Seventh Circuit Blocks Basketball Team Seller's Deduction for Deferred Comp Liability

(Parker Tax Publishing August 2023)

Affirming the Tax Court, the Seventh Circuit held that a limited partnership that sold the assets of an NBA basketball team could not claim a deduction for a liability to pay deferred compensation to two players that was assumed by the buyer in the sale. The court found that under Code Sec. 404(a)(5), since the limited partnership chose not to contribute to a qualified plan, it could not claim the deduction until the compensation was actually paid and includible in the gross income of the players. Hoops, LP v. Comm'r, 2023 PTC 219 (7th Cir. 2023).

Background

Hoops, LP is a limited partnership that formed in 2000 to acquire a National Basketball Association franchise, the Vancouver Grizzlies, which later became the Memphis Grizzlies. In October 2012 Hoops sold the Grizzlies to Memphis Basketball, LLC. At that time Hoops owed two players, Mike Conley and Zach Randolph, deferred compensation for their strong performance in the 2009, 2010, and 2011 seasons. Conley and Randolph accrued $12.6 million in total deferred compensation for those seasons, which Hoops promised to pay sometime after 2012. But Hoops never paid the deferred compensation to either player. Instead, as part of the asset sale, Memphis Basketball assumed Hoops' liability for the $12.6 million owed to them.

Hoops later calculated the liability to be $10.7 million at its discounted present value. In computing its gain on the 2012 sale, Hoops reported to the IRS that it realized $419 million in the transaction, of which Memphis Basketball paid $200 million in cash and assumed $219 million in liabilities. Included in the liabilities was the $10.7 million (discounted) deferred compensation obligation. In Hoops' view, the assumption by Memphis Basketball of the obligation to pay Conley and Randolph was reflected in the purchase price: Memphis Basketball paid Hoops $10.7 million less because it undertook Hoops' liability. In other words, Hoops believed that the $10.7 million was a "deemed payment" it made to Memphis Basketball to compensate it for the deferred compensation that remained owed to the two players.

Hoops filed its partnership tax return for the 2012 tax year using the accrual method of accounting. On its return, Hoops made no reference to the $10.7 million deferred-compensation liability that the buyer had assumed in the 2012 sale. Hoops later filed an amended partnership tax return for 2012. On this amended return, Hoops claimed a $10.7 million deduction for the deferred compensation owed to Conley and Randolph. In a 2018 final partnership administrative adjustment letter, the IRS disallowed the deduction. Hoops, through its tax matters partner, then petitioned the Tax Court for review. The Tax Court agreed with the IRS, and Hoops appealed to the Seventh Circuit.

Under Code Sec. 461(a) and Reg. Sec. 1.461-1(a)(2), an accrual-based taxpayer generally can deduct ordinary and necessary business expenses, including employee salaries, for the tax year in which all the events have occurred that establish the fact of the liability, when the amount of the liability can be determined with reasonable accuracy and economic performance has occurred. As a practical matter, this means accrual-based taxpayers can normally deduct employment related expenses as employees render services.

A different set of rules addresses deductions for employee compensation paid pursuant to a deferred-payment plan. Under Code Sec. 404, employers may claim deductions for deferred compensation as employee services are rendered only if compensation is paid pursuant to a qualified plan. Code Sec. 404(a)(5) provides that employers that do not pay deferred compensation into and pursuant to a qualified plan cannot claim deductions until the compensation is actually paid and includible in the gross income of employees participating in the plan. In other words, Code Sec. 404(a)(5) allows employers to take deductions only when they contribute to qualified plans (by making payments for services rendered) or when they pay the compensation.

Observation: By regulating deferred compensation plans this way, Congress gave accrual-method employers a choice. On one hand, they can contribute deferred-compensation payments to a qualified plan and take deductions as they make these payments. On the other hand, employers can forego the costs of a qualified payment plan, with the tradeoff that they may not take any deduction until they make the payments to their employees. In this way, Code Sec. 404(a)(5) establishes a matching rule between employee and employer, requiring employers to deduct deferred compensation expenses and employees to report income in the same tax year.

