Deferred compensation not deductible in year basketball franchise sold

By James A. Beavers, CPA, CGMA, J.D., LL.M.

A partnership that owned the Memphis Grizzlies NBA franchise was not allowed a deduction in the year the partnership sold the franchise for deferred compensation owed to two players.

Background

On March 30, 2000, Hoops LP was established as a Delaware limited partnership for the purpose of acquiring, owning, operating, and conducting a sports franchise within the rules, guidelines, and other requirements established by the National Basketball Association (NBA). On May 11, 2000, Hoops acquired the Vancouver Grizzlies, a member of the NBA. In 2001, the Vancouver Grizzlies moved to Memphis, Tenn., and the name of the franchise was changed to the Memphis Grizzlies. Hoops owned and operated the Grizz-lies until it sold the team in 2012 to Memphis Basketball LLC.

In the sale, Hoops sold substantially all of its assets and transferred substantially all of its liabilities and obligations to Memphis Basketball. As part of the sale, Memphis Basketball assumed liabilities and obligations under certain binding agreements, which included NBA Uniform Player Contracts for Zach Randolph and Michael Conley. At the time of the sale, under these contracts, Randolph and Conley were owed deferred compensation with an accrued value of $12.64 million. Consequently, as a result of the sale, Hoops was relieved of the obligation to pay Randolph and Conley the deferred compensation.

Using a 3% discount rate, Hoops LLP determined that the present value of the deferred compensation liability was $10.6 million. On its original tax return for 2012, Hoops included the deferred compensation liability in the amount realized on the sale of the Grizzlies and did not take a deduction for it. However, the partnership later filed an amended return on which it took a deduction for the deferred compensation amount, stating that it was claiming the additional deduction because it had not claimed a deduction on its original 2012 tax return under Regs. Sec. 1.461-4(d)(5) to reduce the partnership's deferred compensation liability included in the amount realized on the sale of the Grizzlies.

The IRS disagreed with this position and issued Hoops a final partnership administrative adjustment (FPAA), disallowing the additional deduction for the deferred compensation. Hoops petitioned the Tax Court to review the IRS's decision.

The Tax Court's decision

The Tax Court held that under Sec. 404(a)(5), Hoops was not entitled to a deduction for the deferred compensation liability.

As the Tax Court explained, Sec. 162(a) ordinarily allows a deduction for all ordinary and necessary expenses paid or incurred during a tax year in carrying on any trade or business, including compensation paid or incurred by an employer to or on account of an employee. However, Sec. 404(a) governs the deductibility of such amounts if they are contributed by an employer under a pension, annuity, stock bonus, or profit-sharing plan, or under any plan of deferred compensation.

The parties agreed that Randolph's and Conley's deferred compensation was paid under a nonqualified plan of deferred compensation subject to Sec. 404(a) and that, specifically, Sec. 404(a)(5) applied to the deferred compensation at issue. Sec. 404(a)(5) provides that, in a case of a nonqualified plan, a deduction for deferred compensation paid or accrued is allowable for the tax year for which an amount attributable to the contribution is includible in the gross income of the employees participating in the plan.

The Tax Court concluded that under the plain language of Sec. 404(a)(5), Hoops could not deduct deferred compensation until the tax year for which an amount attributable to the compensation is includible in the employee's gross income. Hoops and the IRS agreed that Hoops had not paid any of the deferred compensation liability owed to Randolph and Conley in 2012 and no amounts were includible in the players' gross incomes as compensation in 2012. Therefore, the IRS had correctly disallowed the additional deduction for the deferred compensation liability Hoops took on its 2012 amended return.

Hoops argued that despite Sec. 404(a)(5), under Sec. 461(h) and the regulations thereunder, it was allowed to deduct the deferred compensation liability in the year it sold the Grizzlies. In particular, the partnership argued that the rule in Sec. 404(a) regarding the timing of the deduction is incorporated into the economic performance requirement of Sec. 461(h) and that under Regs. Sec. 1.461-4(d)(5)(i), the deduction for the deferred compensation liability would be accelerated due to the assumption of the liability in the sale of the Grizzlies.

