Deferred Compensation Deduction Blocked on Sale of Basketball Operations
Hoop, LP v. Commissioner of the Internal Revenue Service, T.C. Memo 2022-9
A recent U.S. tax court memorandum decision shows how a deferred compensation liability can impact a seller’s gain on a sale of a business. Hoops LP. (“Hoops”) was a partnership that owned and operated the NBA Memphis Grizzlies. On Oct. 29, 2012, Hoops sold their basketball operations to an unrelated buyer. Hoops sold substantially all the assets, and the buyer assumed substantially all the liabilities.
One of the liabilities assumed by the buyer was accrued deferred compensation amounts due on two players’ contracts. The amounts earned by the two players before the sale totaled approximately $12,640,000. Hoops in computing the gross proceeds received on its sale of assets included $10.3M as the present value of this deferred compensation liability assumed by the buyer. Hoops filed its tax return reporting the sale on Sept. 16, 2013. No deduction was claimed on this tax return for the deferred compensation.
On October 10, 2013, Hoops filed an amended return claiming an ordinary income deduction for the amount of the deferred compensation liability. Ultimately the Internal Revenue Service (“IRS”) rejected the refund claim and Hoops filed suit in the U.S. tax court.
Hoops’ amended return claimed that it should have received a deduction under Regulation (“Reg.”) §1.1461-4(d)(5). This regulation provides that if in connection with the sale or exchange of a trade or business the buyer assumes a liability that, except for the economic performance rules, the seller would have been able to deduct, then economic performance is deemed to occur on the date of the sale. One could view this provision to allow a deduction to the seller as if the seller “pays” the accrued liability when the buyer assumes it in the deal. Thus, economic performance occurs, and a deduction is permitted. This provision allows the seller to take deductions for amounts that it otherwise would not be able to deduct but for the sale.
The IRS rejected the application of Reg. §1.1461-4(d)(5), and instead applied § 404(a) that governs the deductibility of payments of deferred compensation. §404(a)(5) states that deferred compensation amounts become deductible only in the year in which the employee is required to pick up the compensation in gross income on their own individual returns. The player/employees did not receive compensation at the date of sale and were not “deemed” to receive their deferred compensation at the date of the sale. Therefore, these individuals did not report either $10.3 million or $12,640,000 of compensation on their own individual income tax returns. The IRS argued that §404(a)(5) was the appropriate rule in this situation and denied the deduction to Hoops for the deferred compensation. The tax court agreed with the IRS.
Hoops also made an alternative argument that the deferred compensation liability should not be considered a liability assumed by the buyer in the sale transaction. Hoops argued that accrued expense of the seller that never gave rise to a deduction or was never included in tax basis of an asset should not be a liability included in the gross proceeds received on the sale. This argument also failed.
Hoops’ overall complaint was that it incurred a liability for deferred compensation that 1) it never paid, 2) never deducted, 3) never received payment for, and 4) never increased basis in any asset sold, but upon assumption by the buyer, Hoops was required to recognize the liability as gain on the sale of the basketball operations.
Hypothetically, if the Hoops transaction had instead been a sale of stock in “Hoops, Inc.”, and the seller had actually paid the deferred compensation to the employees at the closing, §404(a)(5) may again limit the seller’s deduction.
Reg. 1.404(a)-12(b)(1) provides the following rule:
“A deduction is allowable for a contribution paid … only in the taxable year of the employer in which or with which ends the taxable year of an employee in which an amount attributable to such contribution is includible in his gross income as compensation, . . .”
This language can become problematic when the seller’s tax year ends as a result of the transaction.
Say, “Hoops, Inc.” closed its tax year on the sale date, October 29, 2012, but the two employees receiving payments did not close their tax years until December 31, 2012. Even though the seller, “Hoops, Inc.”, has made payment to satisfy its deferred compensation liability, the tax year of the employees did not end with or within “Hoops Inc.’s” tax year. Under the regulations, the seller may not deduct a compensation expense for this payment on its short year tax return.
Sellers should fully understand the tax implications of their deferred compensation liabilities and make plans to avoid the trap of §404(a)(5) that doomed a deduction for Hoops.
If you are contemplating a sale or purchase of a business, please reach out to your Cherry Bekaert Tax Advisor or the Cherry Bekaert Transactions Advisory team.