Insights and Resources

IRS takes skeptical view of agency argument to avoid income inclusion


Authored by RSM US LLP

In a newly released PLR 202138001, the IRS refuted taxpayer’s use of the agent/principal argument to avoid currently recognizing income for a portion of the funds the taxpayer receives from its primary customers. The taxpayer may have been taking this position to better match the income recognition with the corresponding expenditures. While the IRS generally lauds the matching of income and expenses, it seems the IRS is only really concerned about deferring expenses to match revenue, not deferring revenue to match expenditures.

The taxpayer is regulated by a state government. The taxpayer provides services to its primary clients and in order to provide those services, the taxpayer must also perform statutorily mandated obligations. The taxpayer charges a standard rate for its primary services but also collects fees from its primary customers to fund its statutorily mandated obligations and deposits the funds into accounts that have some restrictions on the use of those funds.

When analyzing the taxpayer’s argument that the taxpayer was merely a conduit for statutorily mandated obligations, the IRS focused on the fact that the taxpayer’s primary customers have no interest in, nor participate in, the statutorily mandated obligations. Also, the taxpayer was under no obligation to repay the funds to its primary customers if the taxpayer failed to perform the obligations. The IRS determined that the fees were not for the benefit of the taxpayer’s primary customers.

The takeaway is that the agent/principal relationships are determined under a facts and circumstances test. The IRS is looking to see that expenditures do not inure to the agent in any material way. Under the facts of the PLR, the taxpayer was able to discharge its statutorily mandated obligations with the funds they collected from the primary customers, and in some cases, the taxpayer was able to purchase equipment with the funds for the taxpayers use. The IRS concluded that the taxpayer benefited from the expenditures. Conversely, in an agent/principal relationship the expenditures must inure to the principal and under this PLR, the primary customers did not have any interests in the statutorily mandated obligations. If a taxpayer is using the agent/principal theory to not recognize income and corresponding expenditures, it is important to make sure that expenditures inure to the principal and not to the agent in any material way.

The IRS did not address any deposit arguments, as from the facts the IRS may have thought that there were insufficient restrictions on the use of the funds.

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This article was written by Christian Wood and originally appeared on 2021-09-27.
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