The IRS, through Technical Advice Memorandum (TAM) 202121010, has clarified when the all-events test of Sec. 461 is met for an accrual-method taxpayer that promised to pay sales incentives to third-party distributors. The IRS concluded that the liability generated from the sales incentives is incurred under the all-events test in the tax year the incentives are earned, not in the tax year of the taxpayer’s promise to pay.
To incentivize a third-party distributor to make additional purchases of the taxpayer’s product before year end, the manufacturing and distribution company made an offer guaranteeing a minimum sales incentive payment for sales of products in the distributor’s inventory at the end of year 1, which were sold during a specified period in the subsequent year 2. The minimum payment applied only if the distributor did not earn sales incentives in the specified period equaling at least the amount of the guaranteed minimum. The offer was made in writing a few days before the end of the taxpayer’s fiscal year to encourage additional purchases of products. The taxpayer’s position was that its promise in writing to pay a guaranteed minimum of sales incentives to distributors in the following year met the all-events test, allowing the taxpayer to deduct the guaranteed minimum as a reduction of gross receipts in the tax year the offer was made, not the year the incentive was paid.
Sec. 461(a) states that deductions and credits must be taken in the proper tax year, according to the taxpayer’s method of accounting used to determine taxable income. Under the accrual method, taxpayers can deduct an expense if the liability meets the all-events test as described in Sec. 461(h) and Regs. Sec. 1.461-1(a)(2)(i). The all-events test is met when (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. Sec. 461(h)(1) states that the all-events test shall not be treated as met any earlier than when economic performance with respect to that item occurs. Applying the all-events test to the facts and circumstances of the taxpayer’s sales incentive offer clarifies the IRS’s decision.
Generally, all events have occurred to establish the fact of a liability when (1) the event fixing the liability occurs, whether that is the required performance or other event, or (2) the payment is unconditionally due. The taxpayer’s sales incentive offer here was contingent upon the distributor’s selling at least one unit of product from its ending inventory of year 1 in the subsequent year 2. Given that the sales could not occur until year 2 to be eligible for the incentive, the event(s) fixing the liability did not occur during year 1. Additionally, the sales incentive offer stated that the taxpayer was not obligated to make the guaranteed minimum payment unless the distributor did not earn enough sales incentives during the specified period to equal at least the amount of the guaranteed minimum payment. Given both of these facts, the IRS concluded that the first prong of the all-events test was not met.
To pass the second prong of the all-events test, the amount of the liability has to be determined with reasonable accuracy. It is not necessary to know the exact amount, so long as the liability has been incurred and the amount is determined with reasonable accuracy. A liability is not deductible if it is contingent or based upon an estimate if the events in question have not occurred by the end of the tax year, no matter how statistically certain (General Dynamics Corp., 481 U.S. 239 (1987)). Here, the taxpayer’s guaranteed minimum payment is not payable unless the distributor makes sales of the inventory in year 2. Given that the event necessary to determine the liability did not occur during year 1, the IRS concluded that the second prong of the all-events test also was not met.
Additional sections of the TAM provide guidance about the economic performance requirement for the liability in question. A sales incentive is in effect a rebate. Regs. Sec. 1.461-4(g)(3) provides that economic performance as it relates to liabilities of rebates, refunds, or other payments occurs as payment is made to the person to which the liability is owed. However, a recurring-item exception to this general rule of economic performance described in Regs. Sec. 1.461-5(b)(1) applies if:
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;
Economic performance with respect to the liability occurs on or before the earlier of (a) the date the taxpayer files a timely (including extensions) return for that tax year, or (b) the 15th day of the ninth calendar month after the close of that tax year;
The liability is recurring in nature; and
Either the amount of the liability is not material or the accrual of the liability results in better matching to the income it relates to.
In the case of the manufacturing and distribution company being discussed, all incentives were paid during the first 8½ months of year 2. Therefore, the economic performance requirement would be met under the recurring-item exception if the liability was fixed at the end of year 1. However, since the distributor was required to sell at least one unit during year 2, the liability was not fixed and, therefore, the third prong of the all-events test was not met.
Reviewing the facts and circumstances of the company’s sales incentive offer along with the provisions of the all-events test provides clarity into the IRS’s decision to disallow the acceleration of the liability to the year the offer was made. The company’s mere promise to pay was not sufficient to consider the liability fixed since all of the events to establish the fact of the liability did not occur during the year the offer was made. The IRS concluded that the taxpayer must deduct the sales incentive payments in the tax year they were earned by the distributors under the all-events test.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or firstname.lastname@example.org. Contributors are members of or associated with SingerLewak LLP.