In a Technical Advice Memorandum[1] the IRS ruled that an overall accrual basis corporation’s promise to pay minimum incentives to dealers in the following year did not meet the requirements of the all events test under IRC §461, and thus could only be deducted in the year when the dealers sold the products in question.

Facts of the Program in Question

The TAM provides the following description of the program in question:

To encourage sales of A to retail customers, Taxpayer offers a sales incentive program to B and to retail customers. This advice concerns the sale incentives offered to B. Under its sales incentives program, Taxpayers offers a variety of retail sales incentives to B and retail customers (e.g., bonuses, rebates, etc.). The rules and guidelines of these programs are outlined in a document called the C. The rules require that B must satisfy certain conditions before Taxpayer is obligated to make an incentive payment. The sales incentive program is communicated in the form of E and are offered throughout the year. However, it is only those sales incentives earned by B that was in B’s ending inventory as of Date1 of Year 1 and sold by B between Date2 of Year 2 (“the qualifying period”) that is relevant for this discussion.

In Year 1, Taxpayer introduced the D in order to encourage additional purchases of A. Under the D, Taxpayer makes an irrevocable promise, to pay participating B an allocated share of a guaranteed minimum sales incentive payment if B sell A during the qualifying period, which is sales of A that was in B’s ending inventory as of Date1 of Year 1 between Date2 of Year 2. Moreover, the promise to make the guaranteed minimum sales incentive payment under the D takes effect only if the participating B, in the aggregate, do not earn sales incentive payments during the qualifying period equaling at least the guaranteed minimum amount promised under the D.

To earn the incentive B must sell A during the qualifying period, and to be eligible to share in the D, B must sell A during the qualifying period.

Taxpayer effectuates the D by posting two short announcement letters — one addressed to each of the respective B divisions — to a B portal website that guarantees that participating B will have the opportunity to earn a minimum sales incentive payment in the following year. Taxpayer usually posts the letters for the D near the end of the fiscal year-end. Although the letters indicate that Taxpayer will provide additional details about the D, which include how the individual incentives will be calculated and a mechanism to allocate the guaranteed minimum payment among the B at a later date, Taxpayer has never published any additional details or information about the D other than the letters issued a few days before year-end.

For every taxable year of the D, Taxpayer set the guaranteed minimum payment amount to be “somewhat below” the total incentive payments Taxpayer expected to pay B pursuant to C for the qualifying period. In effect, Taxpayer did not develop a mechanism to allocate the guaranteed minimum payment among the B for any of the taxable years at issue because the participating B always qualified to receive sales incentive payments in excess of the guaranteed amount promised under the D.

Also, for the taxable years at issue for the D, there is no evidence indicating that participating B relied upon the announcement letters to purchase any additional A prior to the fiscal year-end announcement period. Taxpayer was unable to confirm or track whether any participating B opened or viewed the D announcement letters and Taxpayer received no inquiries or communication from B regarding the D announcement letters.[2]

Positions of the Taxpayer and the IRS Examination Team

Based on the promised minimum incentive payments under the program, the taxpayer took the following positions on tax returns for the years in question:

For the taxable years at issue, Taxpayer has been treating the amount of the guaranteed minimum payment as a reduction to its gross receipts in the taxable year Taxpayer issues the D announcement letters. For sales incentive payments earned by B outside of the qualifying period (which is shorter than a year) and thus not covered by the D, Taxpayer deducts the sales incentive payments earned by B when Taxpayer pays or credits B.[3]

In the exam, the IRS is proposing to deny these deductions in the year claimed, and pushing them back into the years that the dealer is required to sell the product:

For the taxable years at issue, the IRS field office has proposed disallowing Taxpayer’s reduction to its gross receipts for Year 1 for the amount of the guaranteed minimum payment promised under the D announcement letters because all events have not occurred to establish the fact of this liability in Year 1.[4]

A request for technical advice was raised to obtain a ruling on which treatment, if either, was proper for this program and the timing of the deduction.

The All Events Test

The TAM begins by discussing the all events test that applies to accrual basis taxpayers under IRC §461. The memorandum notes that under IRC §461(h) and Reg. §1.461-1(a)(2)(i), a deduction is taken into account by an accrual basis taxpayer in the taxable year when

All 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.[5]

The memorandum discusses special details that impact the economic performance test:

Section 1.461-4(g)(3) provides that if the liability of the taxpayer is to pay a rebate, refund, or similar payment to another person (whether paid in property, money, or as a reduction in the price of goods to be provided in the future by the taxpayer), economic performance occurs as payment is made to the person to which the liability is owed. This provision 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 cost of goods sold.

