March 2, 2022
Tax Court rejects common positions on assumed liabilities for deferred compensation in memorandum opinion
In Hoops, LP v. Commissioner,1 the Tax Court held that a partnership that sold a professional basketball team could not deduct the unpaid deferred compensation owed to two players in the tax year ending with the transaction, even though it was required to include the associated liability assumed by the buyer in the computation of its gain on the sale. The Tax Court based its ruling on IRC Section 404(a)(5), which only allows an employer to deduct deferred compensation in the tax year that the compensation is included in the employee's gross income.
Under IRC Section 461, an accrual-basis taxpayer generally deducts compensation in the tax year in which (1) all events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability (the "all events" test). For liabilities expressly assumed by a buyer in connection with the sale of a trade or business for which the economic performance requirement would not otherwise have been met, Treas. Reg. Section 1.461-4(d)(5)(i) deems economic performance to occur at the time of the sale or exchange.
Under IRC Section 404(a), deferred compensation is not deductible under any other section of the Code, but if otherwise deductible as a business expense under IRC Section 162, it may be deducted as prescribed under IRC Section 404. For nonqualified deferred compensation, IRC Section 404(a)(5) allows the deduction "in the [tax] year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan." Deferred compensation is generally includible in income when received by the employee.
For purposes of IRC Section 404(a)(5), deferred compensation is an arrangement that defers the receipt of compensation for more than a brief period after the end of the employer's tax year in which the services creating the right to such compensation are performed. An arrangement is presumed to be deferred compensation if payment is made after the 15th day of the third calendar month following the end of the employer's tax year in which the related services were performed.
Hoops, LP, an accrual-method taxpayer, owned and operated the Memphis Grizzlies. In 2012, Hoops sold its assets and transferred its liabilities to Memphis Basketball Partners, LP in a taxable transaction. Its liabilities included obligations under NBA Uniform Player Contracts for Zach Randolph and Michael Conley, for whom deferred compensation with a $10.7 million present value as of the date of the sale was payable after 2012. Hoops included the $10.7 million assumed liability when calculating its gain from the sale and claimed a deduction for the $10.7 million on its 2012 Form 1065X, Amended Return or Administrative Adjustment Request (AAR) (which it filed less than a month after its original return).
The IRS issued a final partnership administrative adjustment (FPAA) disallowing the deduction and Hoops filed a petition for readjustment.
Holding and analysis
The Tax Court denied Hoops' petition, holding that IRC Section 404(a)(5) solely governs the timing of the deduction for the deferred compensation to be paid to Randolph and Conley, and only allows the employer to deduct the deferred compensation in the tax year that the deferred compensation is included in the employee's gross income. Hoops had not paid Randolph or Conley any of the deferred compensation in 2012 so nothing was includible in their gross incomes as compensation. Thus, Hoops was not entitled to the $10.7 million deduction on its 2012 amended tax return.
Hoops made two alternative arguments for why the deduction should be permitted in 2012. First, Hoops asserted that the timing rule in IRC Section 404 is incorporated into the economic performance requirement of IRC Section 461. As a result, Hoops argued that Treas. Reg. Section 1.461-4(d)(5)(i)'s rule deeming economic performance to be satisfied in the case of a sale effectively satisfied IRC Section 404(a)(5)'s income-inclusion requirement. Second, Hoops alternatively argued that either the deferred compensation liability should not have been included in the sale price or Hoops should have been entitled to offset the amount realized in the sale by the deferred compensation liability. The Tax Court rejected both arguments.
In rejecting Hoops' argument that Treas. Reg. Section 1.461-4(d)(5)(i) accelerates the timing under IRC Section 404(a)(5), the Tax Court found that IRC Section 404(a)(5) exclusively governs the deductibility of deferred compensation. As a result, in the Tax Court's view, Treas. Reg. Section 1.461-4(d)(5)(i)'s sale or exchange rule does not apply. The Tax Court even agreed with the IRS that IRC Section 404(a)(5) is a "congressionally mandated deviation from the clear reflection of income principle."
