On February 23, 2022, the Tax Court issued a Memorandum Opinion in the case of Hoops LP v. Commissioner (T.C. Memo. 2022-9). The primary issues presented in Hoops LP v. Commissioner were whether partnership was entitled to deduct deferred compensation owed to two of its basketball franchise’s players, and whether the partnership was required to take into account the amount of its deferred compensation liability for players when computing its taxable gain or loss from sale of franchise under IRC § 1231.
Held: No. Yes. Win, IRS.
Background to Hoops LP v. Commissioner
The petition was before the court for readjustment of the final partnership administrative adjustment (FPAA) issued to the partnership’s tax matters partner for 2012. In the March 2018 FPAA, the IRS disallowed an additional deduction of $10,673,327 for salaries and wages that Hoops LP (“Hoops”) claimed on its Form 1065X, Amended Return or Administrative Adjustment Request (AAR), for tax year 2012 using the accrual method of accounting. The additional deduction Hoops claimed for salaries and wages related to unpaid deferred compensation liabilities assumed by the purchaser of substantially all of Hoops’ assets in 2012.
Hoops was formed in 2000 for the purpose of acquiring, owning, operating, and conducting a sports franchise within the rules, guidelines, and other requirements established by the NBA. The general partner was also the tax matters partner under TEFRA.
On May 11, 2000, Hoops acquired the Vancouver Grizzlies and proceeded to move the franchise to Memphis in 2001. Hoops owned and operated the Grizzlies from the date it acquired the franchise until it sold the franchise in 2012.
In 2012 Memphis Basketball, LLC (Buyer), agreed to purchase substantially all of the assets and to assume substantially all of the liabilities and obligations of Hoops. As of October 2012, Hoops sold substantially all of its assets and transferred substantially all of its liabilities and obligations to Buyer in the 2012 sale. One of the liabilities Buyer assumed in the 2012 sale was the liabilities and obligations under certain binding agreements, which included NBA Uniform Player Contracts for Zach Randolph and Michael Conley.
Randolph played for the Grizzlies from July 2009, through the end of the 2016–17 NBA season. Randolph earned deferred compensation of $4,800,000 during the 2009–10 NBA season, $5,200,000 during the 2010-2011 season, and he earned $1,835,122 during the lockout-shortened 2011-2012. These amounts were due to be paid by Hoops as determined on dates after the 2012 sale. Conley played for the Grizzlies and earned $804,878 during the shortened 2011-2012 season.
Gain on Sale and Tax Reporting
In computing its gain on the 2012 sale Hoops reported a total amount realized of $419,394,032, consisting of $200,690,000 of cash, $218,704,032 of liabilities assumed by Buyer, and other adjustments. Hoops reported an adjusted basis of $120,370,493 in the assets that it sold to Buyer. Thus, Hoops recognized gain of $299,023,539 on the 2012 sale.
As of the date of the 2012 sale the deferred compensation liability had an accrued value of $12,640,000. For purposes of computing the amount realized by Hoops on Buyer’s assumption of the deferred compensation liability, Hoops discounted the sum of the future payments to be made to Messrs. Randolph and Conley with a discount rate of 3%. As such, Hoops included $10,673,327, the present value of the deferred compensation liability, in its amount realized in computing its gain on the 2012 sale.
Tax Returns, FPAA, and Petition
On September 16, 2013, Hoops filed Form 1065, U.S. Return of Partnership Income, for its 2012 taxable year (January through December), using the accrual method of accounting. On its original 2012 tax return, Hoops:
- did not claim an ordinary deduction of $10,673,327 relating to the deferred compensation liability,
- did not reduce its amount realized on the sale by $10,673,327 for the deferred compensation liability, and
- did not adjust its basis in any property it owned as a result of the deferred compensation liability.
On October 10, 2013, Hoops filed Form 1065X for its taxable year ending December 31, 2012 (amended 2012 tax return), which respondent received in October 2013. On its amended 2012 tax return Hoops claimed an additional deduction of $10,673,327 relating to the deferred compensation liability.
Hoops explained that it was claiming the additional deduction because no deduction was claimed on the original 2012 tax return under Treasury Regulation § 1.461-4(d)(5) to reduce the partnership’s deferred compensation liability included in the amount realized. In March 2018, the IRS issued an FPAA for the partnership’s 2012 tax year to Hoops’ tax matters partner disallowing the additional deduction Hoops claimed on its amended 2012 tax return relating to the deferred compensation liability.
