Entertainment Items Offered to Purchasers of Advertising Treated as Reductions of Purchase Price and Not Subject to §274 Limitations

If a taxpayer purchases travel and entertainment items to give to customers who purchase specified amounts of advertising from the taxpayer, does the taxpayer treat that as a cost of sale or some other expense?  And, regardless, does the taxpayer have to take into account the disallowance provisions of §274, such as the 50% disallowance of business entertainment? 

The IRS addressed these issues in Chief Counsel Advice 201501010

The memorandum outlines the following facts upon which the analysis is based:

Taxpayer, a c company, is engaged in the d publication and distribution of e media for f. Taxpayer’s customers are generally advertisers that pay to include their products in the print media and other advertising. Taxpayer established an added value merchandising program under which it purchased b and paid related companies to provide suite accommodations and catering services to the ultimate b holders. Taxpayer also provided customers with merchandising allowances or points to acquire b at a later date. The cost of these items generally constituted no more than twenty-five percent of the order placed. Taxpayer treated these expenditures as an adjustment to its cost of goods sold. The revenue agent determined that Taxpayer should have deducted the expenditures from its gross income under § 162, subject to the limitations of § 274.

The analysis begins by looking at rebates from the customer’s point of view, noting that such items are not consider income under §61 but rather are considered adjustments of the purchase price of the items acquired by the customer.  The memo concludes that the provision of the entertainment type items to the customers were just such a rebate program regardless of the fact that the payments were not made in cash.

The memo then goes on to note that the tax law differentiates between “returns and allowances” and business expenses, noting:

There is a fundamental difference between expenditures that constitute refunds and rebates (also known as "returns and allowances") and expenditures that are treated as business deductions under § 162. Max Sobel Wholesale Liquors v. Commissioner, 630 F.2d 670, 671-672 (9th Cir. 1980), affg 69 T.C. 477 (1977). The cost of goods purchased for resale in a taxpayer's trade or business is subtracted from gross receipts to compute gross income. Treas. Reg. § 1.61-3(a) of the Income Tax Regulations. These offsets do not constitute deductions and are not subject to the various limitations on deductions pertaining to § 162. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 661 (1987). Since we conclude that the expenditures at issue constitute purchase price adjustments, the provisions of §162 are inapplicable and need not be addressed. See Metra Chem Corp.

A key item to note in that analysis is the conclusion that such items are not subject to limitations on §162 deductions, such as §274’s limits on deductible entertainment.  The memo cites the case of Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 and Revenue Ruling 2005-28.  The case involved rebates paid by a dairy wholesaler to customers while the ruling looked at Medicaid rebates paid by a pharmaceutical company, concluding in both cases the payments amounted to purchase price adjustments.

The memorandum thus concludes:

The facts in this case fall squarely within the parameters of Rev. Rul. 2005-28. It is undisputed that Taxpayer agreed to provide and the purchasers agreed to accept both printed advertisements and b or points for a single price. The fact that Taxpayer may incur the expense to acquire the b after it executes the contract with the purchaser is not legally significant under Pittsburgh Milk. Similarly, whether a rebate is payable in merchandise or in cash doesn’t matter. The result is the same. Max Sobel Wholesale Liquors, 69 T.C. at 481. The determinant facts are that the purchaser and Taxpayer negotiated over the amount of b or merchandising allowances or points that would be an integral part of the sale and the adjustment was not contingent on any subsequent performance or consideration from the purchaser.

Since the costs of b which Taxpayer provides to customers are to be treated as cost of goods rather than business expenses deductible under § 162, the costs also are not subject to the limitations of § 274. Metra Chem Corp., 88 T.C. at 661.