Brant J. Hellwig is a professor of tax law and the faculty director of the graduate tax program at the New York University School of Law. He thanks Jonathan Nickas, Gregg Polsky, and Ethan Yale for conversations on topics addressed in the article and their feedback on prior drafts.
In this article, Hellwig analyzes the opinions of the Tax Court and Seventh Circuit in Hoops, and he advances arguments for a different resolution based on general tax principles.
Copyright 2023 Brant J. Hellwig.
All rights reserved.
The Seventh Circuit recently issued its opinion in Hoops LP v. Commissioner1 concerning the tax treatment of nonqualified deferred compensation obligations that are transferred in connection with the sale of the employer’s assets. The appellate court affirmed the determination of the Tax Court2 that, despite the inclusion of the deferred compensation obligations in the amount realized by the original employer upon the sale of its assets, section 404(a)(5) requires the original employer to defer its deduction for the deferred compensation to when the compensation is actually paid by the purchaser and included in the employee’s gross income.
I. Factual Background
Hoops, the taxpayer in the case, was a limited partnership formed to acquire and own the Vancouver Grizzlies, an NBA franchise that later became the Memphis Grizzlies. In 2012 Hoops sold the franchise to a third party. At the time of the sale, Hoops owed deferred compensation to two of its star players, Mike Conley and Zach Randolph, totaling $12.6 million. Hoops determined the present value of those amounts, scheduled to be paid after the 2012 year of sale, to be $10.7 million.
The purchaser of the franchise paid Hoops $200 million in cash and assumed $219 million of Hoops’ liabilities. The latter figure included the $10.7 million present value of the deferred compensation obligations. Thus, Hoops determined a $419 million combined amount realized on the sale of the franchise.
II. Arguments of the Parties
The theory for including relief of a recourse obligation in the amount realized under section 1001(b) rests on equating the liability assumption with the payment of cash to the seller. The seller, in turn, is deemed to pay the cash to the employee, who is then deemed to re-lend the funds to the purchaser.3 Based on that “deemed payment” theory, Hoops claimed a compensation deduction of $10.7 million in the year of sale. Hoops supported its position by pointing to reg. section 1.461-4(d)(5)(ii), which provides an exception to the deferral of a deduction on economic performance grounds in this setting:
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.4 [Emphasis added.]
Also, Hoops highlighted the practical challenges associated with determining its tax liabilities based on events (in this case, the actual timing and amount of payment of deferred compensation) beyond its control or, possibly, even knowledge.
The IRS was not persuaded. Pointing to the plain language of section 404(a)(5) governing the timing of a deduction for nonqualified deferred compensation, the IRS contended that no deduction for nonqualified deferred compensation obligations of this sort could be taken before the year in which the deferred compensation “is includible in the gross income of employees participating in the plan.”5
Because the players would not realize gross income until the deferred compensation was actually paid, Hoops was required to defer its deduction until that time. From the IRS’s perspective, this was an easy case. Section 404(a)(5) provides an unequivocal and inescapable rule governing the timing of deductions for nonqualified deferred compensation payments. That context-specific statute overrides any deemed payment theory or more general economic performance guidance.
III. Resolution of the Case
Affirming the decision of the Tax Court, the Seventh Circuit largely adopted the IRS’s position that section 404(a)(5) speaks directly to the timing of deductions for nonqualified deferred compensation agreements to the exclusion of any other statute, regulatory guidance, or theory grounded in tax logic. “It is section 404(a)(5) and not anything about the asset sale or economic performance rule that precludes the deduction in the 2012 tax year.”6
Thus, Hoops could not take the deduction before the year in which the employee included those amounts in gross income,7 regardless of whether Hoops was in business at the time the compensation was ultimately paid. The Seventh Circuit announced its “firm conviction” that by enacting section 404(a)(5), Congress intended to treat the deductibility of nonqualified deferred compensation obligations differently than ordinary service expenses.8 Further, the court pointed to numerous grounds for determining that the economic performance provisions (including the regulations under section 461 treating a liability assumption as a deemed payment for economic performance purposes) were subordinate to the terms of section 404(a).9
To the extent the straightforward application of section 404(a)(5) operated to the disadvantage of Hoops, the Seventh Circuit was not overly concerned. Indeed, at the outset of its discussion, the court suggested that Congress provided for comparably disadvantaged treatment of nonqualified deferred compensation obligations through the matching rule provided in the statute:
By regulating deferred compensation plans in this way, Congress “create[d] financial incentives for employers to contribute to qualified plans while providing no comparable benefits for employers who adopt plans that are unfunded.”10
This characterization of section 404(a)(5) is curious. There is nothing inherently detrimental about the timing rule in that section. Although the deferral of a deduction on its face appears unfavorable as an economic matter, that instinct generally assumes the nominal amount of the deduction remains constant. However, if the taxpayer’s effective tax rate remains the same, the taxpayer should be indifferent between a current deduction for the present value of deferred compensation amounts (which Hoops was claiming) and a future deduction for the amount of the deferred compensation when paid.11 In the latter case, the deferred deduction will be increased by the time value of money, eliminating any disadvantage.12