Section 1.461-5(b)(1) provides a recurring item exception to the general rule of economic performance. Under the recurring item exception, a liability is treated as incurred for a taxable year if: (i) at the end of the taxable year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (ii) economic performance occurs on or before the earlier of (a) the date that the taxpayer files a return (including extensions) for the taxable year, or (b) the 15th day of the 9th calendar month after the close of the taxable year; (iii) the liability is recurring in nature; (iv) either the amount of the liability is not material or accrual of the liability in the taxable 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 taxable year in which economic performance occurs. Section 1.461-5(b)(5)(ii) provides that, in the case of a liability for rebates, the matching requirement of the recurring item exception is deemed satisfied.[6]

Is the Liability Fixed as of the End of the First Year?

A key question is whether the liability is fixed as of the end of the first year in question. The memorandum takes a look at how, in the view of the author of the memorandum, case law has dealt with this issue.

The first prong of the all events test requires that all events have occurred that establish the fact of the liability. Generally, all events occur to establish the fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment is unconditionally due. Rev. Rul. 2007-3, 2007-1 C.B. 350; Rev. Rul. 80-230, 1980-2 C.B. 169; Rev. Rul. 79-410, 1979-2 C.B. 213, amplified by Rev. Rul. 2003-90, 2003-2 C.B. 353.

A taxpayer may not deduct a liability that is contingent, nor may a taxpayer deduct an estimate of an anticipated expense, no matter how statistically certain, if it is based on events that have not occurred by the close of the taxable year. Brown v. Helvering, 291 U.S. 193, 201 (1934). “The all events test is based on the existence or nonexistence of legal rights or obligations at the close of a particular accounting period, not on the probability — or even absolute certainty — that such right or obligation will arise at some point in the future.” Hallmark Cards, Inc. v. Commissioner, 90 T.C. 26, 34 (1988). Even if that event is merely the arrival of a certain date. Central Investment Corp. v. Commissioner, 9 T.C. 128, 133 (1947), affd. per curiam 167 F.2d 1000 (9th Cir. 1948), cert. denied 335 U.S. 826 (1948).[7]

The memorandum notes that, as the taxpayer is invoking the recurring item exception, the only real issue is whether the fact of the liability is established as of year end:

Taxpayer’s liability is to pay a sales incentive to B which is in effect a rebate. Taxpayer pays the incentives during the first 8½ months of Year 2. Therefore, 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 under the D, in Year 1.[8]

The IRS, not surprisingly, often sees this standard not being satisfied when the taxpayer believes the existence of the liability is clearly fixed. The office handling the examination takes the following position regarding when the liability is fixed under this agreement:

The IRS field office argues that Taxpayer’s commitment to make the guaranteed minimum payment promised under the D is not required to be fulfilled unless and until B sells A that was in B’s ending inventory as of Date 1 of Year 1 between Date2 of Year 2. Also, the IRS field office argues that Taxpayer’s commitment to make the guaranteed minimum payment promised under the D is contingent upon participating B, in the aggregate, not earning sales incentives during the qualifying period in the following year equaling at least the guaranteed minimum amount promised under the D.[9]

The taxpayer claims that the program clearly fixes the liability prior to the end of the first year, rather than not being fixed until product is sold by the dealer in Year 2:

Taxpayer argues that its liability to pay the guaranteed minimum payment under the D is fixed and determinable for purposes of § 461 in Year 1 when it issues the D announcement letters because its situation is indistinguishable from United States v. Hughes Properties, Inc., 476 U.S. 593 (1986). In Hughes Properties, the Supreme Court allowed a Nevada casino operator to deduct amounts guaranteed for payment of progressive 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 and, moreover, the Court found “[t]he effect of Nevada’s law was the equivalent to the situation where state law requires the amounts of the jackpot indicators to be set aside in escrow pending the ascertainment or the identity of the winners.” Hughes Properties, 476 U.S. at 602. Further, the Court noted that “[t]he obligation is there, and whether it turns out that the winner is one patron, or another makes no conceivable difference as to basic liability.” Id.

According to Taxpayer, Taxpayer was under a fixed obligation to pay the guaranteed minimum payment under the D at the end of its Year 1, even though it is based on when B sells A during the qualifying period, which occurs in Year 2. Taxpayer argues that the event triggering Taxpayer’s obligation pay the guaranteed minimum payment under the D, which is when B sells A during the qualifying period in tax Year 2, was no different than when a patron wins a jackpot in the year following the taxable year in which the casino was allowed a deduction for the jackpot amount in Hughes Properties. Taxpayer adds that the event triggering Taxpayer’s obligation to pay the guaranteed minimum payment under the D, which is when B sells A during the qualifying period in tax Year 2, was inevitable and that the Court in Hughes Properties held that a liability incurred by a taxpayer at the end of a taxable year is deductible in that taxable year if payment of the liability was inevitable even though some act remained to be completed in the following taxable year.[10]

The memorandum sides with the IRS examining office position on this issue:

We agree with the field that these are conditions precedent that are necessary to establish Taxpayer’s liability for purposes of § 461. Since the last event necessary to establish Taxpayer’s liability occurs in Year 2, Taxpayer cannot establish the fact of its liability in Year 1. Thus, since Taxpayer may not treat the liability as incurred in tax Year 1 when it issues the commitment letter to make the guaranteed minimum payment under the D, the liability does not meet the requirements of the recurring item exception at that point.[11]

The memorandum rejected the taxpayers’ arguments to the contrary, distinguishing the facts in this case from those in Hughes Properties.