The Tax Court further rejected Hoops' alternative argument that either the deferred compensation liability should not have been included in the sale price or Hoops should have been able to offset or reduce its gain on the 2012 sale by the deferred compensation. When the buyer assumed the deferred compensation liability, the Tax Court said, Hoops was discharged from its obligation to pay deferred compensation. "Thus, pursuant to [IRC S]ection 1001, Hoops was required to take into account the amount of the deferred compensation liability in computing its gain or loss from the sale," the Tax Court said.
The Tax Court decision notes that it is appealable to the U.S. Court of Appeals for the Seventh Circuit.
Generally, buyers may not deduct assumed liabilities for deferred compensation in a taxable asset acquisition. IRC Section 381 does not apply in a taxable asset acquisition to allow a buyer to succeed to the tax attributes of an acquired company. Because the liabilities were not incurred in its trade or business, a buyer assuming a seller's liabilities in an asset deal may not deduct them under IRC Section 162. Rather, the assumed liabilities are added to the buyer's basis in the acquired assets. Buyers may not capitalize the deferred compensation until the requirements of IRC Section 404(a)(5) are satisfied.2
On the other side of the transaction, the seller in a taxable sale of assets must include in the sale proceeds the present value of a compensation liability assumed by the buyer, even though the buyer will make that payment to a third party in the future. As a result, absent an offsetting deduction, the seller is taxed on this assumed liability despite the absence of corresponding cash in hand. Put another way, Hoops has to pay taxes on money it never received because the present value of the deferred compensation is added to the sale proceeds.
The Tax Court rejected two alternative positions: (1) that Hoops should be permitted to deduct the liability at the time of the sale under Treas. Reg. Section 1.461-4(d)(5) or (2) that Hoops should be entitled to offset or reduce its amount realized on the sale by the amount of the deferred compensation liability in order to clearly reflect income. The two positions are similar to ones often taken when deferred compensation liabilities are assumed as part of a taxable asset sale. While the decision does not address what happens for Hoops in the later year when the deferred compensation is paid to Randolph and Conley, one might reasonably assume that Hoops — having sold all its assets — is no longer a going concern after the transaction (if Hoops continues to exist it would be entitled to a deduction when the compensation was paid out), which would match the income inclusion at the time of the sale. There is no indication that Congress intended IRC Section 404(a)(5) to operate, in effect, as a disallowance provision.
The challenges created by this opinion cannot be addressed in most cases simply by having the seller pay the deferred compensation upon the sale. Even if the deferred compensation is paid upon closing, IRC Section 404(a)(5) will require the deduction to be taken on the tax return following the closing, when the seller may no longer exist as a legal entity. Further, accelerating payment of deferred compensation would subject the seller's employees to an acceleration of income and possible adverse tax consequences, including an additional 20% tax, under IRC Section 409A.
This Tax Court memorandum decision could leave sellers with an untenable result — but this might not be the final word. Although the IRS took a similar position more than 30 years ago in TAM 8939002, now that the Tax Court — albeit in a memorandum opinion — has agreed with the IRS, some taxpayers may be more hesitant to take these positions. (It will surprise many practitioners that a memorandum opinion was issued in this case, because the issues involved are not particularly fact-driven and the law is not well-settled.) Presumably, the case will be appealed and, if so, the Seventh Circuit's ruling will be watched with interest.
1 No. 11308-18 (Feb. 23, 2022 Tax Ct.).
2 David R. Webb v. Commissioner, 708 F.2d 1254 (7th Cir. 1983), aff'g 77 T.C. 1134 (1981) (holding that a purchaser is not entitled to deduct an assumed deferred compensation liability, but instead must capitalize the liability when IRC Section 404(a)(5) is satisfied). See generally, Amergen Energy Co. v. US, 113 Fed. Cl. 52 (2013) (holding, in part, that a purchaser is not entitled to deduct assumed nuclear decommissioning liabilities but must capitalize such costs when economic performance occurs).