Jurisdiction of Tax Court
The Tax Court has jurisdiction only when it has been given jurisdiction. However, the Tax Court has the jurisdiction to determine whether it has jurisdiction. Even where the parties do not raise the issue, as in this case, the Tax Court is required to resolve a question as to its jurisdiction on its own initiative.
The Tax Court’s jurisdiction over a TEFRA partnership-level proceeding is invoked upon the IRS’s issuance of a valid FPAA and the proper filing of a petition for readjustment of partnership items for the year or years to which the FPAA pertains. In the present case, the tax matters partner (who we refer to as Hoops hereafter for simplicity’s sake) timely filed a petition with the Tax Court within 90 days after the IRS mailed the FPAA.
No Entitlement to Deduction for Deferred Compensation Liability in 2012
IRC § 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Ordinarily, the deductibility of compensation paid or incurred by an employer to or on account of an employee is governed by IRC § 162(a).
However, if amounts are contributed by an employer under a pension, annuity, stock bonus, or profit-sharing plan, or under any plan of deferred compensation, IRC § 404(a) governs the deductibility of such amounts and prescribes limitations as to the amount deductible for any year.
The parties agree that the compensation at issue was a nonqualified plan of deferred compensation, the deductibility of which is governed by IRC § 404(a). Specifically, the parties agree that the deferred compensation liability at issue reflects an arrangement as described in IRC § 404(a)(5), which covers all cases for which deductions are allowable under IRC § 404(a) but not allowable under paragraph (1), (2), (3), (4), or (7) of that subsection.
Deductibility Under IRC § 404(a)(5)
IRC § 404(a) provides, in pertinent part, that
if compensation is paid or accrued on account of any employee under a plan deferring the receipt of such compensation, such … compensation shall not be deductible under this chapter; but, if [the compensation] would otherwise be deductible, [it] shall be deductible under this section, subject, however, to the following limitations as to the amounts deductible in any year.
Thus, in order to be deductible under IRC § 404(a), compensation “must be expenses which would be deductible under IRC § 162 (relating to trade or business expenses) or IRC § 212 (relating to expenses for production of income) if it were not for the provision in IRC § 404(a) that they are deductible, if at all, only under IRC § 404(a).” Relevant to this case is that the compensation, which would otherwise be deductible, is further subject to the limitations under IRC § 404(a)(5) as to the amount deductible for any year.
IRC § 404(a)(5) provides that, in a case of a nonqualified plan, a deduction for deferred compensation paid or accrued is allowable for the taxable year for which an amount attributable to the contribution is includible in the gross income of the employees participating in the plan. The regulations under IRC § 404(a)(5) further confirm that
[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, and then only to the extent allowable under IRC § 404(a).
Under the plain terms of IRC § 404(a)(5), Hoops is not allowed to deduct deferred compensation until the taxable year for which an amount attributable to the compensation is includible in the employee’s gross income. The parties agree that Hoops had not paid any amounts owed to Randolph or Conley with respect to the deferred compensation liability in 2012 and, therefore, no amounts were includible in their gross incomes as compensation.
Thus, even if the deferred compensation liability was otherwise deductible under IRC § 162, Hoops is not entitled to a deduction for the deferred compensation liability for 2012 because no amounts attributable to the compensation were includible in the gross incomes of Randolph and Conley. Instead, pursuant to IRC § 404(a)(5), any deduction for an amount attributable to the compensation is allowed when the amount is includible in the gross incomes of Randolph and Conley.
Accordingly, the Tax Court sustained the IRS’s determination to disallow the additional deduction of $10,673,327 relating to the deferred compensation liability that Hoops claimed on its amended 2012 tax return.
Petitioner’s Economic Performance Argument
Despite the plain text of IRC § 404(a)(5), Hoops argues that IRC § 461(h) and the regulations promulgated thereunder nevertheless allow Hoops to deduct the deferred compensation liability for the year of the sale. Specifically, Hoops argues that the timing rule in IRC § 404(a) is incorporated into the economic performance requirement of IRC § 461(h) and, in the present case, is accelerated under Treasury Regulation § 1.461-4(d)(5)(i) (sale provision).
The Tax Court then stated plainly, “[Hoops’] reliance on the economic performance requirement of IRC § 461(h) is misplaced.”
To use parlance that Hoops will understand, this argument was a turrible airball.
IRC § 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 § 446. An accrual method taxpayer is generally entitled to deduct expenses for the years in which the taxpayer incurred the expenses, regardless of the actual payment dates.
