpayer’s liability is in line with existing authority addressing the all-events test and nonministerial versus ministerial acts. Where the submission of a claim form is not merely the mechanism for payment but rather a condition precedent to payment, the sale of goods or performance of services does not establish the fact of the liability. Compare, for example, General Dynamics Corp., 481 U.S. 239 (1987) (the submission of a claim form by an employee under the employer’s self-insured medical plan represented the last event that fixed the employer’s liability because some employees might neglect to file the claim form or choose not to submit it because of fear of disclosing a medical condition), with:
- Rev. Rul. 98-39 (once services are performed under an agreement, establishing the fact of the liability is not delayed by an additional requirement that a claim or documentation be submitted for payment as long as the claim’s submission is merely a ministerial act);
- Dally, 227 F.2d 724 (9th Cir. 1955) (a contractor accrued income at the time it delivered houses rather than at the time it submitted a properly certified invoice as required under the government contract); and
- Hughes Properties, Inc., 476 U.S. 593 (1986) (a casino had fixed liability for guaranteed payment amounts on progressive slot machines that were not yet won because its liability was fixed by state gaming regulations after the slot machine’s last play of the year).
In its analysis in CCA 200834019, the IRS determined that the taxpayer’s rebate program liability was more in the nature of the employer’s self-insured medical expense liability in General Dynamics than the casino’s jackpot liability in Hughes Properties, based on the fact that there was no state law requiring the taxpayer to set aside funds to cover its rebate liability. Further, in analogizing the taxpayer’s situation with the facts in General Dynamics, the IRS noted that “the last event fixing Taxpayer’s liability for cash rebates occurs when the customer mails a properly completed rebate form with the required attachments” and that the actual processing and issuance of a rebate constituted a ministerial act.
Implications
CCA 200834019 highlights the importance of taxpayers’ ensuring that a liability meets the all-events test before applying the economic-performance rules. Furthermore, while automatic consent is available under Rev. Proc. 2008-52 for a qualifying accrual-method taxpayer that wants to change its accounting method for treating its liability for rebates to the recurring-item exception method under Sec. 461(h)(3) and Regs. Sec. 1.461-5 (see Rev. Proc. 2008-52, Appendix §19.07), practitioners must take time to review a taxpayer’s rebate program terms to ensure that the related liability is fixed by year end before filing an automatic consent request to apply the recurring-item exception. If a taxpayer files a Form 3115, Application for Change in Accounting Method, to use the recurring-item exception for a rebate liability that is not fixed by year end and the form is selected for post-consent review by the IRS National Office or reviewed as part of an examination, the taxpayer could subsequently lose the method change and consequently be subject to interest and penalties.
EditorNotes
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or [email protected].
