A $10.7 million compensation deduction miss

Editor: Greg A. Fairbanks, J.D., LL.M.

The rules governing nonqualified deferred compensation deductions under Secs. 404(a)(5) and 461 are generally straightforward when applied to typical business situations. So why was a partnership disallowed a $10.7 million deduction when the IRS, the Tax Court, and the Seventh Circuit all disagreed with the partnership’s interpretation of these relatively established statutory provisions and underlying guidance?

This was not a typical business situation. The taxpayer, Hoops LP, an accrual-basis taxpayer, argued it was entitled to a deduction for compensation deferred by two of its employees based on relevant statutory and regulatory provisions. In Hoops, LP, 77 F.4th 557 (7th Cir. 2023), the Seventh Circuit disagreed, affirming a Tax Court decision (Hoops, LP, T.C. Memo. 2022-9). The Seventh Circuit’s holding will have ramifications for nearly every business that sponsors a nonqualified deferred compensation plan if the business is sold as part of an asset sale or a transaction treated as one. This item discusses Hoops’ costly analysis imbalance by examining the nonqualified deferred compensation deduction argument within the case and revisiting the IRS’s position on the issue.

Deferred compensation in sale of Grizzlies

Hoops owned the Vancouver Grizzlies (later called the Memphis Grizzlies) National Basketball Association franchise. In 2012, Hoops sold substantially all of its assets to Memphis Basketball LLC (the buyer). Hoops did not pay the deferred compensation it owed to its players Mike Conley and Zach Randolph in 2012. Instead, the buyer assumed substantially all of Hoops’ liabilities, including the obligation to pay nonqualified deferred compensation owed to the two players, with a discounted present value of approximately $10.7 million. Hoops included the $10.7 million discounted assumed liability in its amount realized in computing its gain on the sale in 2012. Hoops did not include the $10.7 million as a deduction on its original 2012 income tax return but later included it on an amended 2012 return under the rules of Sec. 461 and associated regulations.

In general, an accrual-method taxpayer is allowed a tax deduction under Sec. 461 in the tax year in which (1) all the events have occurred to 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 first two prongs are generally referred to as the “all-events test.”

Hoops and the IRS ultimately agreed that Sec. 404(a)(5) governs deductibility of the $10.7 million nonqualified deferred compensation liability. For this purpose, “deferred compensation” means any compensation received by the employee (or nonemployee service provider) after the end of the applicable 2½-month period. The applicable 2½-month period ends on the 15th day of the third calendar month following the end of the employer’s tax year in which the services were performed to create the right to the compensation (e.g., March 15 for a calendar-year taxpayer).

For example, assume an employer is an accrual-method taxpayer with a calendar tax year. A Feb. 1, 2024, payment by the employer for services performed in the tax year ended on Dec. 31, 2023, would not be considered deferred compensation, while a May 31, 2024, payment would.

The Seventh Circuit focused significant attention on Sec. 404(a)(5), and it became the most important provision in this case. Under Sec. 404(a)(5), an employer may deduct deferred compensation in the employer’s tax year that includes the last day of the employee’s tax year in which the employee has included the deferred compensation in gross income as compensation. For example, if an employee is paid nonqualified deferred compensation on April 1, 2024, the deduction is allowed in the employer’s tax year that includes Dec. 31, 2024.

This does not result in unexpected deduction timing for employers with a calendar tax year. However, it can significantly affect the deduction timing for employers with noncalendar tax years or short tax years due to, for example, a midyear sale of the business.

Hoops’ arguments for a deduction

Hoops made two arguments for why it should be allowed a deduction despite the timing rule in Sec. 404(a)(5): (1) The timing rule of Sec. 404 is incorporated into the economic-performance rule of Sec. 461(h), and (2) denying its deduction by applying Sec. 404(a)(5) would “lead to the ridiculous result” of having to include the liability in its sale proceeds while potentially never obtaining an offsetting deduction.

First, Hoops argued that, pursuant to Regs. Sec. 1.461-4(d)(5)(i), economic performance occurred when the nonqualified deferred compensation liability was assumed by the buyer as part of the sale. This regulation generally provides that if, in connection with the sale or exchange of a trade or business by a taxpayer, a purchaser expressly assumes a liability that the taxpayer — but for the economic-performance requirement — would have been entitled to incur as of the sale date, then economic performance occurs as the amount is properly included in the amount realized on the sale by the taxpayer. Thus, Hoops argued that all events had occurred to establish the liability, the amount of the liability was determinable, and economic performance occurred as of the sale date. Accordingly, it had incurred the liability on the sale date and was entitled to a deduction in 2012. 

The Seventh Circuit agreed that the deferred compensation liability was incurred within the meaning of Sec. 461 as of the sale date in 2012. The parties agreed that the deferred compensation liability was fixed and the amount of the liability was determinable. Also, with respect to compensation for services, economic service occurs as the services are provided. The two players performed the services to earn the deferred compensation prior to 2012, so the service-based economic-performance requirement had already been met. According to the Seventh Circuit, it was not the Sec. 461(h) economic performance requirement that prevented Hoops from taking the deduction in 2012, but instead, it was the rule in Sec. 404(a)(5) governing nonqualified deferred compensation.