The Seventh Circuit went on to endorse the IRS’s unsympathetic view of the plight of Hoops in this case. In somewhat flippant fashion, the court noted that Hoops could have availed itself of several options to avoid or otherwise address the deferral of the compensation deduction past the point of selling the franchise and exiting the business. Specifically, Hoops could have (1) used qualified deferred compensation plans instead of nonqualified arrangements; (2) accelerated actual payment of the deferred compensation obligations at the point of the sale of the franchise; or (3) negotiated an adjustment in the sales price to compensate for the inability to deduct the deemed payment of deferred compensation in the year of sale.13
The court’s responses are unavailing. To start, the dollar figures involved far exceeded the contribution limits on qualified plans, to the point of being comical. Regarding the prospect of accelerating the payment of deferred compensation, that form of self-help to avoid an anomalous tax result is not as straightforward as it sounds. Employees often have their own justifications — tax-related or otherwise — to defer receipt of compensation,14 which could complicate acceleration of payment. Further, it would have been necessary for the prospect of acceleration to have been included in the deferred compensation plan to avoid triggering section 409A and its 20 percent surtax for noncompliant accelerations.15 Lastly, because the resulting tax disadvantage to Hoops did not produce an offsetting tax benefit to the purchaser, Hoops could not easily resolve the matter through negotiation over the purchase price for the franchise. In any case, scolding a taxpayer for not seeking contractual protection from an unwarranted tax result (one that was not clear at the time)16 is less than satisfying.
IV. The ‘Right’ Outcome in Theory
The practical consequences of applying the timing rule in section 404(a)(5) to deferred payment obligations despite an intervening sale of a business to a third party are significant. Broadly speaking, the goal of any tax on income is to account for expenses in a manner that aligns those expenses with the revenue they facilitate. The adherence to section 404(a)(5) when the original employer has sold the assets making up its trade or business in a transaction that includes the buyer’s assumption of trade obligations does just the opposite.17 The revenue-generating activity has ceased, yet the relevant deduction is nonetheless deferred. When the taxpayer does not engage in any other income-producing activities and instead winds up operations, the value of the future deduction is diminished considerably.18 Given the harsh result of deferring a deduction to a period after which a taxpayer has exited the trade or business through a sale of its assets, courts should give pause in determining that section 404(a)(5) controls in this setting.
In adopting the timing rule of section 404(a)(5), Congress most likely contemplated (understandably) that the party who entered into the deferred compensation arrangement would be the same party to actually pay the deferred compensation.19 In other words, Congress probably did not consider the prospect of a separate party assuming the nonqualified deferred compensation arrangements, with those arrangements surviving the change in employer. Hence, it is worth considering what the proper result should be in this setting by applying general tax principles.
Whether this approach is sufficient to overcome a literal interpretation of the statute turns on one’s inclinations and sensibilities regarding statutory construction and, for that matter, the proper role of the judiciary.20 Yet given the stark tax consequences of deferring a deduction to a year following a taxpayer’s sale of its business, finding section 404(a)(5) to be noncontrolling in this context is by no means unreasonable. So let’s consider what the “first-best” resolution of the tax consequences would be in this setting.
Section 404(a)(5) defers an employer’s deduction for nonqualified deferred compensation until the employee includes those amounts in gross income. In most cases, this directive aligns with deferring the deduction until the compensation is paid by the employer-taxpayer.21 One difference is when the employer sells its trade or business to a third party. Because no logical construction of an income tax would continue to defer the deduction for nonqualified deferred compensation to the original employer beyond that point, it makes sense to adopt the deemed payment approach for the payment of deferred compensation. That is, the buyer’s assumption of the present value of the deferred compensation obligation would be treated as a deemed payment of cash by the purchaser to Hoops, who then uses the cash payment to satisfy the deferred compensation obligations.
Because Hoops had effectively exited the deferred compensation arrangement through its deemed payment, Hoops would be entitled to a deduction for the present-value figure ($10.7 million) at the point of sale.22 Although that approach is consistent with the deemed-payment rule of reg. section 1.461-4(d)(5)(ii) in the economic performance regulations, the result is not mandated by that regulation but instead is guided by the general tax principles embodied in that provision.23
To ensure the proper treatment of the deferred compensation obligation, the buyer would be precluded from deducting the interest inherent in the payment obligation — whether as it accrues economically24 or upon payment of the $12 million amount to the employees.25 Denial of the interest deduction is critical to ensuring that some party (following the sale, the purchaser) is paying tax on the investment yield implicit in the deferred compensation arrangement. Otherwise, the deferred compensation arrangement from that point forward would offer the same tax advantage as qualified plans — namely, exemption of the investment yield from taxation.
