Editor: Anthony Bakale, CPA
It is sometimes said "The exception makes the rule." In the case of the Internal Revenue Code, then, perhaps the exception to the exception (and so on and so forth) makes the rule. The "exception" in question here arises in business acquisitions that include assumption of deferred compensation costs and has to do with who — buyer or seller (or neither) — has a right to deduct those compensation amounts. The Tax Court, in Hoops LP, T.C. Memo. 2022-9 (issued Feb. 23, 2022), highlighted how complications can arise in this context.
In this case, Hoops LP (Hoops), the owners of the NBA team the Memphis Grizzlies, in 2021 sold the franchise to Memphis Basketball LLC. In the transaction, Memphis Basketball bought substantially all the assets and assumed the liabilities of Hoops LP. Among these liabilities were deferred compensation contracts for two Grizzlies' players, Zach Randolph and Mike Conley. Under these contracts, at the time of the sale, the players were owed $12.6 million of deferred compensation for services provided before the sale that were due to be paid after the sale.
In computing gain on the sale, Hoops reported a total amount realized of $420 million, which included $220 million of assumed liabilities and other adjustments. In determining the amount realized, Hoops included $10.7 million (the present value of the $12.6 million owed to Randolph and Conley) for Memphis Basketball's assumption of the deferred compensation liability.
Hoops did not claim the deduction of $10.7 million related to the deferred compensation liability on its original tax return, nor did it reduce its amount realized on the sale for the deferred compensation liability. However, Hoops later amended its tax return and claimed the $10.7 million as a compensation deduction. In March 2018, the IRS disallowed the deduction.
Deductibility of deferred compensation
Sec. 162(a) generally allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. If costs are contributed by an employer under a plan of deferred compensation, however, the deduction of these costs is governed by Sec. 404(a). Sec. 404(a)(5) states that a deduction for any deferred compensation is only allowable in the tax year in which the compensation is includible in the employee's gross income as compensation. Generally, this is the year the compensation is paid. In Hoops, the issue was whether the seller of a business was entitled to deduct the deferred compensation costs.
In a typical taxable asset sale, the general rule on assumption of liabilities is relatively clear. When a buyer assumes a seller's liability, the assumption of that liability is included in the consideration paid to the seller. From the buyer's perspective, the assumption of liabilities is treated as an additional amount "paid" by the buyer to acquire the assets. That amount is capitalized and added to the buyer's basis for the assets acquired at the time the liability is treated as incurred under the buyer's method of accounting. If the buyer does not get a deduction for the payment of the liability, who does? Depending on the type of liability, that answer is not so clear, and the tax treatment for the seller may not be symmetrical to the buyer.
Consider an example where the buyer assumes an operating expense liability (accounts payable or accrued expense) of the seller, but the seller uses the cash method of accounting (expenses generally deducted as paid) and, therefore, has not taken a deduction related to the unpaid liability. At the time of the sale of assets, the cash-basis seller includes the liability in the amount realized (see Sec. 1001), even though it has not been recorded for tax purposes, but also receives an immediate deduction as if the liability was paid, under Regs. Sec. 1.461-4(d)(5)(i). Hoops argued that in its case, it should obtain the same result under the regulation, which provides:
If, in connection with the sale or exchange of a trade or business by a taxpayer, the purchaser expressly assumes a liability arising out of the trade or business that the taxpayer but for the economic performance requirement would have been entitled to incur as of the date of the sale, economic performance with respect to that liability occurs as the amount of the liability is properly included in the amount realized on the transaction by the taxpayer.
The Hoops case
Similar to the cash-basis example above, Hoops argued that under Regs. Sec. 1.461-4(d)(5)(i), economic performance occurred at the time of the NBA franchise sales transaction, allowing an acceleration of the deduction for the deferred compensation. In rejecting this argument, the court noted that the timing restrictions of Sec. 404(a)(5), which govern the timing of the deduction for deferred compensation, do not allow an employer to deduct a compensation payment until it is included in the employee's income (i.e., it is paid to the employee). Thus, Hoops' reliance on Regs. Sec. 1.461-4(d)(5)(i) was misplaced because it was the Sec. 404(a)(5) deduction limitation that precluded the deduction of the deferred compensation in 2012, not any purported failure to satisfy the economic performance requirement.
Hoops further argued that, if not allowable as a deduction, then the deferred compensation liability was not a liability for purposes of determining gain under Sec. 1001 because it was not included in basis and it did not give rise to a deduction.
The court also rejected this argument, stating that because Hoops had an obligation to pay the deferred compensation, the buyer's assumption in connection with the 2012 sale discharged Hoops from its obligation. Thus, Hoops was required under Sec. 1001 to take into account the amount of the deferred compensation liability in computing its gain from the sale.
This case is a great example of a situation in which an exception to a general rule can lead to a trap for the unwary. In cases where deferred compensation is involved in a sale of assets, such as in Hoops, it is advisable (barring a change in the rules) that the seller entity continue to exist so that when the deferred compensation is paid by the buyer and included in the employee's income, the seller can claim a deduction. Based on a clear reading of the statute, if the seller is in existence at that time, it should be entitled to the deduction for the payment of the deferred compensation under the Sec. 404(a)(5) timing rule.
Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.
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