All-events test for sales incentives — another perspective

By Zhonglu Yang, CPA, MBT, Los Angeles

Editor: Mark G. Cook, CPA, CGMA

In Technical Advice Memorandum 202121010, also discussed in this item, the IRS addressed the timing of a manufacturer’s deduction for sales incentive payments to third-party distributors of its products. The manufacturer contended that its written promise to pay the distributors a sales incentive of a guaranteed minimum amount accelerated the time when it incurred the liability for purposes of the Sec. 461 all-events test. Disagreeing, the IRS concluded that the liability was incurred only in the tax year the distributors earned the sales incentive, because the guaranteed payment was contingent on the distributors’ selling at least one of the taxpayer’s units in a subsequent year and not earning incentives exceeding the guaranteed minimum.


The taxpayer manufactured and distributed products to third-party distributors for resale to retail customers. In year 1, to encourage additional purchases of its products, the taxpayer made an irrevocable promise to pay participating distributors a guaranteed minimum sales incentive if a distributor sold at least one unit of the taxpayer’s product in the qualifying period (date 1 of year 1 to date 2 of year 2) and did not earn sales incentives exceeding that guaranteed minimum payment. The taxpayer announced the incentive payment in letters posted to a distributor-used portal website near the end of year 1.

The taxpayer did not provide details in the announcement letters on how the individual incentives would be calculated or develop a mechanism to allocate the guaranteed minimum payment among distributors for any of the tax years at issue, because the participating distributors always qualified to receive sales incentive payments in excess of the guaranteed amount.

For the tax years at issue, there is no evidence indicating that participating distributors relied upon the announcement letters to purchase additional units of the taxpayer’s products prior to the end of year 1. The taxpayer was unable to confirm or track whether any participating distributor opened or viewed the announcement letters, and the taxpayer received no inquiries or communication from distributors regarding the announcement letters.

The taxpayer had been taking the amount of the guaranteed minimum payment as a deduction in the tax year when the taxpayer issued the announcement letters (year 1).


Under an accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, 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) (Sec. 461(h) and Regs. Sec. 1.461-1(a)(2)(i)). Regarding the first requirement, all the events have occurred that establish the fact of the liability when (1) the event fixing the liability occurs or (2) payment therefore is due, whichever happens earlier (Rev. Rul. 2007-3).

So, the key here in determining when the manufacturer was entitled to take the deduction is to find out if its liability for the minimum payments was fixed as of the end of year 1. In Brown v. Helvering, 291 U.S. 193 (1934), the Supreme Court indicated that a taxpayer may not deduct a contingent liability. And in Hallmark Cards, Inc., 90 T.C. 26 (1988), the Tax Court stated that 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.

Under the taxpayer’s facts, the guaranteed minimum payment was not required to be paid unless participating distributors sold the products in the following year (year 2) and earned sales incentives less than the guaranteed minimum amount. The IRS concluded that 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.

Relevant case law: In the memorandum, the IRS discussed two court cases regarding the deduction of guaranteed payments in analyzing whether the taxpayer’s liability could be deducted in the year when the guaranteed minimum payment was promised. In Hughes Properties, Inc., 476 U.S. 593 (1986), 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 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 last play, which the casino was required to pay to the eventual winner.

But the IRS found that the manufacturer’s facts were distinguishable. One of the two last events necessary to establish the liability for the minimum payments was when distributors sold the products during the qualifying period in year 2. In other words, the existence of the taxpayer’s liability in year 1 was still uncertain because it depended on distributors’ sales events in year 2. In contrast, in Hughes Properties, the existence of the liability to pay the jackpot was certain — the only contingency was the identity of the jackpot winners.

Similarly, the manufacturer’s situation was distinguishable from that in Willoughby Camera Stores, Inc., 125 F.2d 607 (2d Cir. 1942), the IRS concluded in the memorandum. In Willoughby, at the end of each year, the taxpayer’s board of directors determined an amount to be paid as bonuses during the next year, which was set up on the taxpayer’s books as a reserve. The taxpayer then was allowed a deduction for the tax year in which this determination was made. The Second Circuit noted that the action of the taxpayer’s board of directors must be regarded as definitely fixing a minimum payment and that it was apparent that the action was intended by the company and accepted by the employees as more than a statement that so much would be paid if the company did not change its mind.

Unlike in Willoughby, the manufacturer’s distributors in the present case would not expect to receive the guaranteed minimum payment until they sold the manufacturer’s products in year 2. And, even then, the guarantee would arise only if certain requirements were met. Thus, the situations are not parallel, the IRS concluded.

The taxpayer’s contract law argument: To justify accelerating its deduction to year 1, the manufacturer also argued that its commitment to make the guaranteed minimum payment was enforceable under state law as a unilateral contract, pointing to legal principles that the commencement of partial performance by an offeree can render an offer irrevocable. Specifically, the taxpayer argued that it extended an offer when it promised in the announcement letters to make the guaranteed minimum payment and that the distributors partially performed — making the offer irrevocable — by purchasing additional products by the close of the announcement period (date 1 of year 1).

Disagreeing, the IRS said the facts did not indicate that participating distributors had relied upon the offer to purchase any additional products from the taxpayer in year 1. Also, the Service noted that since the taxpayer issued the announcement letters only a few days prior to its fiscal year end, the distributors would have had little or no time or opportunity to act upon the taxpayer’s offer in year 1. In addition, the IRS said, 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 any distributors regarding the announcement letters. Thus, the taxpayer’s contractual argument in support of accelerating the deduction failed, too.

Final thoughts

For accrual-method taxpayers, a liability is incurred in the tax year when the all-events test is met. Importantly, before a liability is considered as incurred, the “last event” necessary to establish the existence of the taxpayer’s liability must have happened, and the liability cannot be contingent. Based on the Hughes Properties and Willoughby cases, it can be assumed that a set-aside reserve account for future payments can be helpful in demonstrating that a liability has been incurred. And if the unilateral-contract doctrine is applicable in a taxpayer’s state and relied on by the taxpayer, the taxpayer should retain any evidence of the offeree’s reliance on the offer and actual partial performance in case the IRS audits the transaction.

Editor Notes

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 Contributors are members of or associated with SingerLewak LLP.

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