Want to Cut Gross Income? Pay a Rebate

How a REIT got a tax break on the payment for the services it performed for a joint venture.
Robert WillensJune 30, 2011

It’s always good to know whether something is a reduction of gross income or a separate expense. If it’s the former, it will affect a company’s gross-profit ratio, an important metric that shows how much of a company’s revenues remain after paying for the goods sold as well as suggesting how much tax it might pay.

The reminder about gross income arrived recently in the form of an Internal Revenue Service ruling I came across during the course of my research for a real estate investment trust client. The 2009 IRS decision also involved a REIT, which I’ll dub CenterShop, that acquired, developed, leased, and managed shopping centers.

Further, CenterShop was a partner in a joint venture we’ll call JayVee Co. On a certain date, CenterShop entered into an agreement (A1) to receive fees to provide property-management services for JayVee.

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A second agreement (A2) provided that if JayVee’s net operating income was below a certain level for the year beginning with the closing date of A1, CenterShop would be required to repay JayVee a portion of those fees. Similarly, if JayVee’s net operating income was below a certain level for the second year after the closing date of A1, CenterShop would be required to repay part of those fees.

Section 856(c)(2) of the Internal Revenue Code provides that a REIT must derive at least 95% of its gross income from dividends, interest, rents from real property, and other specified sources. In addition, Section 856(c)(3) requires that a REIT must derive at least 75% of its gross income from certain enumerated real estate sources, including rents from real property and qualified temporary investment income.

Section 61 states that gross income includes “all income from whatever source derived.” But purchase-price adjustments and rebates are an exception to the broad definition of gross income. Generally when a payment is made by a seller to a customer as an inducement to purchase the property, the payment does not constitute income; instead, it’s an adjustment to the cost or price of the property.

Nevertheless, it does not follow that all rebates made by a seller constitute adjustments to the sale price. The test to be applied includes two questions: What did the parties really intend and for what purpose was the allowance really made?

Under that “purpose and intent” test, a payment CenterShop would make to JayVee under their first agreement is a factor used by the two parties to reach an agreed price for services negotiated and agreed upon before CenterShop would undertake them, according to the IRS ruling (LTR 200932021). In computing CenterShop’s gross income, any payment it had made to JayVee under A1 would thus be an adjustment to the price for the property-management services, the IRS concluded.

That payment, the ruling observed, must be taken into account in the taxable year in which the “all events” test is met. Regulation Section 1.461-1(a)(2) provides that under the accrual method of accounting, a liability is incurred, and therefore taken into account, in the taxable year in which all events have occurred that establish the fact of the liability; the amount can be determined with “reasonable accuracy”; and “economic performance” has occurred — that the service has been provided. Moreover, Regulation Section 1.461-4(g)(3) provides that if the liability is to pay a rebate to another person, economic performance occurs when payment is made, according to the IRS.

For CenterShop the adjustment to the payment for the services qualified as a rebate, according to the IRS. The portion of the fees repaid by CenterShop to JayVee thus resulted in a reduction of CenterShop’s gross income in — and only in — the years in which the repayment would occur.

The lesson to be derived from the ruling? When a seller makes a payment to a purchaser, its character will be determined by applying the purpose and intent test to the payment. If the payment is designed to enable the parties to reach an agreed price, the payment constitutes a “purchase price adjustment” or “rebate.” And in that case, only the agreed-upon net price will be given recognition for tax purposes.

Robert Willens, founder and principal of

Robert Willens LLC,

writes a weekly tax column for