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:
- establish the fact of the liability,
- the amount of the liability can be determined with reasonable accuracy, and
- economic performance has occurred with respect to the liability.
In this case the parties agree that Hoops incurred the deferred compensation liability, as of the date of the 2012 sale, because all the events had occurred that establish the fact of the deferred compensation liability, the amount can be determined with reasonable accuracy, and economic performance occurred.
The regulations under IRC § 461, however, further instruct that if, as here, the taxpayer uses an accrual method of accounting, “[a]pplicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account.” Thus, under the regulations, the initial question is whether another provision of the Code or the Regulations prescribes the manner in which the deferred compensation liability is taken into account.
As discussed in the previous section, IRC § 404(a)(5) is the applicable Code provision that governs the deductibility of and prescribes the manner in which a deferred compensation liability is taken into account. Under the plain text of IRC § 404(a)(5), a deduction for deferred compensation is taken into account only for the taxable year in which an amount attributable to the contribution is includible in the gross income of the employee and then only to the extent allowable under IRC § 404(a).
As the Tax Court previously concluded, Hoops is not entitled to deduct the deferred compensation liability for the year of the sale because no amounts attributable to the compensation were includible in the gross income of Randolph or Conley. This result remains the same, regardless of the fact that Hoops files its returns using the accrual method of accounting.
Accordingly, the Tax Court goes on, Hoops’ reliance on the sale provision is misplaced because it is the IRC § 404(a)(5) limitation as to the amount deductible for any year that precludes deduction for the year of the 2012 sale, not any purported failure to satisfy the economic performance requirement.
Hoops also argues that, if IRC § 404(a)(5) and the tax accounting rules were applied in a manner that would deny Hoops a deduction, it would “lead to the ridiculous result” of Hoops including the deferred compensation liability in its sale proceeds but potentially never obtaining an offsetting deduction. Thus, Hoops contends that allowing Hoops to deduct the deferred compensation liability for the year of the 2012 sale comports with the purpose of clearly reflecting income.
In Jacobs v. Commissioner, the Tax Court stated that IRC § 404(a)(5) “removes arrangements from the normal rules of tax accounting, regardless of which method of accounting a taxpayer uses.” In looking at Congress’s intent for the special timing rule for deferred compensation, the U.S. Court of Appeals for the Ninth Circuit noted in Albertson’s, Inc. v. Commissioner, that
Congress provided a single explanation for the timing restrictions of IRC § 404(a)(5): to ensure matching of income inclusion and deduction between employee and employer under nonqualified plans. As both the House and Senate Reports note, “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.”
The Ninth Circuit further noted that Congress exempted contributions to qualified retirement plans from the special timing rule in IRC § 404(a) because Congress “compensates employers for meeting the burdensome requirements associated with qualified plans by granting them favorable tax treatment.”
Holding Part One
Accordingly, in the light of Congress’ 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 Tax Court concluded that disallowing a deduction for the year of sale would not lead to a “ridiculous result.” To the contrary, the Tax Court observed that “under the facts of this case, such a result comports with the clear purpose of IRC § 404.”
Necessary Inclusion of Deferred Compensation Liability in Computing Gain on Sale
Alternatively, Hoops argues that, if the Tax Court finds that the deferred compensation liability is not deductible for the year of the 2012 sale, as it did rather summarily, then either the deferred compensation liability should not have been included in the sale price or Hoops should be entitled to offset or reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability.
Once more, the Tax Court disagreed.
IRC § 1001(a) provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis. The “amount realized” 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.
Hoops 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 petitioner argues that the deferred compensation liability is not a liability within the meaning of IRC § 1001 because it was not included in basis and did not give rise to a deduction.
In support of its position, petitioner asserts that Congress intended for IRC § 404(a)(5) to delay the employer’s deduction to the year for which the payment is includible in the employee’s gross income, not to create an asymmetry in which a liability was never included in basis or deducted. Thus, Hoops contended that the Tax Court should avoid applying IRC § 404(a)(5) and avoid this asymmetry by adopting the definition of liability already applied by the Tax Court and the Supreme Court.
Here, the parties agree that Randolph and Conley had already performed the services. Therefore, Hoops had an obligation to pay the deferred compensation. When the buyer assumed the deferred compensation liability, Hoops was discharged from its obligation to pay deferred compensation as a result of the 2012 sale. Thus, pursuant to IRC § 1001, Hoops was required to take into account the amount of the deferred compensation liability in computing its gain or loss from the sale.
