Tax Court in Brief | Hoops, LP v. Commissioner: Deductibility of Deferred Compensation

The Tax Court in Brief – February 21 – 25th 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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Tax Litigation:  The Week of February 21, 2022, through February 25, 2022

• Hicks v. Comm’r, T.C. Memo. 2022-10 | February 23, 2022  | Gale, J. | Dkt. No. 10406-17

Hoops, LP v. Comm’r, T.C. Memo. 2022-9 | February 23, 2022  | Nega, J. | Dkt. No. 11308-18

Opinion

Short Summary: Hoops, LP owned the Memphis Grizzlies, an NBA franchise. In 2012, Hoops sold substantially all its assets, and assigned its liabilities to a buyer. The liabilities included two NBA player contracts and deferred compensation that earned by the players but not due to be paid by Hoops until after the 2012 sale. In computing its gain on the 2012 sale, Hoops claimed $10,673,327 (total deferred compensation discounted by 3%) as a deduction on Hoops’ 2012 return. The IRS issued a notice of final partnership administrative adjustment (FPAA) for the 2012 tax year, disallowing the deduction. Heisley Member, Inc., the tax matters partner of Hoops, filed a petition for readjustment. By the parties’ concessions, the case focuses on Section 404(a)(5) of the Internal Revenue Code and the deductibility of compensation that is earned but payable in a later year under a nonqualified plan of deferred compensation.

Primary Holdings: 

• Section 162(a) contains the general rule for allowing a deduction for expenses incurred in carrying on any trade or business, including a reasonable allowance for compensation for personal services. However, if amounts are contributed by an employer under any plan of deferred compensation, deductibility is governed by Section 404(a).
• Under Section 404(a)(5), if an employer on the accrual basis defers paying any compensation to the employee until a later year or years, the employer will not be allowed a deduction until the year in which the compensation is paid.
• Hoops had not paid any amounts owed to the players with respect to the deferred compensation liability in 2012, and thus, Hoops is not allowed to deduct the amount of the deferred compensation.
• When Buyer assumed the deferred compensation liability, Hoops was discharged from its obligation to pay deferred compensation. Thus, pursuant to Section 1001, Hoops was required to take into account the amount of the deferred compensation liability in computing Hoops’ gain or loss from the sale.

Key Points of Law:  

• The Tax Court is a court of limited jurisdiction. The Court’s jurisdiction over a TEFRA partnership-level proceeding is invoked upon the Commissioner’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. See 26 U.S.C. § 6226(a).
• The Commissioner’s determinations in an FPAA are presumed correct, and the party challenging the FPAA bears the burden of proving that those determinations are erroneous.
• A disregarded entity for federal tax purposes but a general partner under state law may be designated the tax matters partner of a partnership subject to the TEFRA partnership provisions.
• Deductions are a matter of legislative grace, and the burden is on the challenging party to prove entitlement to any claimed deductions.
• Section 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. See 26 U.S.C. § 162(a)(1). However, if amounts are contributed by an employer under any plan of deferred compensation, Section 404(a) governs the deductibility of such amounts and prescribes limitations as to the amount deductible for any year. Treas. Reg. § 1.404(a)-1(a)(1); see also Reg. § 1.162-10(c).
• Section 404(a)(5) covers all cases for which deductions are allowable under Section 404(a) but not allowable under paragraph (1), (2), (3), (4), or (7) of that subSection. See Reg. § 1.404(a)-12(a).
• Section 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. See also Reg. § 1.404(a)-12(b)(1).
• 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. See 26 U.S.C. § 461(h); Treas. Reg. §§ 1.446- 1(c)(1)(ii)(A), 1.461-1(a)(2)(i). However, if another provision of the Code or the Regulations prescribes the manner in which deferred compensation liability is taken into account, that prescription controls over the economic performance rule. In this case, Section 404(a)(5) prescribes the manner in which the deferred compensation in issue is taken into account.
• Section 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. 26 U.S.C. § 1001(b); Treas. Reg. § 1.1001-2(a)(1).

Insights: When a taxpayer, as part of the sale of a business, assigns to the buyer, liabilities for earned compensation that is payable in a later tax year pursuant to a nonqualified deferred compensation plan, the taxpayer should take into account and closely evaluate Section 404 of the Code and its effect on the proper account of gain to be realized from the sale of the business. As shown in Hoops, L.P., and under the special rules for deductions set forth in Section 404, if an employer on the accrual basis defers paying any compensation to the employee until a later year or years, the employer will not be allowed a deduction until the year in which the compensation is paid, even if the compensation would otherwise be deductible under Section 162.

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