The Tax Court found that, because Hoops' claimed deduction reflected deferred compensation that Hoops had not paid to a qualified plan, Code Sec. 404(a)(5) by its plain terms precluded Hoops from taking the deduction until the players were paid. However, Hoops argued that the sale, and Memphis Basketball's assumption of its liability, changed the tax treatment of the $10.7 million in deferred compensation. According to Hoops, Code Sec. 461 and Reg. Sec. 1.461-4(d)(5)(i) permitted an earlier deduction even though the deferred compensation was not paid in 2012 to either Mike Conley or Zach Randolph. Reg. Sec. 1.461-4(d)(5)(i) provides that: "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."

Hoops contended that, because of the specific context of the asset sale, Reg. Sec. 1.461-4(d)(5)(i) allowed it to accelerate that deduction regardless of whether the players had been paid, as otherwise required by Code Sec. 404(a)(5). The Tax Court rejected that argument. It found that under Reg. Sec. 1.461-1(a)(2)(i), Hoops could not claim the deduction under Reg. Sec. 1.461-4(d)(5)(i) until first addressing any other "applicable 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." The Tax Court identified Code Sec. 404(a)(5) as one such provision. Because Code Sec. 404(a)(5) disallowed the deduction until the tax year in which Conley and Randolph received payment, the Tax Court affirmed the IRS's final partnership administration adjustment letter denying the deduction.

On appeal, Hoops renewed its argument that its deduction was allowed under Reg. Sec. 1.461-4(d)(5)(i). It also urged the court to consider the practical implications of disallowing the deduction. Hoops reasoned that when Conley and Randolph were ultimately paid, it was possible that Hoops could lose the deduction altogether - for example, if the buyer never paid the players or otherwise failed to communicate that the players were paid.

Analysis

The Seventh Circuit agreed with the Tax Court. In the view of the Seventh Circuit, Code Sec. 404(a)(5) made it clear that Congress's intent was 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.

The Seventh Circuit found that, by its terms, Reg. Sec. 1.461-4(d)(5)(i) accelerates only those deductions that a taxpayer cannot take because the economic performance requirement of Code Sec. 461(h) has not been met. But the court noted that under Code Sec. 461(h), economic performance of services occurs as employees render them. Therein lied the fundamental flaw in Hoops' argument: the court found that it was not Code Sec. 461(h)'s economic performance requirement that prevented Hoops from taking the deduction in 2012, but the rule in Code Sec. 404(a)(5) governing nonqualified deferred-compensation plans. Hoops' decision not to pay the players in 2012 and its decision not to contribute to a qualified plan precluded its ability to claim the deduction that same tax year. The court said that Hoops could not assert that either of these are economic performance barriers as that term is defined in Code Sec. 461(h).

Moreover, the court pointed to Reg. Sec. 1.461.4(d)(2)(iii), which states that "the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under section 404 (employer contributions to a plan of deferred compensation)." In the court's view, this explicit reference to Code Sec. 404 further defeated Hoops' position. The court reasoned that by its terms, the regulation provides that economic performance is satisfied and liabilities are therefore deductible if the other requirements of Code Sec. 404 are also met. In addition, the court noted the absence of any reference in Code Sec. 404 to the asset-sale provisions in Code Sec. 461. The court said that these observations reflected Congress's clear intent in passing Code Sec. 404 to displace the accrual method with an approach that requires employers to choose between qualified plan payments and earlier deductions.

The observed that the risk to Hoops of losing its deferred-compensation deduction was foreseeable, especially given the clear instructions from Congress in Code Sec. 404(a)(5). The court observed that Hoops could have avoided this problem in my ways - by adjusting the sale price to reflect the deductibility, contributing to qualified plans for the players to take earlier deductions, or renegotiating the players' contracts and accelerating their compensation to the date of the sale.

For a discussion of the rules relating to nonqualified deferred compensation plans, see Parker Tax ¶135,525. For a discussion of the economic performance requirement as it relates to the deduction of expenses, see ¶241,740.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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