Customer Reward Programs: Deducting Fulfillment Costs Prior to Economic Performance

By Natalie B. Takacs, CPA, M. Tax., and Anthony S. Bakale, CPA, M. Tax., Cohen & Co. Ltd., Cleveland

Editor: Anthony S. Bakale, CPA, M. Tax.

Tax Accounting

Regs. Sec. 1.451-4 provides a narrowly construed exception to the economic performance rules that allows accrual-basis taxpayers who issue premium coupons (or trading stamps) to deduct the estimated fulfillment cost of the coupons (or stamps) at the time they are issued. Taxpayers desiring to take advantage of this favorable treatment must be careful to distinguish their coupon programs from rebates, for which economic performance does not occur and no deduction is allowed until the rebates are actually paid (see Regs. Sec. 1.461-4(g)(3)). To qualify for the favorable treatment for premium coupons available under Regs. Sec. 1.451-4, taxpayers must issue them “with sales,” and the coupons must be “redeemable by [the] taxpayer in merchandise, cash, or other property.”

Premium Coupons

The term “coupon” is not defined in Regs. Sec. 1.451-4; however, in Texas Instruments, Inc. , T.C. Memo. 1992-306, the Tax Court noted a dictionary definition of “‘a token or certificate given with a purchase and redeemable in merchandise or cash’ and a ‘trademark, wrapper, box top, or similar evidence of a purchase for which premium articles are given.’” In Chief Counsel Advice 200826006, the IRS held that a single-coupon rebate was not a premium coupon eligible for favorable treatment under Regs. Sec. 1.451-4. Referring to the Blue Book explanation of the Revenue Act of 1978, P.L. 95-600, for Sec. 466 (later repealed by the Tax Reform Act of 1986, P.L. 99-514), the IRS Chief Counsel’s Office distinguished “discount coupons,” which are individually redeemable, from premium coupons, which are “intended to be collected and redeemed in large numbers for a single product.” Based on this definition of premium coupons, customer reward programs (modeled on the affinity programs used by airlines and credit card companies), under which customers are awarded points that may be accumulated for future redemption, would appear to exemplify the type of coupon programs eligible for the favorable treatment of Regs. Sec. 1.451-4.

With Sales

The IRS has denied taxpayers the benefits of Regs. Sec. 1.451-4 on the grounds that the “with sales” requirement was not met. In Capital One Financial Corp., 133 T.C. 136 (2009), aff’d, 659 F.3d 316 (4th Cir. 2011), the Tax Court determined that the taxpayer (Capital One) was a buyer, rather than a seller, in the transaction. Capital One issued points toward the purchase of an airline ticket for each dollar charged on a Capital One credit card. The Tax Court denied Capital One the benefit of Regs. Sec. 1.451-4, noting that although a sale had occurred between the cardholder and the merchant, Capital One’s role in the transaction was that of a buyer (having purchased a note receivable).

In Rev. Rul. 74-69, the IRS denied the benefits of Regs. Sec. 1.451-4 to a casino operator who issued coupons to winners, concluding that the coupons were issued to “winning patrons” and not “with sales.” In Rev. Rul. 78-97, the taxpayer awarded coupons to former customers who furnished a sales prospect for whom a sale was completed. Once again, the IRS denied the benefits of Regs. Sec. 1.451-4 because “the coupon is neither issued as part of the sale to the former purchaser (the person making the sales referral) nor as part of the sale resulting from such referral. The coupon is issued to the former purchaser for a separate consideration, that is, compensation for a lead that results in a sale.” Likewise, in Rev. Rul. 73-415, coupons distributed gratuitously through the mail or in newspaper or magazine advertisements were not “with sales” and therefore not eligible for the benefits of Regs. Sec. 1.451-4.

Redeemable in Merchandise, Cash, or Other Property

In Rev. Rul. 78-212, the taxpayer issued “on-pack” coupons (appearing on the face of the product) and “in-pack” coupons (included in the package) that entitled consumers to a discount on future product purchases. Although the coupons satisfied the “with sales” requirements, the benefits of Regs. Sec. 1.451-4 were denied because consumers were required to make an additional purchase, and thus the coupons were not unconditionally redeemable.

Even coupons that are unconditionally redeemable, however, may not qualify for favorable treatment under Regs. Sec. 1.451-4 if they are redeemable for other than merchandise, cash, or other property. The IRS and some commentators have asserted that this requirement prevents favorable treatment of the redemption of coupons for services, and best practices may be to preclude the redemption of coupons for services. The authors of this item, however, assert that it may be possible to include redeeming coupons for services. The first argument that supports this is that the term “merchandise” appears broad enough to encompass services. Regs. Sec. 1.451-4 does not define “merchandise.” The dictionary ( defines it as “the commodities or goods that are bought and sold in business,” and, in turn, defines “good” as “something that has economic utility or satisfies an economic want.” Consider, for example, design services or educational services offered by a taxpayer to its customers. Based on these dictionary definitions, such services would appear to be “merchandise.”

The second argument is that, since cash is an eligible redemption item, it would seem possible to break down the redemption of coupons for services into two independent steps—first, their redemption for cash, followed by the payment of the cash for services. To safeguard the deduction, the rewards program should state that the cash redemption value can be applied as payment for services provided under the program. In making this second argument, however, taxpayers should be careful to ensure that their programs satisfy the definition of a premium coupon program (requiring the accumulation of points to be redeemed in large numbers). Taxpayers should also be careful that the points can be unconditionally redeemed without any additional consideration by the customer.

