Cash payments for upgrades may be income

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To encourage auto dealerships to expand, modernize or renovate their facilities, some auto manufacturers offer facility image upgrade programs that promote a standard brand image so that all dealerships that carry the manufacturers’ brand look similar. The government’s position is that the payments are intended to motivate each dealership to upgrade its facilities and to defray the dealership’s costs for upgrades, not to reduce the dealership’s costs of vehicles.  

Recent IRS Legal Advice (AM 2014-004) addressed the tax implications of the receipt of such payments. Although the context is automotive dealers, the advice could apply more broadly and raises interesting related issues.

The IRS Legal Advice stated that auto dealerships are treating program payments inconsistently. Some exclude such payments from income, taking the position that the payments are nonshareholder contributions to capital under Section 118 of the Internal Revenue Code. Other dealerships and a trade association assert that payments reduce the basis in the constructed assets and should not be included in gross income. Still other dealerships might treat the amount received as a purchase price adjustment.  

In the Legal Advice, the IRS considered three separate fact patterns and concluded on whether the payments received by the dealerships would be income or would serve to reduce basis in the building improvement (or reduce the basis in purchased vehicles). In two of the fact patterns, the payments depended partly on purchases over a specified time period.

The IRS determined that, under the facts presented, all payments can be included in the dealerships’ gross income under Section 61 of the code. The dealerships had all agreed to make specific upgrades and would receive payments for the successful completion of those upgrades under the various programs. The IRS concluded that the dealerships, not the manufacturers, owned the property that was constructed or improved by using the payments. Under the facts in the Legal Advice, the dealerships receive payments to defray their expense for construction of, or improvements to, their property. Therefore, the IRS ruled that the automotive dealerships had been enriched by receiving the payments and had to include them in their taxable income.  The IRS stated that revenue recognition was not prevented or delayed by any subsequent conditions that might have required the dealerships to return some or all of the payments.  

The IRS further stated that because the dealerships own the improved property and must recognize income in connection with those payments, the payments received do not reduce the dealerships’ cost basis in the improved property.  

The IRS also addressed whether the payments received could be viewed as discounts on vehicles to be purchased later from the manufacturer. The agency concluded the payments were not discounts. The Legal Advice states that the test for whether a payment is a purchase price adjustment (i.e., a discount) is the parties’ intent and the purpose for which the payment, credit, allowance or rebate was paid. Although in the Legal Advice, the IRS stated that it was clear the parties intended the payment to relate to property improvements, not to the later purchase of vehicles from the manufacturer, the IRS later stated that the manufacturers want the dealerships to buy more vehicles from the manufacturers. Further, the case law cited by the IRS does not deal with an analogous fact pattern and thus does not support the IRS’s conclusory dismissal of the two situations in which the terms of the arrangements were based on sales of vehicles.      

Finally, the IRS considered whether the payments could be excluded from income as nonshareholder contributions to capital under Section 118. The IRS concluded, in part, based on case law dealing with similar payments to an auto dealer, that the dealerships could not exclude the cash payments from income under Section 118.  

The underlying issue of income versus nonincome can arise in a variety of retail situations beyond the one discussed here. Over the years, the IRS has considered cash payments received by retailers in numerous fact patterns and involving advance trade discounts, slotting payments, branding costs and payments related to cooperative advertising.  

In light of the IRS guidance on this topic, retailers that receive cash payments from vendors or other entities should consider whether they are treating these cash payments properly for U.S. federal income tax purposes.  Because these types of payments may not be included as income for book purposes, retailers may be inadvertently following book and under-reporting gross income. It’s important to analyze the terms of the contract and facts and circumstances of the arrangement to determine whether payments are appropriately recognized or excluded from income or treated as a purchase price adjustment.      

Rich Shevak

William Stickney

Jeff Betts

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