Admittedly, the doctrinal basis for denying a deduction for the difference between the buyer’s $10.7 million assumed liability and the $12 million payment is not clear.26 Hence, the “first-best” resolution of the tax treatment of this transaction turns on two leaps of tax-logic faith from a statutory perspective.
As somewhat of an aside, another framing of the transaction that would achieve the proper tax result for the selling taxpayer in this setting — but this time in a manner consistent with the terms of section 404(a)(5) — would be to treat Hoops as effectively conveying property to the employees in satisfaction of their deferred payment obligations through the creation of a payment obligation issued by a third party (the purchaser).27 The scope of an unfunded and unsecured promise to pay entitled to deferral under section 83, properly understood, is limited to payment obligations that are issued by the service recipient.28 A payment to a third party who assumes the obligation (for example, the purchase of an annuity from an insurance company) would create a third-party promise that constitutes property for purposes of section 83. The creation of the third-party promise therefore would trigger inclusion of the present value of the payment obligation in the gross income of the employee at that time. In short, the assignment of the payment obligation by Hoops to the purchaser effectively operates to accelerate payment to the employees29 — one of the forms of self-help suggested by the IRS in this case.
Because the employee would recognize compensation income at the point of sale under this framing, section 404(a)(5) would afford Hoops a deduction for the present-value amount of the obligation. As the deferred compensation arrangement winds up at this point, there is no further need to disallow the interest deduction to the purchaser. The purchaser would generate investment income on the funds set aside to fund the future payment while also being entitled to a deduction for the interest paid or accrued on the obligation.
The employee, on the other hand, would include as interest income the difference between the amount included as compensation (that is, the present value of the payment obligation) and the deferred payment amount. Hence, if the deferred compensation arrangement is effectively terminated by operation of the purchaser’s assumption of the payment obligations, the tax consequences of both the sale and the ongoing arrangement are far more conventional and straightforward.
Suffice it to say that the employees may not cheer the tidiness of this approach. Obtaining the proper tax treatment for the selling taxpayer through this route would be unwelcome and likely surprising news to the employees because they would face income taxation while retaining essentially the same illiquid payment obligation. Explaining to a layperson that their payment obligation was transformed into property because of a change in the identity of their employer is not likely to go over well.
Indeed, the change of the employee’s employer in this setting is too thin of a basis to distinguish a second-party promise to pay (entitled to deferral under section 83) and a third-party promise to pay (that constitutes property for purposes of the statute). Rather, a purchaser of the assets of a trade or business should be treated as stepping into the shoes of the service recipient for purposes of section 83.30 That approach — that is, essentially holding the transaction in abeyance for tax purposes while substituting the purchaser of the assets of a trade or business for the seller from a tax perspective — is consistent with and informs the second-best resolution described below.
V. A Second-Best Solution
If the application of section 404(a)(5) in the context of a taxable asset sale by the original employer indeed inescapably defers a deduction for the nonqualified deferred compensation to the point of income inclusion by the employee, a different tax lens should be applied to the transaction altogether. Importantly, the present value of the deferred compensation deduction assumed by the purchaser should not be included in the amount realized by the seller on the asset sale.
Assumption of a payment obligation should be included in the amount realized by the seller on the asset sale only to the extent the payment obligation constitutes a liability for federal income tax purposes. Not all payment obligations are properly treated as liabilities for tax purposes. Rather, liabilities in this sense are limited to payment obligations that have produced some form of tax benefit for the obligated party — that is, the creation or enhancement of basis in property, an immediate deduction, or some form of consumption that is neither deductible nor subject to capitalization per the terms of the code (most commonly, personal consumption).
That understanding of a liability for tax purposes has been catalogued in tax literature,31 and it is reflected in the regulatory definition of a liability for purposes of section 752.32 This fundamental tax logic also informs the approach of holding the tax consequences attendant to the assumption of trade liabilities (that is, those giving rise to a deduction when paid) by a transferee corporation under section 357(c)(3) and a transferee partnership under 704(c)(3). The same logic is reflected in section 108(e)(2), which excludes a discharge of indebtedness from gross income to the extent payment of the obligation would give rise to a deduction.
These statutory and regulatory embodiments of the theory for when a payment obligation constitutes a liability for tax purposes should not be viewed as idiosyncratic exceptions to a general rule to the contrary. Rather, these provisions merely reflect a broader theory of when the assumption or discharge of a payment obligation should trigger an income tax consequence.