Hoops further argues that it should be entitled to offset or reduce its amount realized on the 2012 sale by the amount of the deferred compensation liability. Hoops cites James M. Pierce Corp. and Commercial Security Bank for the proposition that either the buyer assumes the liability and pays the seller the net cash amount or the buyer pays the gross cash amount and the seller uses a portion to satisfy the liability. Thus, in substance, by accepting less cash than the seller otherwise would have received had it retained the liability, it effectively made a constructive payment to the buyer to satisfy the liability.
However, Commercial Security Bank and James M. Pierce Corp. are distinguishable, namely, because they did not involve deferred compensation subject to IRC § 404(a)(5). Indeed, IRC § 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. This result is consistent with Congress’ intent for nonqualified plans under IRC § 404(a), as discussed in the previous section, to deviate from the clear reflection of income principle and require matching of income inclusion and deduction between the employee and employer.
Holding Part Deux
Accordingly, Hoops must include the deferred compensation liability in its amount realized on the 2012 sale and is not entitled to offset or reduce its amount realized by the amount of the deferred compensation liability.
- Judge v. Commissioner, 88 T.C. 1175, 1180-81 (1987); Naftel v. Commissioner, 85 T.C. 527, 529 (1985). ↑
- Hambrick v. Commissioner, 118 T.C. 348, 350 (2002); Pyo v. Commissioner, 83 T.C. 626, 632 (1984); Kluger v. Commissioner, 83 T.C. 309, 314 (1984). ↑
- Powell v. Commissioner, 96 T.C. 707, 710 (1991). ↑
- See Harbor Cove Marina Partners P’ship v. Commissioner, 123 T.C. 64, 78 (2004). ↑
- See IRC § 6226(a). ↑
- See IRC § 162(a)(1). ↑
- Treas. Reg. § 1.404(a)-1(a)(1); see also Treas. Reg. § 1.162-10(c). ↑
- Treas. Reg. § 1.404(a)-12(a). ↑
- Treas. Reg. § 1.404(a)-1(b). ↑
- Treas. Reg. § 1.404(a)-12(b)(1). ↑
- So sayeth, Sir Charles. ↑
- IRC § 461(h)(4); Caltex Oil Venture v. Commissioner, 138 T.C. 18, 23 (2012); Treas. Reg. § 1.461-1(a)(2). ↑
- IRC § 461(h); Treas. Reg. § 1.446-1(c)(1)(ii)(A); Treas. Reg. § 1.461-1(a)(2)(i). ↑
- Treas. Reg. § 1.461-1(a)(2)(i); Treas. Reg. § 1.446-1(c)(1)(ii)(A). ↑
- See JP Morgan Chase & Co. v. Commissioner, 458 F.3d 564, 568 (7th Cir. 2006), aff’g in part, vacating in part, and remanding Bank One Corp. v. Commissioner, 120 T.C. 174 (2003). ↑
- See Treas. Reg. § 1.404(a)-12(b)(1). ↑
- See Jacobs v. Commissioner, 45 T.C. 133, 136 (1965). ↑
- See Treas. Reg. § 1.404(a)-1(c). ↑
- See H.R. Rep. No. 77-2333 (1942); S. Rep. No. 77-1631 (1942). ↑
- 45 T.C. at 135. ↑
- 42 F.3d 537, 543 (9th Cir. 1994), aff’g 95 T.C. 415 (1990) ↑
- H.R. Rep. No. 2333 (1942); S. Rep. No. 1631 (1942). ↑
- Albertson’s, Inc., 42 F.3d at 543. ↑
- IRC § 1001(b); Treas. Reg. § 1.1001-2(a)(1). ↑
- See Tufts v. Commissioner, 461 U.S. 300 (1983); Focht v. Commissioner, 68 T.C. 223 (1977); Treasury Regulation § 1.752-1(a)(4). ↑
- Com. Sec. Bank v. Commissioner, 77 T.C. 145, 148–49 (1981) (citing Crane v. Commissioner, 331 U.S. 1 (1947)). ↑
- 326 F.2d 67 (8th Cir. 1964), rev’g 38 T.C. 643 (1962). ↑
- 77 T.C. at 149. ↑
- See James M. Pierce Corp., 326 F.2d at 71-72. ↑
- Com. Sec. Bank, 77 T.C. at 149 (citing James M. Pierce Corp., 326 F.2d at 71-72). ↑
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