The Seventh Circuit pointed out that the regulations under Sec. 461 specify that if another provision of the Code or regulations prescribes the manner in which an incurred liability is taken into account, the other provision governs the tax deduction. The Seventh Circuit stated that Sec. 404(a)(5) “leaves us with a firm conviction of Congress’s intent to treat the deductibility of deferred-compensation salary plans differently than ordinary service expenses — and that this special treatment prevails over any general provisions otherwise applicable to liabilities assumed in asset sales.” Thus, according to the court, Hoops’ reliance on the sale provision of Regs. Sec. 1.461-4(d)(5)(i) was misplaced, and the deduction was allowed only in accordance with Sec. 404(a)(5). 

Second, Hoops had argued in the Tax Court that denying its deduction by applying Sec. 404(a)(5) would “lead to the ridiculous result” of including the liability in its sale proceeds while potentially never obtaining an offsetting deduction. Hoops urged the Seventh Circuit to consider the practical implication of denying it a tax deduction for the deferred compensation.

Hoops alternatively argued that allowing it a deduction in 2012 “comports with the purpose of clearly reflecting income.” Sec. 446(b) generally requires a taxpayer’s method of accounting to clearly reflect income and gives the IRS the authority to determine whether a method of accounting does so. In disagreeing with the taxpayer’s method, the IRS may replace the taxpayer’s method with another method it asserts clearly reflects income.

In alignment with the IRS’s arguments, the Tax Court highlighted Congress’s intent in enacting Sec. 404(a)(5), which was to deviate from the clear-reflection-of-income principle and to ensure matching of the income inclusion and the deduction between employee and employer. The court rejected Hoops’ clear-reflection-of-income argument and stated that, in this case, the result comports with the clear purpose of Sec. 404. 

The Seventh Circuit took a different approach when considering the practical implications of its interpretation. According to the court, any risk of losing the deferred compensation deduction is foreseeable, especially given the clear instructions from Congress in Sec. 404(a)(5). Also, the court believed that parties could account for tax risk as an economic matter by negotiating contractual provisions to minimize and compensate for financial contingencies. As a result, the practical implications of the Tax Court’s holding did not sway the Seventh Circuit in reaching its decision.

Additional Sec. 1001 argument in Tax Court

Hoops also argued in the Tax Court that, to the extent it was denied a deduction for the deferred compensation in 2012, the liability should not be included in the sale price, or it should be allowed to offset or reduce its amount realized in the sale by the $10.7 million liability. Pursuant to Sec. 1001, the amount realized upon a sale includes the amount of liabilities from which the seller is discharged as a result of the sale.

Hoops first argued that the deferred compensation liability was not a liability within the meaning of Sec. 1001 because it was not included in its basis and did not give rise to a deduction. The court disagreed with this argument and stated that when the buyer assumed the deferred compensation liability, Hoops was discharged from its obligation to pay the liability. Thus, Hoops was required to include the liability amount in the amount realized in the sale.

Hoops’ alternative argument was that it should be entitled to offset or reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability because, in substance, it accepted less cash than if it had retained the liability — effectively making a constructive payment to the buyer to satisfy the liability. In rejecting Hoops’ constructive-payment argument, the Tax Court held that, consistent with Congress’s intent, Sec. 404(a)(11)(B) clearly instructs that no amount of deferred compensation should be treated as received by the employee or paid until it is actually received by the employee.

Thus, even if the deferred compensation was constructively paid to the employees, they did not actually receive it. The result for Hoops was that, according to the Tax Court, Hoops was not allowed a deduction in 2012 for the $10.7 million present value of nonqualified deferred compensation, and it must include the $10.7 million in the amount realized upon sale of its assets.

Importantly, the Tax Court’s ruling is specific to nonqualified deferred compensation subject to the deduction timing rules of Sec. 404(a)(5). It does not appear that the ruling should extend to other liabilities assumed in a sale transaction. Interestingly, the Seventh Circuit’s opinion does not address the Tax Court’s holding that the assumed deferred compensation obligation should be included in Hoops’ amount realized. Perhaps Hoops did not press that argument in front of the Seventh Circuit.

Is the buyer entitled to the deduction?

Surely the buyer will be permitted a deduction for the nonqualified deferred compensation when the buyer settles the liability after the sale, since Hoops would not be permitted a deduction, right? Maybe not. Whether the buyer was entitled to a compensation deduction for the deferred compensation was not an issue for the Tax Court or the Seventh Circuit to consider. However, the odds would not be in the buyer’s favor for an ordinary tax deduction. Notably, the liability may not constitute an “ordinary and necessary” expense.