If section 404(a)(5) is applied to deny a taxpayer a deduction for deferred compensation obligations that are assumed by a purchaser in connection with the sale of a business, the taxpayer who initially entered into the deferred compensation arrangement received no tax benefit from the arrangement. No basis was created to the selling party and, up to and including the moment of sale, section 404(a)(5) disallowed a deduction for the expense. Returning to the facts of the case, the obligation of Hoops to make deferred compensation payments therefore did not constitute a liability for tax purposes. Thus, inclusion of the assumption of the $10.7 million present value of the deferred compensation obligations in the amount realized by Hoops upon the sale of its assets was improper.33
Because section 404(a)(5) essentially holds the deduction in abeyance despite the transfer of assets and liabilities to the purchaser, the proper result in this setting would be to permit the purchaser to step into the shoes of the seller for trade liabilities of this sort. That is, because Hoops was denied the deduction under section 404(a)(5), the buyer would assume the role of employer for this purpose and would be entitled to a deduction for the $12 million payment when it actually pays this amount to the employees.34
Because both the seller and the buyer would be precluded from taking a deduction for interest before the payment of the deferred compensation,35 the investment yield implicit in the arrangement would be subject to taxation at the employer level (first to the seller, and following the sale, to the purchaser). Hence, this approach achieves the proper tax treatment of the nonqualified deferred compensation arrangement. This point is numerically illustrated in Table 3 in the appendix.
The shortcomings of the second-best approach in comparison with the first-best option rest in the character effects on the seller’s side and the timing discrepancies on the purchaser’s side. Because the assumption of the deferred payment obligations would not be included in the amount realized under the second-best approach, the seller would be trading an immediate deduction against ordinary income for a (likely) reduced residual allocation to goodwill under section 1060.36 In this case, Hoops would be trading a $10.7 million compensation deduction for a $10.7 million reduction in the purchase price residually allocated to goodwill — swapping an ordinary deduction for reduced capital gain in the process. The purchaser in turn would take a lower overall purchase-cost basis in the acquired assets of the trade or business.
Assuming the same residual allocation to goodwill, the purchaser in the transaction at issue would have $10.7 million less basis in goodwill that would have been amortized over a 15-year period under section 197. On the other hand, the purchaser would be entitled to an ordinary deduction for the $12 million of deferred compensation when paid. Depending on the terms of the deferred compensation arrangement, this trade-off likely would benefit the purchaser. Hence, the overall tax benefits and burdens of the transaction could be subject to negotiation by the parties (that is, if the above-described tax consequences of the transaction are clear).
VI. Conclusion
The opinions of both the Tax Court and the Seventh Circuit in Hoops upholding the IRS’s invocation of section 404(a)(5) despite an intervening sale of the employer’s trade or business appear reasonable on the surface. Section 404(a)(5) provides the rule for the nonqualified deferred compensation context, and the terms of the statute are not ambiguous. However, the application of section 404(a)(5) to defer a deduction to a tax year after the employer disposes of the assets making up its trade or business runs counter to a reasonable measurement of net income.
Because Congress likely did not contemplate the circumstance at issue in Hoops when enacting section 404(a)(5), perhaps there is an opening to achieve the correct result — that is, to apply general tax principles to permit a deduction of the present value of the deferred obligations when assumed by the purchaser of the franchise. The Tax Court and the Seventh Circuit, however, did not view this unique context as providing any daylight for avoiding the terms of section 404(a)(5).
If section 404(a)(5) is indeed inescapable in this setting, the amount of the deferred compensation obligations assumed by the purchaser should not be included in the amount realized by Hoops on the disposition of its business. Because those payment obligations provided no tax benefit to Hoops, the assumption of those obligations should not give rise to a tax detriment. That second-best resolution of the tax consequences of the deferred compensation arrangement in this context, although not ideal, is far superior to deferring the original employer’s deduction to a year subsequent to its exit from the revenue-generating activity.
VII. Appendix
Table 1 shows the tax benefits for an original employer, S, under a range of scenarios pertaining to the timing of the payment of the deferred compensation to the employee, E, and the deduction of the deferred compensation payment to S. This three-period chart is an extension of the two-period chart introduced by Daniel Halperin in his 1996 article exploring the tax treatment of the assumption of contingent liabilities in the context of a sale of a business.37 The chart uses the same assumptions as Halperin’s hypothetical. Payment to the employee would occur at the end of the stated year; both S and E earn a 10 percent rate of return and are subject to a 40 percent tax rate on all income; and the deferred compensation arrangement contains a growth rate equal to the employer’s 6 percent after-tax rate of return.
