If a taxpayer were to sell the assets that comprise the taxpayer’s business, they would realize gain if the amount realized by the taxpayer from the sale is more than the taxpayer’s adjusted basis for the property.[i]
The taxpayer’s “adjusted basis” for a property is their original cost for the property – what they paid for it plus certain costs incurred in connection with the acquisition – increased by certain additions[ii] and decreased by certain deductions.[iii] In general, the adjusted basis may be described as the taxpayer’s unrecovered investment in the property.
The “amount realized” by the taxpayer from the sale of a property is the total of (a) all the money plus (b) the fair market value of all other property received by the taxpayer in exchange for the property sold.[iv]
The amount realized by the taxpayer also includes any of the taxpayer’s liabilities that are assumed by the buyer[v] and any liabilities to which the property transferred is subject.
From the buyer’s perspective, the assumption of the taxpayer’s liability is treated as an additional amount “paid” by the buyer to acquire the taxpayer’s assets; as such, it is capitalized and added to the buyer’s basis for the assets acquired.
For example, assume taxpayer is a corporation with an asset valued at $100. Taxpayer owes bank $30 for a loan the proceeds of which it used to purchase the asset years before. The buyer may pay taxpayer $100 in cash for the asset, following which taxpayer would satisfy its $30 obligation to bank. The satisfaction of the debt would not generate a deduction for the taxpayer – it is merely repaying a loan the receipt of which was not taxable to the taxpayer (there not having been any accretion in value). Alternatively, the buyer may pay $70 in cash to taxpayer and assume the $30 liability. Either way, the result is the same: taxpayer has an amount realized of $100 and is left with $70 of cash, and the buyer acquires the asset with a basis of $100.
What if the taxpayer’s liability is not in respect of an amount borrowed but, rather, in respect of a liability arising out of taxpayer’s trade or business – say, for services or the use of property provided to taxpayer – for which taxpayer would have been entitled to claim a deduction (basically, an accrued expense) upon payment of the liability, but for the intervening sale and the assumption of such liability by the buyer?
Assume the same facts as in the example, above, except that the liability is one for which taxpayer would have claimed a deduction had they paid the liability. The buyer pays taxpayer $70 in cash and assumes the $30 liability to acquire the asset. Thus, taxpayer has an amount realized of $100 and the buyer has a basis for the asset of $100. Buyer subsequently satisfies the liability.
As between the taxpayer and the buyer, who – if anyone – is entitled to claim a deduction in respect of the liability? Taxpayer incurred the liability in the ordinary course of its business; the buyer did not. Moreover, taxpayer accepted only $70 in cash for an asset worth $100; the “discount” was provided to leave (or give?) the buyer with the cash needed to satisfy the $30 liability. In other words, the taxpayer in effect paid for the liability by accepting less cash.
Indeed, the IRS seems to have accepted this position in regulations:[vi]
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.
A recent decision of the U.S. Tax Court,[viii] however, serves as a reminder that the assumption of certain liabilities by the buyer in the context of the purchase and sale of taxpayer’s business will not be deductible by taxpayer notwithstanding taxpayer’s having in effect “paid” for the liability by forgoing a larger cash payment at closing.
Taxpayer was a limited partnership that was formed “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.” (A “tall” order you might say.)
In 2000, Taxpayer acquired the Grizzlies[x] and operated the team until it sold the franchise in 2012.
In 2012, Buyer purchased substantially all of Taxpayer’s assets. Buyer also assumed substantially all of Taxpayer’s liabilities, among which were certain contractual obligations; specifically, under the terms of their respective contracts, two players had earned several million dollars[xi] of deferred compensation for services that were due to be paid by Taxpayer as determined on dates after the 2012 sale.
In computing its gain on the 2012 sale, Taxpayer reported a total amount realized of approximately $420 million, consisting of more than $200 million of cash, almost $220 million of assumed liabilities, and other adjustments. Taxpayer
reported an adjusted basis of just over $120 million in the assets sold. Thus, Taxpayer recognized gain on the sale just shy of $300 million.[xii]
As mentioned above, one of the liabilities that Buyer assumed, and of which Taxpayer was relieved in connection with the sale, was the obligation to pay deferred compensation that had been earned by two of its players. As of the date of the 2012 sale, the deferred compensation liability had an accrued value in excess of $12.6 million.
