Timing issues are one of the aspects of effective tax planning. There are scores of options for timing and tax deferral and recognition that depend on the taxpayer’s circumstances.
For example, for corporate taxpayers, these timing issues may involve timing the receipt of income using the installment rules or the use of losses or foreign tax credits in years where the tax liability is expected to be higher. It may include accounting methods, capitalization rules, and inventory rules. It may also involve structuring payments as loans.
It may also involve the strategic disposition of assets or even liquidating the business to accelerate tax deductions. With this, there is a question as to whether you can trigger a tax deduction now by selling a business when the business would not otherwise be able to take advantage of the deduction for several years.
The recent Hoops, LP v. Commissioner, No. 22-2012 (7th Cir. 2023) addresses this in the context of the sale of a business when the buyer assumes the liability for the non-qualified deferred compensation obligations of the seller. The court had to consider whether the seller can structure an unfunded non-qualified deferred compensation plan and then trigger an immediate deduction by selling the business. The case is not limited to non-qualified deferred compensation. The same concepts apply to just about any liability owed by a business that is being sold.
Facts & Procedural History
The taxpayer was a limited partnership. It owned the rights to the NBA Grizzlies basketball team. It had a non-qualified deferred compensation plan that was payable to two of the team’s players.
The owners of the entity sold the business in 2021, and structured the sale as an asset sale. The purchase price was $200 million in cash and the buyer assumed $219 million in liabilities. Of the liabilities, the buyer assumed the $10 million dollar liability under the non-qualified deferred compensation plan.
The taxpayer treated the $10 million dollar assumption as a business expense. This was based on the premise that the buyer paid $10 million less for the business given that the buyer had to assume the non-qualified deferred compensation liability.
The partnership filed its tax return for 2012 and did not report the $10 million dollar deduction. A month later, it filed another return to report the deduction.
The IRS apparently audited the return and issued a partnership adjustment notice. The partnership petitioned the U.S. Tax Court, which concluded that the $10 million payment was not deductible. The tax court held that the payment was not deductible until the payment was paid to the players. It also rejected the taxpayer’s argument that the regulations allowed the deduction to be accelerated to the date of the sale. The taxpayer filed an appeal, which led to the current court case.
About Non-Qualified Deferred Compensation
The term “non-qualified deferred compensation” refers to a written plan that allows employees to defer a portion of their income to be received at a later date, often after retirement.
Unlike qualified retirement plans, such as 401(k)s or IRAs, non-qualified plans do not need to adhere to certain tax-advantaged rules and are not subject to the same contribution limits. As such, they are typically set up by employers for key executives or highly compensated employees to provide additional retirement benefits and retain top talent.
With non-qualified plans, an employee elects to set aside a portion of their salary or bonus to be paid out in the future, often upon reaching a specific retirement age or triggering event. The deferred compensation may or may not be held in a separate account and the amounts may or may not be put into investments for the employee. Plans that hold the payments in a separate account or trust are usually referred to as “funded” and those that are not are referred to as “unfunded.”
The ability to actually receive the deferred compensation payment depends on the financial health of the employer. If the business faces financial difficulties or goes bankrupt, the employee’s deferred compensation may be at risk.
Taxation of NQDC Plans
With non-qualified plans, the amounts allocated to employees for future compensation are generally not considered income for the employee in the current year. Additionally, these amounts are not immediately deductible for the employer, only becoming so when they are eventually paid to the employee.
Although the current taxable income of the employee is effectively lowered by the portion of income that has been deferred, the employee is still subject to Social Security and Medicare taxes on the deferred income at the time it’s deferred. Consequently, the employee receives a Form W-2 that excludes this deferred income for income tax purposes, yet it remains subject to Social Security and Medicare tax.
From the employee’s perspective, non-qualified plans are a timing play. The principal advantage lies in the potential for tax deferral. By opting for these plans, employees can postpone the payment of income taxes on their deferred compensation until the actual receipt of the funds in the future. This can prove especially beneficial if the employee anticipates being in a lower tax bracket during their retirement years.
The Accrual Method Rules
The taxpayer in this case focused on the accrual method rules.
These bookkeeping rules concern the timing of the recognition of income and expenses. The majority of taxpayers operate under the cash-basis method. Under this method, income is reported when actual payment is received, and expenses are deducted at the time of their disbursement.
However, certain taxpayers, including the one in this case, are required to or elect to adopt the accrual method. Within this method, the timing of income and expense recognition is contingent upon the occurrence of economic performance. Unlike mandatory accrual method usage for some taxpayers, the elective nature of this method permits others to make a conscious choice. Taxpayers generally opt for this method when they accrue expenses before their actual payment, effectively deferring the payment to a later date. This strategic decision hinges on the alignment of economic events with the allowable reporting of income and expenses.
Consider the example of services. With the cash method, the employer deducts the wages when the employee is paid. With the accrual method, the employer deducts the wages when the services are rendered.
When it comes to deferred compensation for an unfunded plan, the tax code effectively puts all taxpayers on the cash method for these payments. The agreement to make payments in unfunded plans is deductible when paid to the employee.
Accrual Method & Timing for Business Sales
The implementing regulations include another rule that applies when a business is sold. It says that:
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.
This is set out in Treas. Reg § 1.461-4(d)(5)(i). This provision is not limited to non-qualified deferred compensation liabilities.
According to the taxpayer, this provision allows the deduction for the unfunded non-qualified plan given the asset sale for the business and the assumption by the buyer. This does seem to be the result given the plain language of the rule.
The tax court noted that these rules do not apply if there is any other rule that could apply first. This ordering rule is set out in Treas. Reg. § 1.461-1(a)(2)(i). Thus, the tax court concluded that the general rules set out above for unfunded non-qualified plans apply first. They, in essence, take away the benefit provided by Treas. Reg § 1.461-4(d)(5)(i).
This results in a perplexing situation for those who sell businesses and who accept less as the buyer assumes the non-qualified deferred compensation liability, as in this case. This court case does not stand for the proposition that the taxpayer can never deduct the deferred compensation payment. It stands for the proposition that the asset sale is not a triggering event.
When, as in this case, the payment is made by a reduction in the amount realized on the sale, the taxpayer can still get the deduction. It just has to wait until the payment is made. Thus, as in this case, the taxpayer has to wait until the employees are paid by the buyer (at some point in the future) and the deduction will be available to the seller at that point. This does seem to be the wrong result and an impracticable solution and it does not address cancellation of debt income questions, but it also avoids the tax planning that would be possible if taxpayers could structure non-qualified deferred compensation and then trigger tax deductions with business sales.
Non-qualified deferred compensation can be a great tool for retaining key employees. Given that payroll expenses often constitute a significant portion of a business’s outlays, these plans serve a dual purpose of nurturing business operations by postponing employee payments until financial feasibility improves. They can also facilitate the even distribution of income for business owners and other stakeholders, allowing the income to be reported and taxes paid on the payments when the owners or others are in lower tax brackets in specific years–usually retirement years.
However, these advantages come at the cost of complexity. As evidenced in this particular case, the timing issues for non-qualified deferred compensation plans can be difficult to fully understand–particularly as business deals are negotiated and closed. We previously considered NQDC plans for an entity owned by an ESOP. This is an example of the types of planning that one can consider.
Nevertheless, in light of this court case, those selling their businesses should discuss this issue with their tax attorneys. There are ways to structure deals to avoid this situation of waiting for the deduction and alternative structures or safeguards to ensure the optimal utilization of these tax deductions.