Table 2 shows the tax treatment of the original employer, S, who sells the assets of a trade or business to purchaser, P, who assumes S’s deferred compensation obligations to employee, E. The comparison uses the same presumptions as Table 1 — that is, all parties earn a 10 percent rate of return and are subject to a 40 percent tax on all income. Also, the deferred payment obligation has a growth rate equal to the employer’s 6 percent after-tax rate of return. Table 2 details the tax benefit to S (columns I and II) and to P (columns III and IV) resulting from the payment in year 3 of compensation having a year 1 value of $100 under two scenarios: (a) S is entitled to a deduction for the present value of the year 3 payment of compensation in year 2 when the assets of the business are sold; and (b) S is entitled to a deduction for the year 3 payment of compensation by P in year 3.
Table 3 shows the tax treatment of the original employer, S, who sells the assets of a trade or business to purchaser, P, who assumes S’s deferred compensation obligations to employee, E. The analysis uses the same presumptions as Table 1 — that is, all parties earn a 10 percent rate of return and are subject to a 40 percent tax on all income. Also, the deferred payment obligation contains a growth rate equal to the employer’s 6 percent after-tax rate of return.
Table 3 details the tax benefit to S and to P resulting from the year 3 payment of deferred compensation under an approach that provides a deduction to S in year 3 and under an approach in which the year 3 deduction flows to the party who makes the deferred compensation payment (in this case, P). Note that if it’s determined that P should step into the shoes for S for deduction purposes, then S need only transfer to P the after-tax value of the deferred compensation obligation (in the example, $63.60) instead of the pretax value of the deferred compensation obligation (in the example, $106) as part of the sale of the business.
| I Year 1 Payment; Year 1 Deduction | II Year 2 Payment; Year 1 Deduction | III Year 2 Payment; Year 2 Deduction | IV Year 3 Payment; Year 1 Deduction | V Year 3 Payment; Year 2 Deduction | VI Year 3 Payment; Year 3 Deduction |
|---|---|---|---|---|---|---|
a. Transfer to E or set aside for E at end of year 1 | 100 | 100 | 100 | 100 | 100 | 100 |
b. Tax benefit in year 1 (40% of a) | 40 | 40 | — | 40 | — | — |
c. Amount retained by S in year 1 | 40 | 140 | 100 | 140 | 100 | 100 |
d. Pretax earnings in year 2 (10% of c) | 4 | 14 | 10 | 14 | 10 | 10 |
e. Tax in year 2 (40% of d) | 1.6 | 5.6 | 4 | 5.6 | 4 | 4 |
f. Net earnings in year 2 (d - e) | 2.4 | 8.4 | 6 | 8.4 | 6 | 6 |
g. Available to S at end of year 2 (c + f) | 42.4 | 148.4 | 106 | 148.4 | 106 | 106 |
h. Distribution to E at end of year 2 | — | 106 | 106 | — | — | — |
i. Tax benefit from year 2 deduction (40% of h) | — | — | 42.4 | — | 42.4 | — |
j. Available to S in year 3 (g - h + i) | 42.4 | 42.4 | 42.4 | 148.4 | 148.4 | 106 |
k. Pretax earnings in year 3 (10% of j) | 4.24 | 4.24 | 4.24 | 14.84 | 14.84 | 10.6 |
l. Tax in year 3 | 1.7 | 1.7 | 1.7 | 5.94 | 5.94 | 4.24 |
m. Net earnings in year 3 (k - l) | 2.54 | 2.54 | 2.54 | 8.9 | 8.9 | 6.36 |
n. Available to S at end of year 3 (j + m) | 44.94 | 44.94 | 44.94 | 157.3 | 157.3 | 112.36 |
o. Distribution to E at end of year 3 | — | — | — | 112.36 | 112.36 | 112.36 |
p. Tax benefit from year 3 deduction (40% of o) | — | — | — | — | — | 44.94 |
q. Retained by S at end of year 3 (n - o + p) | 44.94 | 44.94 | 44.94 | 44.94 | 44.94 | 44.94 |
Consequences to S | I Year 3 Payment; Deduction for Present Value in Year 2 to S | II Year 3 Payment; Year 3 Deduction to S
| Consequences to P | III Year 3 Payment; Deduction for Present Value in Year 2 to S | IV Year 3 Payment; Year 3 Deduction to S |
|---|---|---|---|---|---|
Transfer to E or set aside for E at end of year 1 | 100 | 100 |
|
|
|
Tax benefit in year 1 | — | — |
|
|
|
Amount retained by S in year 1 | 100 | 100 |
|
|
|
Pretax earnings in year 2 | 10 | 10 |
|
|
|
Tax in year 2 | 4 | 4 |
|
|
|
Net earnings in year 2 | 6 | 6 |
|
|
|
Available to S at end of year 2 | 106 | 106 |
|
|
|
Transfer of fund from S to P at end of year 2 | 106 | 106 | Set aside for E at end of year 2 | 106 | 106 |
