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In Hoops, LP v. Commissioner,¹ the Seventh Circuit affirmed a Tax Court holding that the owner of a professional basketball team could not deduct unpaid deferred compensation in the tax year ending with the team's sale, even though the owner had to include the associated liability assumed by the buyer when computing its gain on the sale. Like the Tax Court, the Seventh Circuit based its holding on IRC Section 404(a)(5), which only allows employers to deduct deferred compensation in the tax year in which the employee recognizes income (e.g., upon payment).

Background

Under IRC Section 461, an accrual-basis taxpayer generally deducts compensation in the tax year in which (1) all events have occurred establishing the fact of the liability, (2) 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 a sale of a trade or business that would be incurred as of the sale but for the unmet economic performance requirement, Treas. Reg. Section 1.461-4(d)(5)(i) deems economic performance to occur at the time of the sale or exchange.

IRC Section 404(a) precludes taxpayers from deducting deferred compensation under any other section of the Code. If otherwise deductible as a business expense under IRC Section 162, deferred compensation may be deducted as prescribed under IRC Section 404. For nonqualified deferred compensation, IRC Section 404(a)(5) allows the deduction for the tax year in which the employee received the compensation. Nonqualified deferred compensation is typically paid in addition to deferred compensation provided through qualified retirement plans (plans that meet the requirements of IRC Section 401(a)) because of the nondiscrimination requirements and other limitations on compensation that may be provided through qualified retirement plans.

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 employees performed the services creating the right to that compensation. 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.

Facts

Hoops, LP, an accrual-method partnership, 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.

The Tax Court denied Hoops's 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 (see Tax Alert 2022-0350). 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 could not deduct the $10.7 million on its 2012 amended tax return.

Holding and analysis

Before the Seventh Circuit, Hoops argued that the asset sale and the buyer's assumption of the $10.7 million deferred compensation liability changed the tax treatment that would otherwise apply to the deferred compensation under IRC Section 404(a)(5). In making its argument, Hoops asserted that IRC Section 404(a)(5)'s requirement to pay the compensation was effectively an economic performance requirement that was deemed satisfied under Treas. Reg. Section 1.461-4(d)(5)(i) when the sale occurred. Consequently, the deferred compensation liability could be recharacterized as a "deemed payment" to the buyer, as Hoops reduced the sale price of the company's assets by $10.7 million to reflect the buyer's assumption of the deferred compensation liability. The deemed payment, Hoops argued, could then be deducted as an ordinary and necessary business expense under IRC Section 162 because players Conley and Randolph had rendered their services in 2012.

Rejecting this argument, the Seventh Circuit agreed with the Tax Court that IRC Section 404(a)(5) exclusively governs the deductibility of deferred compensation. In reaching this conclusion, the court noted that IRC Section 404(a)'s specific treatment of deferred compensation trumps Treas. Reg. Section 1.461-4(d)(5)(i)s more general treatment of assumed liabilities in an asset sale. Because Hoops did not pay the players the $10.7 million in 2012, it could not deduct the deferred compensation in 2012. In reaching this conclusion, the court placed particular emphasis on its understanding of the Congressional intent to incentivize qualified plans by requiring employers to choose between qualified plan responsibilities paired with earlier deductions versus the flexibility of nonqualified plans paired with their attendant later deductions.

Moreover, the court reasoned, IRC Section 461(h) dictated that economic performance was satisfied before the sale for purposes of Treas. Reg. Section 1.461-4(d)(5)(i), when players Conley and Randolph rendered their services. As such, the absence of payment to the players in 2012 did not qualify as "economic performance barriers" that could be deemed satisfied upon the closing of the sale. Rather, they represented requirements to be met before Treas. Reg. Section 1.461-4(d)(5)(i) could apply. As such, the court concluded, the definition of economic performance did not "sweep[] broadly enough to include the specific, deferred-compensation provision in [IRC Section] 404(a)(5)."

To further support its conclusion, the Seventh Circuit noted that (1) Treas. Reg. Section 1.461-4(d)(5)(i) precludes taxpayers from deducting deferred compensation without first satisfying IRC Section 404(a)(5)'s requirements; and (2) treating the deferred compensation liability as a deemed payment ignores the transaction's substance, which consisted of assumption of a liability for deferred compensation, which Hoops could not have otherwise deducted in 2012.

In response to Hoops's alternative argument that denying the deduction now could cost it the deduction entirely, the Seventh Circuit observed that Hoops and the buyer could have addressed that problem before the sale by increasing the purchase price to account for the liability, contributing the compensation to a qualified plan or renegotiating the players' contracts to allow for earlier payment.

Implications

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 Seventh Circuit notes that Hoops may claim the compensation deduction in the tax year the deferred compensation is ultimately paid and acknowledges a risk that the deferred compensation deduction may be lost altogether if, for example, buyer fails to pay the deferred compensation or fails to notify Hoops when payment is made. The Seventh Circuit does not address what happens for Hoops if, in the later year when the deferred compensation is paid, Hoops — having sold all its assets — is no longer a going concern. 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.

Likewise, the Seventh Circuit's suggestion that Hoops could have accelerated its deduction under IRC Section 404 by contributing millions of dollars to a qualified retirement plan for the benefit of Randolph and Conley in 2012 does not take into account how that would violate qualified retirement plan requirements.

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Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor

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ENDNOTES

¹ No. 22-2012 (Aug. 9, 2023 7th Cir.).

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).