Taxpayer computed the amount realized from Buyer’s assumption of the deferred compensation liability by determining the present value of the future payments to be made.[xiii] Taxpayer included this amount – approximately $10.7 million, rather than the $12.6 million aggregate amount to be paid – in its amount realized in computing its gain on the 2012 sale.
Amended Tax Return
In 2013, Taxpayer filed its federal tax return[xiv] for its taxable year ending December 31, 2012, using the accrual method of accounting. On this original 2012 tax return, Taxpayer (1) did not claim an ordinary deduction relating to the deferred compensation liability, (2) did not reduce its amount realized on the sale by the deferred compensation liability, and (3) did not adjust its basis in any property it owned as a result of the deferred compensation liability.[xv]
Shortly thereafter, Taxpayer amended its tax return.[xvi] On its amended tax return, Taxpayer claimed an additional deduction of approximately $10.7 million relating to the deferred compensation liability (the present value of the compensation to be paid). Taxpayer explained that it was claiming the additional deduction because no deduction had been claimed on the original tax return[xvii] to reduce the deferred compensation liability included in the amount realized.
The IRS disallowed the additional deduction Taxpayer claimed on its amended tax return relating to the deferred compensation liability. Taxpayer timely petitioned the Tax Court for relief.[xviii]
The issues for decision before the Court were: (1) whether Taxpayer was entitled to an additional deduction relating to the deferred compensation liability assumed by Buyer as part of the sale in 2012; or, alternatively, (2) whether Taxpayer, in computing its gain from the 2012 sale, was entitled to reduce its amount realized by the deferred compensation liability assumed by Buyer.
The Code allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business; among these deductible expenses is a reasonable allowance for compensation for personal services actually rendered.[xix] Ordinarily, the deductibility of compensation paid or incurred by an employer to or on account of an employee is governed by Section 162 of the Code.[xx]
In the present case, the parties agreed that the compensation at issue was a “nonqualified” plan of deferred compensation, the deductibility of which was generally governed by Section 404(a) of the Code.[xxiii]
Section 404 of the Code
Under this provision, if compensation is paid or accrued on account of an employee under a plan that defers the receipt of such compensation, the compensation, if otherwise deductible by the employer,[xxiv] would only be deductible subject to certain limitations.[xxv] Specifically, in the case of a nonqualified deferred compensation plan, a deduction for any deferred compensation that is paid or accrued with respect to an employee would be allowable only in the taxable year of the employer in or with which ends the taxable year of the employee in which the deferred compensation is includible in the employee’s gross income as compensation.[xxvi]
According to the Court, Taxpayer had not paid any of the amounts owed to the two players with respect to the assumed deferred compensation liability in 2012 and, therefore, no amounts were includible in the players’ gross incomes as compensation. Thus, the Court concluded, even if the deferred compensation liability was otherwise deductible, Taxpayer was not entitled to a deduction for the liability for 2012 because no amounts attributable to the compensation were includible in the gross incomes of the players.
With that, the Court sustained the IRS’s disallowance of the additional deduction of $10.7 million relating to the deferred compensation liability that Taxpayer claimed on its amended 2012 tax return.
Having decided that Taxpayer was not entitled to a deduction, pursuant to Section 404(a)(5) of the Code, the Court then addressed each of Taxpayer’s arguments.
Taxpayer argued that the regulations promulgated under the “economic performance” rules[xxvii] allowed Taxpayer to deduct the deferred compensation liability for the year of the sale. Specifically, Taxpayer argued that the Section 404 “timing rule” was incorporated into the economic performance requirement – described earlier in this post – and was accelerated because of the sale of Taxpayer’s business.[xxviii]
The Court disagreed. After explaining how an accrual method taxpayer[xxix] would generally be entitled to deduct expenses for the year in which the taxpayer incurred the expenses, regardless of the actual payment dates,[xxx] the Court pointed out that the accrual method regulations direct such a taxpayer to consider “[a]pplicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary” that prescribe the manner in which a liability that has been incurred is taken into account.[xxxi] Thus, the Court continued, the initial question was whether another provision of the Code or Regulations prescribed the manner in which the deferred compensation liability should be taken into account.