Distribution to E at end of year 2 | — | — | Distribution to E at end of year 2 | — | — |
Tax benefit from year 2 deduction | 42.4 | — | Tax benefit from year 2 deduction | — | — |
Available to S in year 3 | 42.4 | 0 | Available to P in year 3 | 106 | 106 |
Pretax earnings in year 3 | 4.24 | 0 | Pretax earnings in year 3 | 10.6 | 10.6 |
Tax in year 3 | 1.7 | 0 | Tax in year 3 | 4.24 | 4.24 |
Net earnings in year 3 | 2.54 | 0 | Net earnings in year 3 | 6.36 | 6.36 |
Available to S at end of year 3 | 44.94 | 0 | Available to P at end of year 3 | 112.36 | 112.36 |
Distribution to E at end of year 3 | — | — | Distribution to E at end of year 3 | 112.36 | 112.36 |
Tax benefit from year 3 deduction | — | 44.94 | Tax benefit from year 3 deduction | — | — |
Retained by S at end of year 3 | 44.94 | 44.94 | Retained by P at end of year 3 | 0 | 0 |
Consequences to S | I Year 3 Payment; Year 3 Deduction to S | II Year 3 Payment; Year 3 Deduction to P | Consequences to P | III Year 3 Payment; Year 3 Deduction to S | IV Year 3 Payment; Year 3 Deduction to P |
|---|---|---|---|---|---|
Transfer to E or set aside for E at end of year 1 | 100 | 100 |
|
| — |
Tax benefit in year 1 | — | — |
|
| — |
Amount retained by S in year 1 | 100 | 100 |
|
| — |
Pretax earnings in year 2 | 10 | 10 |
|
| — |
Tax in year 2 | 4 | 4 |
|
| — |
Net earnings in year 2 | 6 | 6 |
|
| — |
Available to S at end of year 2 | 106 | 106 |
|
| — |
Transfer of fund from S to P at end of year 2 | 106 | 63.6 | Set aside for E at end of year 2 | 106 | 63.6 |
Distribution to E at end of year 2 | — | — | Distribution to E at end of year 2 | — | — |
Tax benefit from year 2 deduction | — | — | Tax benefit from year 2 deduction | — | — |
Available to S in year 3 | 0 | 42.4 | Available to P in year 3 | 106 | 63.6 |
Pretax earnings in year 3 | 0 | 4.24 | Pretax earnings in year 3 | 10.6 | 6.36 |
Tax in year 3 | 0 | 1.7 | Tax in year 3 | 4.24 | 2.54 |
Net earnings in year 3 | 0 | 2.54 | Net earnings in year 3 | 6.36 | 3.82 |
Available to S at end of year 3 | 0 | 44.94 | Available to P at end of year 3 | 112.36 | 67.42 |
Distribution to E at end of year 3 | — | — | Distribution to E at end of year 3 | 112.36 | 112.36 |
Tax benefit from year 3 deduction | 44.94 | 0 | Tax benefit from year 3 deduction | — | 44.94 |
Retained by S at end of year 3 | 44.94 | 44.94 | Retained by P at end of year 3 | 0 | 0 |
FOOTNOTES
1 Hoops LP v. Commissioner, 77 F.4th 557 (7th Cir. 2023).
2 Hoops LP v. Commissioner, T.C. Memo. 2022-9.
3 See, e.g., United States v. Hendler, 303 U.S. 564, 566 (1938) (reasoning that the seller’s “gain was as real and substantial as if the money had been paid it and then paid over by it to its creditors”).
4 Reg. section 1.461-4(d)(5)(ii).
6 Hoops, 77 F.4th at 564.
7 See id. at 562.
8 Id.
9 For example, the court noted that the terms of reg. section 1.461-4(d)(5) expressly limit its application to instances in which the deduction would be available but for the economic performance requirement. See id. at 563. Further, the court observed that reg. section 1.461-4(d)(2)(iii) provides 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),” thus further signaling the subordination of the economic performance condition to the terms of section 404(a). See id.
10 Id. at 561 (quoting Albertson’s Inc. v. Commissioner, 42 F.3d 537, 543 (9th Cir. 1994)). The Tax Court made an identical observation in its opinion.
11 See Ethan Yale and Gregg D. Polsky, “Reforming the Taxation of Deferred Compensation,” 85 N.C. L. Rev. 571, 598 (2007) (“A neutral system might tax the employee on the compensatory element at the end of the deferral period, while at the same time allowing the employer to take its compensation deduction [for present value] at the outset.”); Daniel Halperin, “Assumption of Contingent Liabilities on the Sale of a Business,” 2 Fla. Tax Rev. 673, 684 (1996) (explaining that a deduction of the present value of future deferred compensation obligations is “mathematically and economically equivalent” to a future deduction of deferred compensation when paid); see also Table 1 in the appendix below (providing numerical illustrations). This point assumes constant tax rates over the periods at issue and that the implicit investment yield in the deferred compensation arrangement is taxed to the purchaser.
