In brief

A recent decision by the US Court of Appeals for the Seventh Circuit in Hoops v. Commissioner, 77 F.4th 557 (7^th Cir. 2023), affirmed the Tax Court’s 2022 decision that Section 404(a)(5) precludes the seller of a trade or business from claiming a deduction for nonqualified deferred compensation liabilities assumed by the purchaser until the compensation has been paid to the employees. 

The appellate court disagreed with the taxpayer that the purchaser’s assumption of the liabilities was a “deemed payment” that accelerated the deduction for the liabilities to the year of the asset sale under Reg. 1.461-4(d)(5)(i). In the court’s opinion, the transfer of the nonqualified deferred compensation liabilities as part of the asset sale did not change the requirements for deductibility of Section 404(a)(5), concluding that taxpayers must satisfy the clear rule of Section 404(a)(5) before the liability is deductible.

For consideration:  Taxpayers should evaluate the potential impact of this case when contemplating the sale or other transfer of a trade or business, because it is the ultimate payment to the employees that dictates when the seller is entitled to claim a deduction for nonqualified deferred compensation liabilities. Absent appropriate planning, there could be situations in which the seller of a trade or business may not be able to benefit from the deduction associated with this type of liability in the same year as the sale.

Appellate court’s opinion emphasizes statutory construction 

In affirming the Tax Court decision, the Seventh Circuit applied the principles of statutory construction to Sections 404 and 461 by examining Congressional intent and by invoking the principle that requires specific provisions to prevail over more general provisions.

The court’s analysis begins with the general rule of Section 461(h), which provides that economic performance of services occurs as employees render them. Based on its examination of Section 404(a)(5), however, the court then concluded that Section 404(a)(5) includes “mandatory language” that provided a controlling rule, reflecting Congressional intent to treat the deductibility of deferred compensation salary plans differently than ordinary service expenses. According to the court, it was not Section 461(h)'s economic performance requirement that prevented the taxpayer from claiming the deduction when the services were provided, but the rule in Section 404(a)(5) governing nonqualified deferred compensation plans.

After comparing the scope of the two provisions, the court agreed with the IRS that the specific treatment of nonqualified deferred compensation plans by Section 404(a)(5) prevails over the broader treatment prescribed by Reg. 1.461-4(d)(5)(i) of assumed liabilities in connection with the sale of businesses. In this regard, the opinion analyzes the language of Reg. 1.461-4(d)(2)(iii), which treats the economic performance requirement as satisfied to the extent that any amount is otherwise deductible under Section 404.

In the court’s view, the express reference in Reg. 1.461-4(d)(2)(iii) to Section 404 directs taxpayers to return to Section 404 before confirming that a deduction is available under the acceleration provision of Reg. 1.461-4(d)(5)(i). Consistent with the rules of statutory construction, the court concluded that the general timing rules of Section 461(h) did not apply until after the taxpayer met the specific requirements of Section 404(a)(5) for nonqualified deferred compensation plans. Accordingly, the taxpayer could not claim a deduction under Section 404(a)(5) until the players received payment.

Observation: The appellate court also noted the effect that “Section 404(a)(5)‘s deductibility timing direction has on the application of ordinary accrual rules.” According to the court, Section 404 effectively requires all employers utilizing deferred compensation to use the cash method of accounting, establishing a “matching rule” that results in employers deducting deferred compensation expenses and employees reporting income in the same tax year. Because application of Section 461(h) is limited to taxpayers using the accrual method, the court concluded that the exception set forth in Reg. 1.461-4(d)(5)(i) for liabilities assumed in connection with the sale of a trade or business did not apply to nonqualified deferred compensation.

Finally, the court declined to accept the taxpayer’s concerns about the practical implications of the decision and the assented inequitable result. According to the court, the taxpayer could have taken action before the sale took place by adjusting the sales 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.

Observation: The Seventh Circuit decision addresses the deduction of nonqualified deferred compensation liabilities assumed by the purchaser of a trade or business. A question may arise whether the rationale of the decision could be viewed as affecting whether cash-method taxpayers may deduct any of their liabilities assumed by the purchaser of a trade or business, because the liabilities generally are not paid at the time of the sale. In Com. Sec. Bank v. Commissioner, 77 T.C. 145 (1981), the Tax Court allowed a deduction for other operating liabilities under the reasoning that the seller of a trade or business made a constructive payment to the purchaser to satisfy the liabilities when it accepted less cash than otherwise would have been received had the liability been retained. Cash-method taxpayers should analyze continued reliance on the holding of Com. Sec. Bank when engaging in the sale of a trade or business.

Observation: All transactions involving the transfer of nonqualified deferred compensation liabilities should be evaluated to determine the potential impact of this ruling, under which the rules of Reg. 1.461-4(d)(5)(i) may not permit the seller to deduct the liability, even in situations where the liability otherwise was included in the amount realized under Section 1001.