Under Sec. 461 and Regs. Secs. 1.461-1(a)(2)(i) and 1.446-1(c)(1)(ii)(A), a taxpayer is generally allowed to deduct an expense when it is incurred, and a liability is incurred when economic performance occurs for the liability. However, the regulations further state that, if, as Hoops did, the taxpayer uses an accrual method of accounting, "[a]pplicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account."

Thus, according to the Tax Court, the initial question was whether another provision of the Code or regulations governed how the deferred compensation liability is taken into account. The court stated that, as it had already determined, Sec. 404(a)(5) governed how the deferred compensation liability is taken into account, and, under this section, Hoops was not entitled to deduct the liability in 2012, regardless of whether it used the accrual method. Accordingly, the Tax Court concluded that because Sec. 404(a)(5), not Hoops's failure to satisfy the economic performance requirement, precluded the partnership from deducting the deferred compensation liability in 2012, Hoops's reliance on the economic performance requirement was misplaced.

Hoops also argued that if Sec. 404(a)(5) and the tax accounting rules were applied in a manner that would deny a deduction for the deferred compensation liability, this would "lead to the ridiculous result" of the partnership's including the deferred compensation liability in its sale proceeds but potentially never obtaining an offsetting deduction. Thus, allowing it to deduct the deferred compensation liability for the year of the 2012 sale was consistent with the purpose of clearly reflecting income. The IRS, citing legislative history, countered that Sec. 404(a)(5) is a congressionally mandated deviation from the clear-reflection-of-income principle.

The Tax Court, citing its own and Ninth Circuit precedent, concluded that based on Congress's intent to deviate from the clear-reflection-of-income principle and to ensure matching of income inclusion and deduction between employee and employer under nonqualified plans, disallowing a deduction for Hoops in the year of its sale of the Grizzlies would not lead to a "ridiculous result." Rather, the result was in line with the clear purpose of Sec. 404.

Finally, in the alternative, Hoops argued that, if the Tax Court found the partnership was allowed to deduct the deferred compensation liability in 2012, then the partnership should not have included the deferred compensation liability in the sale price of the Grizzlies, or it should be entitled to offset or reduce the amount realized on the sale by the amount of the deferred compensation liability.

Sec. 1001(a) provides that the gain from the sale or other disposition of property shall be the excess of the amount realized from the sale or other disposition over the property's adjusted basis. The amount realized is the sum of any money received plus the fair market value of the property (other than money) received, including the amount of liabilities from which the transferor is discharged as a result of the sale or other disposition.

The Tax Court stated that, by claiming that it should not have to include the liability in the sales price, Hoops was in effect arguing that the deferred compensation liability was not a liability within the meaning of Sec. 1001 because it was not included in the basis and did not give rise to a deduction. Hoops supported this position by asserting that Congress intended for Sec. 404(a)(5) to delay the employer's deduction to the year for which the payment is includible in the employee's gross income, not to create an asymmetry in which a liability was never included in basis or deducted. The court, noting that the parties agreed that Hoops had an obligation to pay Randolph and Conley deferred compensation that was discharged due to the sale of the Grizzlies, concluded that under Sec. 1001, Hoops was required to take the deferred compensation liability into account in computing its gain or loss from the sale.

In support of its contention that it was entitled to offset or reduce its amount realized on the 2012 sale by the deferred compensation liability, Hoops cited James M. Pierce Corp., 326 F.2d 67 (8th Cir. 1964), and Commercial Security Bank, 77 T.C. 145 (1981), for the proposition that either the buyer assumes the liability and pays the seller the net cash amount or the buyer pays the gross cash amount and the seller uses a portion to satisfy the liability. The Tax Court, however, found that these cases did not apply to Hoops because they did not involve deferred compensation subject to Sec. 404(a)(5), under which Hoops was not entitled to offset or reduce the amount realized on the sale by the deferred compensation liability.

Reflections

Because Hoops must include the present value of the deferred compensation liability assumed by the buyer in the sale proceeds, as a result of the Tax Court's decision, it is taxed on money it has not received. While simply paying the deferred compensation at the time of sale might allow an entity in Hoops's position to deduct the deferred compensation liability, this would not necessarily be welcomed by the players because it would accelerate the inclusion of the deferred compensation in the players' income and possibly result in their incurring a 20% additional tax under Sec. 409A.

Hoops LP, T.C. Memo. 2022-9

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