12 The critical assumption of equivalent effective tax rates likely does not hold when the taxpayer sells its business and wraps up operations before the buyer pays the deferred compensation.
13 Hoops, 77 F.4th at 565.
14 See Paresh Dave, “By Deferring Some Earnings, Athletes Can Help Themselves and Their Teams,” Los Angeles Times, Nov. 17, 2013 (discussing the motivation behind Zach Randolph’s deferred compensation arrangement with the Portland Trail Blazers).
15 See section 409A(a)(2)(v) (permitting, to the extent provided in the regulations, a plan to identify a change in control of a corporate employer or a change in ownership of a significant percentage of the corporation’s assets as a permissible acceleration event).
16 For example, a leading treatise notes that a “strict” interpretation of section 404(a)(5) in this setting to postpone the employer’s deduction following the assumption of deferred compensation obligations in connection with the sale of a trade or business may lead to the “ridiculous” result that the seller must include the liability assumption in the amount realized while potentially never receiving an offsetting deduction. See Martin D. Ginsburg, Jack S. Levin, and Donald E. Rocap, Mergers, Acquisitions, and Buyouts para. 304.3(2) (2023); see also Robert H. Wellen, “Contingent Consideration, Contingent Liabilities and Indemnities in Acquisitions (Outline),” William and Mary Annual Tax Conference, at 74 (2014) (noting that the issue “remains in doubt”).
17 This circumstance can be distinguished from an isolated assignment of a deferred compensation obligation for consideration, which, if possible, would amount to a unilateral means of circumventing section 404(a)(5).
18 If the taxpayer were an individual or entity subject to passthrough taxation, the law would limit the ability to take the deduction against salaries or other sources of individual income. Section 461(l) generally limits deductions for business losses of noncorporate taxpayers to $250,000 for single taxpayers and $500,000 for married taxpayers filing jointly, with both thresholds indexed for cost of living. A deduction for any “excess business loss” is disallowed and treated as a net operating loss in the succeeding year under section 172. As a rule, net operating losses may only reduce 80 percent of taxable income in a carryover year. See section 172(a)(2). Although those rules can be critiqued in their own right, the deferral of the selling taxpayer’s deduction under section 404(a)(5) to a point after the trade or business is sold is highly likely to trigger these provisions.
19 In describing the motivation of Congress in enacting the predecessor of section 404(a)(5), the Ninth Circuit in Albertson’s, 42 F.3d at 542, noted that Congress “forced employers who chose to retain their funds for their own use to wait until the end of the deferral period . . . before they could take deductions for deferred compensation payments” (emphasis in original). From this perspective, the matching principle is driven by the employer’s intervening control over the funds that eventually will be paid to the employee. That control obviously ends when the employer sells its trade or business.
20 Many commentators believe a statutory amendment is necessary, at least for the sake of clarity. See Halperin, supra note 11, at 684 (1996) (“The IRS may not be able to allow a deduction at the time of sale without a change in the law.”); see also Yale, “Anti-Basis,” 94 N.C. L. Rev. 485, 506 (2016) (recommending a statutory modification). A doctrinal basis for determining that section 404(a)(5) is not controlling in this setting can be found in the Ninth Circuit’s opinion on reconsideration in Albertson’s. In determining that section 404(a)(5)’s reference to “compensation” also operated to preclude a prior deduction for amounts representing interest in the deferred compensation arrangements, the Ninth Circuit rejected a literal interpretation of the statute because treating interest payments as falling outside section 404(a)(5) “would contravene the clear purposes of the taxation scheme governing deferred compensation arrangements.” Albertson’s, 42 F.3d 537, 546. Here, the “clear purpose of the taxation scheme” has an inverse effect. Because Hoops included the present value of the assumed deferred compensation obligations in its amount realized upon the sale of the franchise on grounds that it was deemed to have satisfied those obligations, it is appropriate to remove those deemed payments from the continued reach of section 404(a)(5).
21 Indeed, the legislative history accompanying the predecessor of section 404(a) emphasizes the payment by the employer rather than inclusion by the employee: “If an employer on the accrual basis defers paying any compensation to the employee until a later year or years . . . he will not be allowed a deduction until the year in which the compensation is paid.” (Emphasis added.) H.R. Rep. No. 77-2333 (1942), 1942-2 C.B. 372, 452; S. Rep. No. 77-1631 (1942), 1942-2 C.B. 504, 609.