We disagree with Taxpayer’s interpretation of Hughes Properties that its situation is analogous to Hughes Properties. 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. In Taxpayer’s case, one of the two last events necessary to establish the liability was when B sells A during the qualifying period in Year 2. In short, in Taxpayer’s case, the contingencies determine the existence of the liability as of the end of tax Year 1, whereas in Hughes Properties the only contingencies relate to the identity of the winners of the jackpot.[12]

IRS and the Fact of a Liability

The decision is not terribly surprising, as the IRS does not much like the “payment is inevitable” position on the fact of the liability. The IRS concludes the memorandum by citing some other theories that might be used to attempt to defend the deduction that the agency seeks to distinguish.

Of particular interest, the IRS distinguishes the situation from that found in Rev. Rul. 2011-29:

… Taxpayer’s situation is distinguishable from Rev. Rul. 2011-29, 2011-49 I.R.B. 824. In Rev. Rul. 2011-29, the Service concluded that a taxpayer had established the fact of its liability, by the end of a taxable year, 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 will be paid was unknown until after the end of the taxable year. The Service noted the fact of the taxpayer’s liability for the minimum amount of bonuses is established by the end of the year in which the services are rendered by the employees. See Rev. Rul. 54-446, 1955-2 C.B. 531, as modified by Rev. Rul. 61-127, 1961-2 C.B. 36 (holding that bonuses payable to ascertainable employees under an incentive compensation plan that has been communicated to the employees, the exact amounts of which are determinable through a formula in effect prior to the end of the taxable year, are properly accruable for Federal income tax purposes for the year to which they relate). Unlike Rev. Rul. 2011-29, in Taxpayer’s case, Taxpayer promise to pay the guaranteed minimum payment under the D is not unconditionally fixed by the end of tax Year 1 because participating B have not rendered any services or provided any other consideration to Taxpayer by the end of tax Year 1 which would unconditionally require Taxpayer to pay the guaranteed minimum payment under the D. Taxpayer’s promise to pay the guaranteed minimum payment under the D becomes unconditionally fixed when participating B sells A during the qualifying period in Year 2 and when participating B do not earn sales incentives during the qualifying period equaling at least the guaranteed minimum amount promised under the D, which can only be determined in Year 2.[13]

That 2011 Revenue Ruling is particularly interesting, as it represented the IRS’s tacit acceptance, after years of questioning the logic of, a decision the agency lost in 1969 that affected tax years 1957, 1958 and 1959 (Washington Post Co[14]. v. United States, 405 F.2d 1279).

The IRS cited the Post case in the ruling, even though the IRS had, until then, announced it would not follow the Post case (Rev. Rul. 76-345, revoked by Revenue Ruling 2011-29). So it only took the IRS 42 years after losing on the issue in court (and continuing to lose in later cases that cited the Post case) to grudgingly agree to that deduction. The key issue was that even though the Company could not determine exactly who would receive specific payments, the plan was such that the amounts in question would be paid out to someone. But the IRS fought that position for decades despite continuing losses.

In this case, a key distinguishing fact is that should the dealer sell none of the product in inventory at the end of the prior year by the due date, the dealer would not receive any payment. Even though that is wildly improbable, the IRS nevertheless uses that highly unlikely event as introducing sufficient uncertainty to find the fact of the liability has not been established.

Thus, even though under generally accepted accounting principles it may seem clear that there is a liability, don’t be surprised if the IRS disagrees if the agency can find any sort of future contingency. It may require going to court (or at least convincing the IRS the taxpayer will do that) to get that earlier deduction.

[1] TAM 202121010, May 28, 2021, https://www.taxnotes.com/research/federal/irs-private-rulings/letter-rulings-%26-technical-advice/promise-to-pay-minimum-sales-incentive-doesn%e2%80%99t-accelerate-liability/67zrc (retrieved May 28, 2021)

[2] TAM 202121010, May 28, 2021

[3] TAM 202121010, May 28, 2021

[4] TAM 202121010, May 28, 2021

[5] TAM 202121010, May 28, 2021

[6] TAM 202121010, May 28, 2021

[7] TAM 202121010, May 28, 2021

[8] TAM 202121010, May 28, 2021

[9] TAM 202121010, May 28, 2021

[10] TAM 202121010, May 28, 2021

[11] TAM 202121010, May 28, 2021

[12] TAM 202121010, May 28, 2021

[13] TAM 202121010, May 28, 2021

[14] The Washington Post Co. was renamed in 2013 to Graham Holdings Company after the sale of the Washington Post newspaper in 2013 to Jeff Bezos. Graham Holdings Company is the corporate parent of Kaplan, Inc.