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When Are Advance Commissions Taxable?

A 1999 tax court case determined that advanced commissions received by an insurance salesman were not taxable when he received them. The Tax Court determined that the salesman received loans and was not required to report the income until the commissions were actually paid. This is contrary to the normal practice in the industry. To learn more about this situation, keep reading...

A 1999 tax court case determined that advanced commissions received by an insurance salesman were not taxable when he received them. This is contrary to the normal practice in the industry. It is common to be paid in advance for commissions due to a salesman, report the commission on Form 1099-MISC, and then report the income as taxable on the current tax return. However, in this particular case, the Tax Court determined that the salesman received loans and was not required to report the income until the commissions were actually paid.

Please note that this ruling will not apply to everyone. However, if it does apply to you, it allows for some cash flow and tax planning. In this particular case, there was an employment contract that clearly stated that an employee would be paid an advance commission based on actual sales for the pay period. However, these amounts would be considered loans and subject to repayment if the employer did not receive the commission payments from the insurance companies involved. In addition, interest would be calculated and due on any amount the employee did not repay by the end of the month.

The IRS took the position that commissions are taxable at the time the salesman receives the money. The taxpayer wanted to report the money only when it was determined that it was not subject to repayment. The tax court reviewed the employment contract, the termination agreement, and a deposition from the company's representative. The court then agreed with the taxpayer. The payment of advance commissions did not represent gross income to the taxpayer until the amounts had actually been received by the employer and thus reduced the outstanding loan.

Another way of considering this ruling is to compare producer "draw accounts" with earned commission. Many agents pay producers a draw against future commissions to be earned. This ruling implies that draw compensation may be considered a loan rather than compensation under two conditions:

The draw must be validated by a loan agreement that requires the producer to pay back any shortage (with interest) in the event that earned commissions do not accumulate in excess of the draw;
Only the draw amount not validated by earned commissions would be exempt from 1099 income during the tax year. As commissions are validated, they would become taxable.

Many agencies pay producers a draw against future commissions and many agencies cover themselves with loan agreements. However, a substantial number of agencies never pursue paid draw if a producer leaves before validating. If the agency is using this device for delaying taxation of commissions until earned, it must provide the producer with Form 1099-MISC if she/he leaves without validating and IF the agency decides not to pursue the loan repayment. The amount of the income for the former employee to report must be the total of the unreimbursed draw.

One further note: If your agency does not regularly pursue these non-paid accounts, the IRS will look at your practices and disregard the recent tax court ruling.