Under the plain text of Section 404(a)(5), the Court observed, a deduction for deferred compensation is taken into account only for the taxable year in which the deferred compensation is includible in the gross income of the employee.[xxxii] Thus, Taxpayer was not entitled to deduct the deferred compensation liability for the year of the sale because no amounts attributable to such compensation were includible in the gross income of either player. This result remained the same, the Court stated, regardless of the fact that Taxpayer filed its returns using the accrual method of accounting.[xxxiii]
Taxpayer then argued that, if Section 404(a)(5) and the tax accounting rules were applied in a manner that would deny Taxpayer a deduction, it would “lead to the ridiculous result” of Taxpayer including the deferred compensation liability in its sale proceeds but potentially never obtaining an offsetting deduction. Thus, Taxpayer contended that allowing it to deduct the deferred compensation liability for the year of the 2012 sale comported with the purpose of clearly reflecting income.
The IRS responded that Section 404(a)(5) was a Congressionally mandated deviation from the clear reflection of income principle, and the Court agreed with the IRS, stating that the timing restrictions of Section 404 were intended to ensure matching of income inclusion and deduction between employee and employer under nonqualified plans. In other words, the employer was not entitled to a deduction until the compensation was paid to the employee.
Accordingly, in the light of what the Court described as “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,” the Court concluded that disallowing a deduction for the year of sale would not lead to a “ridiculous result.”
Finally, Taxpayer argued that either the deferred compensation liability should not have been included in the sale price or Taxpayer should be entitled to reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability.
Again, the Court disagreed. The gain from the sale of property, it stated, is the excess of the amount realized from the sale over the adjusted basis for the property. The “amount realized,” it continued, 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.[xxxiv]
Taxpayer argued that accrued expenses assumed by a buyer should be included in the sale price only if they were deducted by the seller. In effect, Taxpayer’s position was that the deferred compensation liability was not a liability for purposes of determining gain because it was not included in basis and it did not give rise to a deduction.
The Court rejected this argument, stating that because Taxpayer had an obligation to pay the deferred compensation, Buyer’s assumption thereof in connection with the 2012 sale discharged Taxpayer from its obligation. Thus, Taxpayer was required to take into account the amount of the deferred compensation liability in computing its gain from the sale.
Finally, Taxpayer claimed it was entitled to reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability. Taxpayer posited that either Buyer assumed the liability and paid Taxpayer the net cash amount or Buyer paid the gross cash amount and Taxpayer used a portion to satisfy the liability. Thus, in substance, by accepting less cash than Taxpayer otherwise would have received had it retained the liability, it effectively made a constructive payment to Buyer to satisfy the liability.[xxxv]
However, the Court distinguished this argument stating that it did not apply to deferred compensation subject to Section 404(a)(5) of the Code. The Court explained that Section 404(a)(11)(B) provides that, for purposes of determining when deferred compensation is paid, no amount shall be treated as received by the employee, or paid, until it is actually received by the employee. Accordingly, Taxpayer had to include the deferred compensation liability in its amount realized on the 2012 sale and was not entitled to reduce its amount realized by the amount of the deferred compensation liability.
Was the Court’s decision “correct”? It seems to have fallen squarely within the ambit of Section 404 of the Code and the Regulations thereunder. Nevertheless, one has to wonder whether such a faithful reading produced an improper result.
At the time of the 2012 sale, Taxpayer had a fixed and determinable obligation to the players under the terms of the nonqualified deferred compensation arrangement. The amounts owing thereunder were not payable until some time after the sale.
Buyer agreed to assume Taxpayer’s obligation, in consideration of which Taxpayer accepted less cash in exchange for the assets of its business. The amount of the obligation assumed represented part of the purchase price “paid” by Buyer that was allocated among the assets acquired by Buyer and would be recovered in accordance with the applicable cost recovery rules (for example, amortization).
Likewise, the assumed obligation represented part of the amount realized by Taxpayer – the relief of the liability represented the receipt of economic value by Taxpayer.
