7th Circuit disallows deferred comp deduction after asset sale

The Seventh Circuit Court of Appeals recently affirmed a Tax Court decision (T.C. Memo 2022-9) in Hoops, LP v. Commissioner (No. 22-2012, 7th Cir. Aug. 9, 2023) disallowing a deduction for nonqualified deferred compensation claimed by the seller following an asset sale, which included the assumption by the buyer of the deferred compensation obligation.

The seller owned the Memphis Grizzlies NBA franchise and sold substantially all of the assets to a buyer in 2012. The buyer assumed substantially all of the seller’s liabilities, including the obligation to pay nonqualified deferred compensation to two employees with a present value of approximately $10.7 million.

The seller 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 employer tax year that includes the employee’s tax year-end in which the deferred compensation is included in the employee’s gross income as compensation. Thus, under the plain terms of Section 404(a)(5), the seller would not be allowed a deduction until the tax year in which an amount attributable to the deferred compensation is includible in the employees’ gross income. The employees did not receive any portion of the deferred compensation during 2012 (either before or after the asset sale) and did not include any amounts attributable to the deferred compensation in 2012 in income, so the court concluded that the seller should not be allowed a deduction in 2012 for any portion of the deferred compensation.

The seller had argued that it should be allowed a deduction despite the timing rule in Section 404(a)(5) because the timing rule of Section 404 is incorporated into the “economic performance” rule of Section 461(h). The seller 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), which generally provides that if, in connection with the sale or exchange of a trade or business by a taxpayer, a buyer expressly assumes a liability that the seller—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 seller. Thus, the seller 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. The seller therefore argued that it had incurred the liability on the sale date and was entitled to a deduction.

The court agreed 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 prescribes the manner in which an incurred liability is taken into account, the other provision governs the tax deduction. The court already had concluded that Section 404(a)(5) governs the tax deduction timing of nonqualified deferred compensation. Thus, according to the court, the seller’s 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).

In making its argument, the seller urged the court to recharacterize the $10.7 million amount as a “deemed payment” made to the buyer in the asset sale and not as a deferred compensation liability. The seller asserted that the amount is an ordinary business expense deductible in 2021 and the seller implicitly paid the deferred compensation in setting the sale price to the buyer.

In response, the court noted that the seller’s insistence on calling the assumed deferred compensation a “deemed payment” loses sight of the substance of what transpired. There was no question the seller sold its assets, and the transaction entailed the buyer assuming a liability – but not just any liability – instead, a liability of deferred compensation based on services already rendered by the two employees. The court explained that, if no sale occurred, the seller could not have deducted the $10.7 million in deferred compensation because it was not paid to the two employees in 2012. The court ultimately concluded that Section 404(a)(5) precludes the deduction in the 2012 tax year without regard to the asset sale or the economic performance rule.

The result of the case is that the seller is not allowed a deduction in 2012 for the $10.7 million present value of nonqualified deferred compensation even though the seller included the $10.7 million liability assumed in the amount 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.