Tax Treatment of Rebates May Be Clearing Up: Here's How to Manage These Payments' Tax Recognition
EXECUTIVE SUMMARY * The IRS has attempted for many years to categorize rebates as deductions rather than exclusions so that the restrictions of IRC [section] 162 can be applied. But the courts have allowed exclusion treatment for direct seller-to-buyer rebates. * Though the IRS has had some success in the courts challenging rebates to third parties, recent rulings indicate it is pulling back and may be willing to allow exclusion treatment. * The IRS and the courts agree that rebates paid by nonsellers are not excludable, reasoning that only the seller can agree to a price adjustment. * Although the IRS appears to be moving toward allowing most seller-paid rebates as exclusions, it is now insisting that even accrual taxpayers delay the exclusion until the rebate is paid. ********** [ILLUSTRATION OMITTED] Rebates are used in many vendor market channel programs to accomplish objectives such as jump-starting a market, overcoming market barriers and supporting a market until economies of scale can reduce production costs. The income tax treatment of rebates, however, has been a simmering dispute for more than 50 years, leaving uncertainty for both payers and recipients as to characterization and timing. Recently, the IRS has taken steps to reduce some of the confusion. But a major issue remains unsettled: whether a rebate is a sales price adjustment reducing gross income (exclusion) or a deduction from gross income. This would be a distinction without a difference for federal taxable income, which is reduced either way, except that a deduction is subject to the restrictions of IRC [section] 162(c) (state sales taxes could also be affected). Thus, rebates that have not qualified as exclusions have been disallowed altogether when the IRS held them to be not ordinary and necessary, or when the payment fit one of the prohibited categories of section 162(c), such as illegal payments or kickbacks. The rapidly evolving position of the IRS can be viewed through the prism of a series of pronouncements on Medicaid rebates paid by drug manufacturers. In FSA 200101004, the IRS advised that such rebates paid to state agencies were not sales price adjustments. Then in Revenue Ruling 2005-28 and, more recently, in Revenue Ruling 2008-26, the IRS reversed that position using the identical fact pattern. This reversal should not be narrowly interpreted to apply only to Medicaid rebates, because in these more recent rulings the IRS also announced it was suspending an earlier ruling (Revenue Ruling 76-96--see below) that had held that rebates paid by automobile manufacturers were business expenses. A dictionary definition of a rebate is "a return of a part of a payment." This basic nonlegal definition implies that payment is returned from seller to buyer. Through the years, the IRS has resisted exclusion treatment for payments that do not literally match this definition, that is, payments not made to the buyer or payments made by non-sellers. The IRS has argued that the intent of such payments cannot be to reach an agreed-upon net selling price because the payment is not between the buyer and seller. Taxpayers have had a good deal of success in the courts arguing for exclusion treatment for direct payments from seller to buyer. Payments to third parties have been closely scrutinized, but the IRS is currently opening the door. However, neither the courts nor the IRS has allowed exclusion treatment for "rebates" paid by a non-seller. OPEN DOOR ON SELLER-TO-BUYER PAYMENTS The Pittsburgh Milk (26 TC 707) case first established in 1956 that direct seller-to-buyer rebates were excludable from gross income. In that case, a dairy wholesaler paid cash rebates to buyers under an informal arrangement to avoid state minimum milk price regulations. The Tax Court held that despite their illegality, the rebates were exclusions because the purpose was to adjust the gross price to a previously agreed net price, and thus the amounts rebated were really only held temporarily as deposits. …