Interestingly, the Seventh Circuit has held in David R. Webb Co., 708 F.2d 1254, 1256 (7th Cir. 1983), that where a buyer assumes a deferred-compensation liability in the form of a purchase price reduction, the buyer cannot treat its later payments of deferred compensation as deductible business expenses because they are not ordinary and necessary. Instead, the buyer must add the amount of the assumed liability to the basis of the acquired assets when the liability is paid. In most instances, the amount increases the basis of goodwill, which is amortizable ratably over 15 years. Thus, the time value of an immediate deduction versus amortization can be stark.

In Webb, the Seventh Circuit agreed with the Tax Court and the IRS’s position on this scenario: “Contingent obligations, insusceptible to present valuation, which are assumed as part of a purchase agreement, are not to be included in the cost basis of assets” (quoting F.&D. Rentals, Inc., 365 F.2d 34, 41 (7th Cir. 1966)). In other words, if an expense is not an ordinary and necessary business expense of a trade or business (e.g., because the expense was the purchase of an asset), then it generally cannot be a deductible business expense.

Technical Advice Memorandum 8939002

A 1989 IRS technical advice memorandum (TAM) highlights the Service’s position with regard to a similar transaction, with similar results. In TAM 8939002, an employer sought a 1986 deduction for nonqualified deferred compensation it had accrued over the prior three tax years, although the amount owed to the employees had not been paid in 1986. In a 1986 transaction, the employer had sold most of its assets to a buyer, which also agreed to assume the employer’s nonqualified deferred compensation liability.

After reviewing the rules under Secs. 404 and 461, underlying regulations, and related case law, the IRS concluded that the employer was entitled to a deduction for amounts accrued for compensation for services in 1986 on its Nov. 30, 1986, return but disallowed the deduction for pre-1986 accruals.

The IRS took the position that since the pre-1986 amounts were not paid within 2½ months of the close of the tax year “in which significant services required for payment were performed,” the “deductibility of these amounts, therefore, is subject to the deduction timing rules of [Sec.] 404(a)(5).” Because the pre-1986 accruals were not includible in the employees’ income in 1986, no deduction was allowed in 1986.

Unfortunately for the employer in the TAM, it liquidated soon after the sale of the assets, so it was likely never entitled to a tax deduction for the deferred compensation.

Consider situations where Sec. 404(a)(5) might apply

Employers should consider situations in which the unconventional deduction timing rules of Sec. 404(a)(5) could be problematic. An easy situation involves a non-calendar-year taxpayer. As discussed earlier, Sec. 404(a)(5) allows a deduction in the employer’s tax year that includes the last day of the employee’s tax year in which the employee has included the deferred compensation in gross income as compensation.

For example, an employer has a tax year ending Sept. 30, 2023. It pays nonqualified deferred compensation to an employee on Sept. 1, 2023. Even though the payment was made in the employer’s tax year ended Sept. 30, 2023, the deduction is not allowed until the tax year ended Sept. 30, 2024, because that is the tax year that includes the last day of the employee’s year in which the amount is included in income.

This issue becomes more problematic when the employee is transferred as part of the sale, similar to the situation Hoops found itself in. First, consider a stock sale. The buyer acquires 100% of the stock of the target from a consolidated group, resulting in a short tax year for the target ending at the end of the transaction date. The target then joins the buyer’s consolidated group. On the transaction closing date, the seller terminates a nonqualified deferred compensation plan and pays all accrued deferred compensation to the employees. Under Sec. 404(a)(5), the seller is not entitled to a tax deduction for the tax year ending on the transaction closing date for the deferred compensation it pays. Instead, the buyer may be entitled to the deduction. Maybe the seller could have negotiated a purchase price adjustment for the deduction the buyer will receive.

Now, consider a situation where the buyer acquires the assets of the seller but does not assume the seller’s nonqualified deferred compensation liability. Instead, the seller terminates the plan and pays the nonqualified deferred compensation to employees on the closing date. The seller liquidates immediately after the sale. Unless the seller liquidates on or after the Dec. 31 immediately following the sale, the seller might not be entitled to the deduction for the deferred compensation even though the buyer did not assume the liability. This is because the seller was not in existence on the last day of the calendar year when the employee included the amount in income. Remember, according to Sec. 404(a)(5), the deduction is allowed only in the employer’s tax year that includes that last day of the employee’s tax year when the amount is included in income. A possible solution might be to not liquidate the seller until after Dec. 31.

Highlights

Nonqualified deferred compensation paid by a seller in connection with a stock or asset sale transaction is often deductible (if at all) in a tax year after the transaction closes, when the seller may no longer exist to take the deduction. This includes deferred compensation paid prior to the transaction but in the same tax year.

Practitioners should identify situations where a seller in a transaction sponsors a deferred compensation plan. If this is identified prior to the transaction, that seller may be able to implement planning to ensure a benefit is received for the liability. This may include changes to the transaction’s structure or an adjustment to the cash paid by the buyer to account for potential tax benefits a buyer may receive for the assumed liability.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com. Contributors are members of or associated with Grant Thornton LLP.