22 Numerous commentators have explored this issue favor permitting the seller a deduction upon assumption of the deferred compensation obligations. See New York State Bar Association Tax Section, “Report of Proposed Regulations Relating to Economic Performance Requirements,” Rept. No. 673, at 12 (Nov. 7, 1990) (“It is submitted that it would be appropriate to allow the seller to deduct the [deferred compensation obligations] at the time of the asset sale . . . even where the service provider has not yet recognized income.”); see also Yale, supra note 20, at 506; and Halperin, supra note 11, at 710.
23 As illustrated in Table 2 in the appendix, the deemed payment approach does not provide a structural tax advantage to the taxpayer selling the business in relation to the deferral of the deduction to the selling taxpayer until the compensation is paid to the employee. Rather, assuming equivalent tax rates over all periods, the tax consequences of the two approaches are the same. The deemed-payment approach, however, avoids the likely prospect of the selling taxpayer’s deduction being significantly devalued because of being deferred to a period after the revenue-generating activity has ceased.
24 See Albertson’s, 42 F.3d 537 (denying payment of interest implicit in a nonqualified deferred compensation arrangement as it economically accrued).
25 See Halperin, supra note 11, at 682 (“It is . . . the denial of the interest deduction, not the deferral, that is important.”); see also Yale, supra note 20, at 506 (“Allowing the buyer a further deduction for the difference between the time 0 and time 1 value of the claim would replicate part of the seller’s deduction.”). The necessity of denying an interest deduction to the purchaser to achieve parity in the tax treatment of the deferred compensation arrangement is numerically illustrated in Table 1 in the appendix below.
26 The holding of the Ninth Circuit in Albertson’s would not cover this situation because the purchaser of the business is not taking a deduction under section 404(a)(5) when it makes payment of the deferred compensation. See Albertson’s, 42 F.3d 537 (holding that the matching principle embodied in section 404(a)(5) precludes a deduction for interest inherent in the deferred compensation obligation before its payment). Rather, the compensation deduction would be taken by the seller at closing, leaving the purchaser in the position of simply retiring an implicit loan from the employee when the deferred compensation is actually paid.
27 Conceptually, the cash that the selling party could have retained to satisfy the deferred payment obligations is being transferred to the purchasing party who assumes the payment obligation.
28 See, e.g., United States v. Drescher, 179 F.2d 863 (2d Cir. 1950); Brodie v. Commissioner, 1 T.C. 275 (1942); Rev. Rul. 77-420, 1977-2 C.B. 172; Rev. Rul. 69-50, 1969-1 C.B. 140; see also Polsky and Brant J. Hellwig, “Taxing the Promise to Pay,” 89 Minn. L. Rev. 1192, 1125-1150 (2005) (making this point through an exploration of the bounds of an unfunded and unsecured promise to pay under reg. section 1.83-3(e) on doctrinal and policy grounds). But see Childs v. Commissioner, 103 T.C. 634 (1994) (holding that an annuity issued to a plaintiff’s attorney by the defendant’s insurance company does not constitute property for purposes of section 83; the attorney was therefore entitled to defer recognition of compensation income until payments were received under the annuity). The IRS recently announced its intention to interpret Childs narrowly in this setting, essentially rejecting the reasoning of the case in the process. See AM 2022-007 (Dec. 2, 2022).
29 Indeed, many nonqualified deferred compensation arrangements call for the plan to be cashed out (or for rabbi trusts to be converted to secular trusts) upon a change in control in a corporate employer or upon a change in ownership of a substantial portion of the corporation’s assets. See section 409A(a)(2)(v) (permitting acceleration in this circumstance to the extent provided in the regulations).
30 As a matter of substance, this circumstance is far different than the service recipient’s purchase of an annuity from an insurance company payable to the employee.
31 For a definitive explanation of when a liability produces a tax benefit necessitating a tax consequence upon its assumption or discharge, see Yale, supra note 20.
32 See reg. section 1.752-1(a)(4).
33 Hoops made this argument before the Tax Court, to no avail. The Tax Court rejected the argument with little in the way of analysis, apart from highlighting that Hoops was relieved of a fixed payment obligation. Hoops dropped this argument on appeal to the Seventh Circuit.
34 See Halperin, supra note 11, at 710 (arguing in favor of ignoring the assumption of contingent liabilities that cannot be definitively valued that are assumed upon the sale of a business when determining the tax consequences to the seller, and noting that this treatment “might be extended to those fixed liabilities that will lead to future deductions”).
35 See Albertson’s, 42 F.3d 537 (denying payment of interest implicit in a nonqualified deferred compensation arrangement as it economically accrued).
36 That discrepancy would be mitigated, however, by an increase in the cash consideration received by the seller on the transaction owing to the deductibility of the assumed liability in the hands of the purchaser (under the second-best approach).
37 See Halperin, “Assumption of Contingent Liabilities on Sale of a Business,” 2 Fla. Tax Rev. 673 (1996).
END FOOTNOTES