Deferred compensation deduction denied under section 404(a)(5)

ARTICLE | September 06, 2023

Authored by RSM US LLP

Executive summary: Hoops Tax Court decision affirmed

The Seventh Circuit affirmed the Tax Court’s decision in Hoops LP et al. v. Commissioner (T.C. Memo. 2022-9 (Feb. 23, 2022)), in which the Court applied the timing rule in section 404(a)(5) to deny the taxpayer a deduction for a deferred compensation liability assumed by the buyer in a taxable asset sale.

Deferred compensation deduction denied under section 404(a)(5)

Hoops Tax Court decision upheld by Seventh Circuit: Denial of deduction for deferred compensation under section 404(a)(5) timing rules

In February 2022, the Tax Court held in Hoops that an employer-seller could not take a deduction for a deferred compensation liability assumed by the buyer in a taxable asset sale in the year of sale. The court concluded that the rule in Reg. section 1.461-4(d)(5), allowing sellers to accelerate deductions for certain buyer-assumed liabilities to the year of sale does not override section 404’s rules governing deductions of deferred compensation. Thus, the court ruled that in the case of a buyer-assumed liability for nonqualified deferred compensation payable to an employee, the employer-seller’s deduction is deferred until the employee includes the income in their gross income, as required under section 404(a)(5). These rules generally defer the deduction until the employee’s year ends, which is not until Dec. 31st for calendar year employees. Therefore, when a transaction occurs and the seller does not have a tax return with Dec. 31st in its tax period, the seller may permanently lose the deduction.

On Aug. 9, 2023, the Seventh Circuit affirmed the Hoops decision (Hoops LP et al. v. Commissioner; No. 22-2012). It is worth noting that in the Tax Court decision, despite having to defer its deduction, the taxpayer was still required to report the assumption of the liability as income (as increased gain on sale). The Seventh Circuit opinion briefly addresses the taxpayer’s argument that the possibility of losing the deduction altogether makes this decision inequitable, finding that such a risk is foreseeable given the clear application of the rules of section 404(a)(5). Additionally, the Circuit Court pointed out that the taxpayer could have accounted for that risk by negotiating contractual provisions, including adjusting the sales price.

For a more detailed discussion of the technical issues addressed in the Tax Court’s opinion in Hoops, see our prior article: Liability assumption in M&A: Tax Court addresses income and expense.