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By Gerald S. Deutsch, Esq.
Glen Head, NY
Section 162(c)(2) provides that no deduction under §162 is allowed for a payment that is an illegal kickback under federal law or the law of any state (if the state law is generally enforced). There is, however, much authority that rebates, even if illegal, when made to the seller may be considered, not a deduction but, instead, an adjustment to the selling price.
One of the earliest cases allowing such treatment is Pittsburgh Milk Co. v. Comr., 26 T.C. 707 (1956), in which the court said that "gains are taxed irrespective of whether the transaction was legal or illegal but no more than the actual gross income can be subjected to income tax."
The IRS has reacted differently to this decision a number of times, non acquiescing, acquiescing, withdrawing each, etc.
In 1971, §162(c)(3) was added to the Code, which disallows deductions for "kickbacks, rebates and bribes under Medicare and Medicaid." Then, in 1973, the IRS amended the regulations to provide in Regs. §1.61-3(a) that "gross income is determined without subtraction of … amounts which are a type for which a deduction would be disallowed under section 162(c), (f), or (g) in the case of a business expense."
But then in 1980, in the case of Max Sobel Wholesale Liquors v. Comr., 630 F.2d 670 (9th Cir. 1980), the court said:Our conclusion fatally undercuts the Commissioner's attempts in Regs. §1.61-3(a) … to apply the disallowance rule of §162(c)(2) to portions of the cost of goods sold. Despite the deference owed to tax regulations, … they cannot stand if unsupported by the underlying statute … .
And in Rev. Rul. 82-149, 1982-2 C.B. 56, the IRS concluded that price rebates that are illegal payments within the meaning of §162(c)(2) when made by the seller directly to the purchaser may be subtracted from gross sales to determine gross income. That ruling also says:Section 1.61-3(a) of the Income Tax Regulations provides that gross income is determined without subtracting from total sales amounts that are the type for which a deduction would be disallowed under section 162(c) of the Code in the case of a business expense. See also section 1.471-3(d). However, in computing gross income, "total sales" must be determined before any adjustments are made for cost of goods sold.
In light of the decisions in Pittsburgh Milk and Max Sobel, illegal rebates made by a seller directly to a purchaser are allowable adjustments to the sales price of the merchandise (or cost of goods sold as in Max Sobel) for purposes of calculating gross income.
And yet Regs. §1.61-3(a) remains on the books unchanged.
In April of 2005, Rev. Rul. 2005-28, 2005-19 I.R.B. 997, was issued holding that "Medicaid Rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted from gross receipts in determining gross income." This ruling was clarified and superseded by Rev. Rul. 2008-26, 2008-21 I.R.B. 985, which says that it is limited "to Medicaid Rebates that a pharmaceutical manufacturer pays pursuant to the Medicaid Rebate Program" but in view of the history of this topic the effect of this "limitation" is not clear.
Also in CCA 201107011, the Chief Counsel's Office advised that "the discounted amount of the marker or net sales price is the actual price paid by the customer for the Casino's services and the Casino realizes only the discounted amount in income."
It should be noted that allowing these payments to offset sales (i) has generally been where the transaction is with the seller and (ii) applies to rebates, legal or illegal, and not to other payments that would be disallowed by §162(c) or (f).
For more information, in the Tax Management Portfolios, see Maule, 504 T.M., Deduction Limitations: General, and in Tax Practice Series, see ¶2240, Illegal Bribes and Kickbacks.
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