Estimating Reserve and Expense

Regs. Sec. 1.451-4(a) provides that taxpayers who qualify for the favorable tax treatment under Regs. Sec. 1.451-4 should:

subtract from gross receipts . . . an amount equal to:

  1. (1) The cost to the taxpayer of merchandise, cash, and other property used for redemptions in the taxable year.
  2. (2) Plus the net addition to the provision for future redemptions during the taxable year (or less the net subtraction from the provision for future redemptions during the taxable year).

The provision for future redemptions as of the end of a tax year is computed by multiplying “estimated future redemptions” by the estimated average cost of redeeming each trading stamp or coupon. The term “estimated future redemptions” means the number of trading stamps or coupons outstanding as of the end of such year that the taxpayer reasonably estimates will ultimately be presented for redemption. Regs. Sec. 1.451-4(c) provides that a taxpayer may use any method of determining the estimated future redemptions as of the end of a year so long as:

  1. (1) Such method results in a reasonably accurate estimate of the stamps or coupons outstanding at the end of such year that will ultimately be presented for redemption; and
  2. (2) Such method is used consistently.

Normally, the estimated future redemptions of a taxpayer are determined on the basis of the taxpayer’s prior redemption experience. However, if the taxpayer does not have sufficient redemption experience, it may use the redemption experience of similarly situated taxpayers. Regs. Sec. 1.451-4(c)(5) contains a safe-harbor method that uses a five-year moving average ratio of coupons redeemed to coupons issued, multiplied by a growth factor published by the IRS. Unfortunately, the IRS has not issued a new set of growth factors for purposes of Regs. Sec. 1.451-4 since the original one in 1972 (see Rev. Proc. 72-36).

Regs. Sec. 1.451-4 permits taxpayers to use a method other than the five-year rule to estimate future redemptions; however, upon request, the taxpayer must be able to demonstrate to the IRS district director the appropriateness of the method and the accuracy and reliability of the results. If the taxpayer produces an audited financial statement, the method used to determine the outstanding liability related to unredeemed premium coupons (customer rewards) should suffice as a reasonable method under Regs. Sec. 1.451-4.

Regs. Sec. 1.451-4(b)(1)(iii) specifies that the estimated average cost of redeeming each trading stamp or coupon shall include only the amount the taxpayer paid to acquire the merchandise, cash, or other property needed to redeem the coupons. For purposes of Regs. Sec. 1.451-4, such costs include transportation costs but do not take into account Sec. 263A costs.

The estimated future redemptions and the estimated average cost of redeeming each coupon must be no greater than the estimates that the taxpayer uses for purposes of all reports (including consolidated financial statements) to shareholders, partners, beneficiaries, and other proprietors and for credit purposes. Taxpayers that use a method of estimating future redemptions other than the safe-harbor method in Regs. Sec. 1.451-4(c)(5)(i) are required to file a statement with their return showing information that is necessary to establish the correctness of the amount subtracted from gross receipts in the tax year. Taxpayers using the safe-harbor method must file a statement with their return showing, with respect to the tax year and the four preceding tax years:

  1. (1) The total number of stamps or coupons issued or sold during each year; and
  2. (2) The total number of stamps or coupons redeemed in each such year.

Taxpayers desiring the benefits of Regs. Sec. 1.451-4 should carefully structure their coupon programs to comply with its requirements. Any change by the taxpayer in its method of accounting for the redemption of its coupons is a change in method of accounting. Thus, taxpayers not currently accounting for coupon fulfillment costs in accordance with Regs. Sec. 1.451-4 must file Form 3115, Application for Change in Accounting Method , to request the IRS’s permission to change their method of accounting for coupon fulfillment costs. This is not an automatic change, and, thus, the taxpayer must file Form 3115 by the end of the year for which the taxpayer wants to make the change.

The adoption of, or change to, the premium coupon method can result in significant tax savings to the taxpayer, which can accelerate the deduction associated with the rewards program and thus the tax benefit, perhaps by several years.

Example 1: Under a typical reward program, the taxpayer offers one point for each dollar spent by a customer; the value of a point (cost of fulfillment) under the rewards program is estimated at one-half cent per point ($0.005). The taxpayer’s annual gross revenue is $100 million per year. Customers redeem approximately 25% of the points issued during a year in that year. Customers will eventually redeem roughly 90% of all remaining points awarded after the first year at a rate of one-half of the remaining balance each year thereafter. So, in any one year the taxpayer will issue $500,000 worth of rewards points, of which $125,000 will be redeemed that year, leaving an unredeemed balance at the end of the year of $375,000.

Under the economic performance rules, the outstanding balance is deducted in the year in which merchandise, cash, or other products are provided. So, in year 1, the taxpayer’s deduction is $125,000, in year 2, it is $187,500, and in year 3, it is $93,750. This means, as of the end of year 3, there is still an outstanding balance of $93,750 that the taxpayer has not deducted.

Under the premium coupon method provided by Regs. Sec. 1.451-4, however, the taxpayer would deduct $462,500 in the first year ($125,000 redeemed premiums + [90% experience redemption rate × $375,000 outstanding balance]). The deduction in year 1 exceeds the deduction under the economic performance rules allowed in the first four years. If a taxpayer under these facts had been accounting for its reward program under the economic performance rules for 10 years, the total amount not yet deducted for all years would have grown to roughly $750,000. It is apparent that the economic performance rules significantly defer the tax benefit associated with the rewards program.

As noted above, many specific rules and traps are associated with adopting or changing to the accounting method provided under Regs. Sec. 1.451-4. So taxpayers should take extreme care when designing a rewards program to ensure it qualifies for the favorable treatment. Even taxpayers with small programs should consult an expert in the area, as more often than not, the programs will grow as the business grows, and deferred deductions can cause unwarranted strains on the business’s cash flow.


Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.

For additional information about these items, contact Mr. Bakale at 216-579-1040 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.

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