Accrual method taxpayers generally must recognize advance payments in taxable income in the year of receipt, because receipt satisfies the all events test. The trading stamp rules are an exception to this all-events test. These rules apply to businesses that have customer loyalty programs.
The rules can result in significant tax deferral as they allow the taxpayer to receive income now and defer recognition of a portion of the income to a future date when the customer takes advantage of the loyalty program. For example, if the taxpayer sold merchandise for $100 and issued 10 points to the customer as part of its loyalty program, the trading stamp rules would say that a portion of the $100 is for the 10 points and, based on mathematical calculations, it is not likely that all 10 of the points will be redeemed in the current year. So the trading stamp company rules allow the taxpayer to defer part of the $100 of income they received to account for this reality.
There is little guidance that addresses trading stamp companies, which is surprising given the large amounts that are at stake. This brings us to the topic of this post. The IRS recently issued Attorney Memo 2017-002 to clarify its position that hybrid coupons are discount coupons that do not qualify for this tax deferral.
The Trading Stamp Company Rules
The trading stamp company rules are found in Sec. 453 of the Code. They generally say that a trading stamp company can subtract from income both (1) the cost of merchandise, cash, and other property used for redemptions in the taxable year and (2) the net addition to the provision for future redemptions during the taxable year. It is this second element that can result in the tax deferral and savings, as it allows the accrual to be subtracted from income in the current tax year and deferred to a later year. This can be particularly beneficial if the coupons, points, etc. for the customer loyalty program are not redeemed for several years.
This begs the question as to what type of loyalty programs qualify. There has been little guidance on this issue. The IRS’s recent AM 2017-002 address this topic by considering the difference between premium, discount, and so-called hybrid coupons offered by loyalty programs.
Premium coupons are specifically listed as qualifying in Sec. 453. They are not defined in this code section, however. In AM 2017-002, the IRS provides a definition by looking to the explanation provided by the Joint Committee on Taxation:
A premium coupon … generally is issued in connection with the sale of some item and entitles the holder to tender it (or, more usually, a large number of such coupons) in exchange for a product, often selected from a catalog, of the consumer’s choosing. These coupons are used to promote the sale of the product with which the coupon is issued by allowing the consumer to collect coupons in order to acquire a different product.
The coupon is used to acquire a different product than the one being purchased when the coupon is issued. It is used to get a free product.
According to the IRS’s AM 2017-002, a premium coupon is different than a discount coupon. The IRS’s memo defines a discount coupon by looking at former Sec. 466, which has been repealed:
A discount coupon is a sales promotion device used to encourage the purchase of a specific product by allowing a purchaser of that product to receive a discount on its purchase price. … A discount coupon normally entitles its holders to receive nothing more than a reduction in the sales price of one of the issuer’s products. The discount may be stated in terms of a cash amount, a percentage or fraction of the purchase price, a ‘two for the price f one’ deal, or any other similar provision. A discount coupon need not been printed on paper in the form usually associated with coupons; it may be a token or other object so long as it functions as a coupon.
The IRS notes that discount coupons apply to a specific product. The focus is on a discounted product.
The IRS’s AM 2017-002 goes on to define hybrid coupons as being a mix of premium and discount coupons:
[H]ybrid coupons can be viewed as discount coupons allowing a member to acquire enough coupons to receive a discount off the purchase of a product. After a member has acquired a sufficient number of hybrid coupons to receive a discount on the purchase of an item, the member may also continue accumulating coupons until the purchase price is reduced to zero. However, the fact that a discount coupon may be accumulated in sufficinet quantities to result in a free product does not alter the nature of the coupon as a discount coupon. Thus, hybrid coupons are more properly characterized as discount coupons and are not premium coupons under section 1.451-4 because the nature of hybrid coupons, like discount coupons, is that of a price reduction.
The IRS memo concludes that hybrid coupons are more akin to discount coupons and, as such, they do not qualify for the trading stamp company rules.