Which brings us to the question: (i) if Buyer cannot deduct the deferred compensation liability upon payment because it represents purchase price, not a business expense incurred by Buyer, and (ii) if Taxpayer cannot deduct it because, as the Court stated, Section 404 precluded such a deduction until the players included the compensation in income, and (iii) if the players will not include the compensation in gross income until it is paid or otherwise made available to them at some time after the sale, then (iv) who is entitled to claim the deduction for what presumably is otherwise deductible compensation?
The only reasonable answer: Taxpayer. It was Taxpayer to which the players’ services were rendered, it was these services that earned the players the deferred compensation, and it was Taxpayer that incurred the obligation to pay them.
In short, Taxpayer’s final argument, described above, should have carried the day: by accepting less cash than Taxpayer otherwise would have received had it retained the liability, it effectively made a constructive payment to Buyer to satisfy the liability. That constructive payment should have generated a deduction for Taxpayer or, at the very least, should have reduced Taxpayer’s amount realized on the sale.
Sign up to receive my blog at www.TaxSlaw.com.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] IRC Sec. 1001; Reg. Sec. 1.1001-1.
[ii] For example, the cost of certain improvements.
[iii] For example, amortization and depreciation.
[iv] Reg. Sec. 1.1001-1(a).
[v] As a result of which the taxpayer realizes an economic benefit.
[vi] Reg. Sec. 1.461-1(d)(5).
[vii] Yes, I may have gone out of bounds with that one. Oh no. Did it again, I must be stuck in corny/bad-joke-mode.
[viii] Hoops, LP v. Comm’r, T.C. Memo. 2022-9.
[ix] Also the title of a worthwhile documentary.
[x] Originally from Vancouver (which mainland grizzly bears will visit on occasion), before moving to Tennessee (no grizzlies; yes black bears).
[xi] The amounts would have been larger but for the NBA lockout in 2011, which reduced the number of regular season games.
[xii] Gain of $300 million with cash of $200 million from which to pay the tax on such gain. A not insignificant consideration when the buyer assumes the seller’s liabilities, especially if the seller does not enjoy a deduction from the “satisfaction” of such liabilities.
[xiii] Taxpayer used a discount rate of 3% for purposes of this present value calculation.
[xiv] On Form 1065, U.S. Return of Partnership Income.
[xv] It did not capitalize the deferred compensation and add it to its basis for the assets.
[xvi] Filing Form 1065X for its taxable year ending December 31, 2012.
[xvii] Under Reg. Sec. 1.461-4(d)(5).
[xviii] IRC Sec. 6213.
[xix] IRC Sec. 162(a)(1); Reg. Sec. 1.162-7.
[xxii] Reg. Sec. 1.404(a)-1(a)(1); Reg. Sec. 1.162-10(c).
[xxiii] Specifically, the parties agreed that the deferred compensation liability at issue reflected an arrangement as described in IRC Sec.404(a)(5).
[xxiv] For example, it is reasonable and is not required to be capitalized.
[xxv] Reg. Sec. 1.404(a)-1(b).
[xxvi] Reg. Sec. 1.404(a)-12(b)(1).
[xxvii] IRC Sec. 461(h).
[xxviii] Reg. Sec. 1.461-4(d)(5)(i).
[xxix] IRC Sec. 461(h)(4); Reg. Sec. 1.461-1(a)(2). Under an accrual method, a liability is incurred, and generally taken into account for federal income tax purposes, in the taxable year in which “all the events” have occurred that: (1) 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.
In this case the parties agreed that Taxpayer incurred the deferred compensation liability as of the date of the 2012 sale, because all the events had occurred that established the fact of the deferred compensation liability, the amount could be determined with reasonable accuracy, and economic performance had occurred.
[xxx] IRC Sec. 461 provides general rules with respect to the proper year for taking deductions, which in turn rest in part on the taxpayer’s method of accounting under IRC Sec. 446. IRC Sec. 461(h); Reg. Sec. 1.446-1(c)(1)(ii)(A), 1.461-1(a)(2)(i).
[xxxi] Reg. Sec. 1.461-1(a)(2)(i), 1.446-1(c)(1)(ii)(A).
[xxxii] Reg. Sec. 1.404(a)-12(b)(1).
[xxxiii] Reg. Sec. 1.404(a)-1(c).
[xxxiv] IRC Sec. 1001(b); Reg. Sec. 1.1001-2(a)(1).
[xxxv] See earlier in this post.