Our tax laws create categories–income/exclusion, deduction, and credit.
Taxpayers are presented with structured forms that set out these categories. The IRS expects taxpayers to fill out the forms by correctly identifying what items go in each category.
But it is not always clear what items go in each category. Taxpayers may engage in tax planning for how these items are reported.
The ‘returns and allowances’ category is an example. There is a line for ‘returns and allowances’ on business tax returns. The Lakew v. Commissioner, T.C. Summary Opinion 2020-27, case provides an opportunity to consider ‘returns and allowances.’
Facts & Procedural History
The taxpayers owned a driver’s education school.
Like most businesses, the school accepted credit cards. It used the credit card processor Stripe. Stripe has a feature that allows users to make refunds directly to clients through Stripe. The taxpayers did not use this feature in making some refunds to clients. Instead, the taxpayers would apparently write checks or pay cash back to the clients.
The income and expenses for the school were reported on a Schedule C, Profit or Loss from a Business (Sole Proprietorship), for the owner’s personal tax return. The taxpayers reported their net income for the school on the Schedule C, i.e., total income received less monies refunded to clients.
Stripe, the credit card processor, issued a Form 1099-K, Payment Card and Third Party Network Transactions, for the full amount of payments not reduced by refunds. This form is filed with the IRS.
The IRS’s computers in its Automated Underreporter (AUR) program caught the discrepancy between the lower income reported on the tax return versus the higher income reported on the Form 1099-K.
The IRS AUR computers sent a CP2000 notice adjusting their income to the higher amount reported on the Form 1099-K. The taxpayers failed to respond to the IRS CP2000. The IRS issued a notice of deficiency and litigation in the tax court was started.
Gross Receipts, Returns & Allowances, vs. Deductions
The general rule is that taxpayers have to pay tax on gross income. Gross income includes just about every type of income. Gross income starts with ‘gross receipts’ for businesses. Gross receipts is reduced by ‘returns and allowances’ and ‘costs of goods sold.’ This net income is reduced by various tax deductions and credits. This is the basic calculation for income taxes.
The Schedule C form itself provides blanks for each of these items. The Forms 1120, 1120S, and 1065 also include blanks for these items.
So, in theory, an expense could be:
- Netted out of gross receipts in box 1,
- Reported as a return and allowance in box 2,
- Reported as a costs of good sold in box 3, or
- Deducted lower down on the return as an expense.
The law is often not clear where the expense is to be reported. Our tax laws are inconsistent in this regard. This includes the tax code as written by Congress and the regulations issued by the Treasury.
Where an expense is reported can be important. It can be critical in some cases.
In this case, the discrepancy triggered an IRS notice and tax litigation. This is likely due to the taxpayer netting his income on line 1 rather than breaking it out on lines 1 (gross receipts) and 2 (returns and allowances). There is an IRS audit risk if a third party issues one or more Forms 1099 that report more in income than that reported on line 1.
But besides this IRS audit risk, why would anyone care about this issue?
Why would anyone care if the taxpayer reports gross receipts on on line 1 and subtracts returns and allowances on line 2? The net number is the same as if the taxpayer reports a net number on line 1.
The same goes for reporting gross receipts on line 1 and then deducting the return and allowance as a deduction, such as an advertising deduction, lower down on the tax forms. The net profit or loss at the end of the return is the same, isn’t it?
Tax Laws Do Not Factor in Returns & Allowances
The short answer is that there are tax laws that are computed using gross receipts not reduced by returns and allowances. There are other tax laws that factor in only gross receipts. There are other tax laws that factor in net profit at the bottom of the return.
The tax laws that only factor in gross receipts present tax planning opportunities and pitfalls. Take the limit for passive investment income by an S corporation. Excessive passive investment income can terminate the S corporation election. The termination of an S election can trigger significant tax liabilities. Treasury Regulation § 1.1362-2, the rule that penalizes excessive passive investment income for S corporations, only looks to gross receipts. It does not factor in returns and allowances. Those who could be subject to this penalty might want to net gross receipts less allowances on line 1 to avoid terminating their S corporation election.
Tax laws that factor in returns and allowances often present fewer opportunities to strategically decide how to report returns and allowances. Tax laws that are based on net profit or loss are even harder to plan for.
Take the research tax credit for example. To maximize the research tax credit for the current year, the taxpayer will want higher gross receipts in older years and lower gross receipts in the current year. The research tax credit factors in gross receipts less returns and allowances. So the research tax credit is computed using box 1 and 2 on the current and prior year returns. It does not matter whether the taxpayer nets its gross receipts and returns or allowances or not. The gross receipts that are considered are the same in each case.
This does not prevent the taxpayer from deducting the returns and allowance as a tax deduction, such as an advertising cost. That could cause the research tax credit to be overstated.
This reporting issue would not be possible if the research tax credit factored in net profit instead of gross receipts. The net profit would factor in gross receipts, returns and allowances, and allowable tax deductions.
State Tax Laws May Not Factor in Returns & Allowances
Besides Federal tax law, one also has to consider state tax law.
State tax laws often start with Federal gross receipts. Thus, what is reported for Federal tax purposes has a direct impact on state taxes.
The Texas franchise tax is an example. It looks to gross receipts less certain deductions. By netting gross receipts less returns and allowances on line 1 of the Federal return, the business may be under-reporting its Texas franchise tax liability.
You can read more about reducing Texas franchise taxes here.
Lenders & Contractors May Focus on Gross Receipts
There are non-tax considerations too.
A would-be-borrower may need to have higher gross receipts to secure a loan. This happens as lenders usually look to gross receipts to run various financial ratios to assess the viability of the business. By reporting higher gross receipts on line 1, the taxpayer may be able to borrow more money.
Some government contracts require would-be contractors to have higher or lower gross receipts to qualify for the contract. There are a number of government contracts that are only awarded to small businesses or that small businesses are given preference in the bidding process. How gross receipts are reported on the Federal income tax return can dictate whether these small businesses are found to be small enough to get this preference.
There are other instances where a taxpayer is not allowed to issue refunds or rebates to customers. This can come up with government contracts. The taxpayer may be barred from issuing refunds to customers, as there is a chance that the taxpayer and customers can work together to short change the government. The taxpayer may issue refunds to its customers by invoicing them for advertising services. The advertising services may end up as a deduction on the taxpayer’s return. Thus, the refunds may go unnoticed by the government agency that issued the contract.
These are just a few of the considerations that factor into how to report returns and allowances. While it is often not he most exciting topic, the returns and allowance line should be considered in light of the taxpayer’s business and goals. A little foresight can prevent tax disputes and, in some cases, save significant amounts of tax.