The U.S. Tax Court recently held in Hoops, LP v. Commissioner (T.C. Memo 2022-9), that the taxpayer could not rely on the “clear reflection of income” principle to deduct nonqualified deferred compensation subject to Section 404(a)(5) in the year the taxpayer sold substantially all of its assets and transferred liabilities—including an obligation to pay certain deferred compensation. In addition, the taxpayer could not deduct the nonqualified deferred compensation in the year of sale under Section 461 in accordance with the special sale provision for economic performance. Instead, the taxpayer was not entitled to a deduction for the deferred compensation liability that was assumed by the buyer. Moreover, the court held that the taxpayer could not exclude the deferred compensation liability assumed by the buyer from the amount the taxpayer realized upon the sale under Section 1001.
Hoops, LP (“Hoops”) owned the Memphis Grizzlies NBA franchise. In 2012, Hoops sold substantially all of its assets to Memphis Basketball, LLC (the “Buyer”). The Buyer assumed substantially all of Hoops’ liabilities, including the obligation to pay nonqualified deferred compensation with a present value of approximately $10.7 million.
Hoops and the IRS agreed that the liability assumed represented nonqualified deferred compensation—the deductibility of which is governed by Section 404(a)(5). Under Section 404(a)(5), an employer is allowed to deduct deferred compensation in the tax year that includes the year-end of the employee tax year in which the deferred compensation is includible in the employee’s gross income as compensation. Thus, the court held that under the plain terms of Section 404(a)(5), Hoops is not allowed a deduction until the tax year for which an amount attributable to the deferred compensation is includible in the employee’s gross income. The employees did not include any amounts attributable to the deferred compensation in 2012, so Hoops was not allowed a deduction in 2012 for any portion of the deferred compensation.
Hoops made two arguments for why it should be allowed a deduction despite the timing rule in Section 404(a)(5). First, Hoops argued that the timing rule of Section 404 is incorporated into the “economic performance” rule of Section 461(h). Hoops argued that economic performance was accelerated when the liability was assumed as part of the sale under Treas. Reg. Sec. 1.461-4(d)(5)(i). That 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. Hoops therefore argued that it had incurred the liability on the sale date and was entitled to a deduction.
Neither the Tax Court nor the IRS disagreed that the deferred compensation liability was incurred within the meaning of Section 461 as of the sale date in 2012. However, the court pointed out that the regulations under Section 461 also specify that if another provision of the Code or regulations prescribe the manner in which an incurred liability is taken into account, the other provision governs the tax deduction. The court already held that Section 404(a)(5) governs the tax deduction timing of nonqualified deferred compensation. Thus, according to the court, Hoops’ reliance on the sale provision of Treas. Reg. Sec. 1.461-4(d)(5)(i) was misplaced, and the deduction is allowed only in accordance with Section 404(a)(5).
Second, Hoops argued that denying its deduction by applying Section 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 alternatively argued that allowing Hoops a deduction in 2012 would comport with the purpose of clearly reflecting income. In alignment with the IRS’s arguments, the Tax Court highlighted Congress’ intent for enacting Section 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 Section 404.
Hoops also argued that to the extent it is denied a deduction for the deferred compensation in 2012, the liability should not be included in the sale price or Hoops should be allowed to offset or reduce its amount realized in the sale by the $10.7 million liability. Pursuant to Section 1001, the amount realized upon the 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 is not a liability within the meaning of Section 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 Buyer assumed the deferred compensation liability, Hoops was discharged from its obligation to pay the liability. Thus, Hoops was required to include the amount of the liability 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 Buyer to satisfy the liability. In rejecting Hoops’ constructive payment argument, the court held that, consistent with Congress’ intent, Section 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, it was not actually received by the employees.
The result for Hoops is that, according to the Tax Court, Hoops is 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 amounts realized upon sale of its assets. Importantly, the court’s ruling is specific to nonqualified deferred compensation subject to the deduction timing rules of Section 404(a)(5). It does not appear that the court’s ruling should extend to other liabilities assumed in a sale transaction.
Hoops could potentially appeal the Tax Court’s decision—which could have major implications for the court’s application of the “clear reflection of income” principle and its decision that the deferred compensation is an assumed liability within the meaning of Section 1001. The Tax Court’s opinion provided little analysis of why the liability could not be excluded from the amount realized.
Partner, Washington National Tax Office
Sharon Kay is the National Managing Partner of Grant Thornton LLP's Washington National Tax Office. Sharon has over 25 years of tax experience and primarily advises clients on federal income tax issues such as accounting method changes, income and expense recognition, inventories, tangible and intangible asset capitalization and recovery, and certain business credits.
Washington DC, Washington DC
- Strategic federal tax
Practice Leader, Tax Technical, Washington National Tax Office
Grace Kim has more than 20 years of experience in the area of partnership taxation, which includes IRS, law firm and accounting firm positions. Her diversified experience includes working on a broad range of structuring and operational issues in a variety of industries and areas.
Washington DC, Washington DC
- Real estate and construction
- Private equity
- Strategic federal tax
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