Liability assumption in M&A: Tax Court addresses income and expense
February 28, 2022 | Authored by RSM US LLP
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In the recent Tax Court decision Hoops LP et al. v. Commissioner,1 the Tax Court confirmed the IRS position that the deduction timing rule in section 404(a)(5) applies even if a buyer assumes the deferred compensation liability (relating to a nonqualified plan) in a taxable asset acquisition. In the case of nonqualified deferred compensation payable to an employee, the timing rule of section 404(a)(5) defers the employer’s deduction until the employer’s tax year in which the recipient of the income recognizes the income on his or her personal tax return. The taxpayer’s position that Reg. section 1.461-4(d)(5) should allow the seller with a deduction equal to the net present value of the future payments was denied.2 In addition, the Tax Court held that the taxpayer was required to take the assumption of the liability into income despite no corresponding deduction to the taxpayer.3
The court’s decision on income inclusion could have significant implications beyond deferred compensation. The holding could impact the tax result on the assumption of other contingent liabilities assumed in a taxable asset sale where no deduction is allowed.
Assumption of deferred compensation in taxable asset sales
In general, when a buyer assumes a liability of a seller in a taxable asset sale, the assumption of the liability is included in consideration paid to the seller. However, complications can arise when the seller has not yet claimed a deduction on that liability. In the case at hand, the question came down to the application of two different provisions. The first being liabilities for which the all-events test has been met and the deemed economic performance rules for liabilities that are assumed in connection with the sale of a trade or business.4 The other being the provision in section 404(a)(5) that explicitly denies deduction for deferred compensation until the taxable year ending on or after Dec. 31 of the tax year the employee included the compensation into income (assuming the employee is calendar year taxpayer).
Example: XYZ, a June 30 year-end taxpayer has a nonqualified deferred compensation plan in place. Employee A (calendar year individual) has vested in the plan. XYZ makes $1 million in payments to A on May 1, 2022. XYZ is not allowed to claim the deduction on the June 30, 2022 tax year because of the rule in section 404(a)(5). Rather the deduction is deferred until the June 30, 2023 year, the tax year that includes Dec. 31, 2022, the tax year the employee includes the amount into income.
In the Hoops case, the taxpayer sold the assets of the business and as a part of the transaction, the buyer assumed the deferred compensation liability owed to certain employees for past services. The taxpayer, citing Reg. section 1.461-4(d)(5), argued for a deduction equal to the net present value of the deferred compensation liability.5 The court, citing the plain language in the law held that the deferral rule of section 404(a)(5) and regulations thereunder applied to defer the deduction and not the economic performance rules of section 461, and in fact, despite leading to income inclusion without a corresponding deduction, fit the “clear purpose” of section 404.6
The deduction in this case is not necessarily lost but rather deferred. To the extent the seller remains in existence through Dec. 31 of the year the employee includes the compensation, then seller could claim the deduction on that return. The IRS confirmed this in TAM 8939002. However, in the event the seller goes out of existence because of, for example, a section 338(h)(10) or section 336(e) transaction, the ability to claim an ordinary deduction would appear lost.
Income inclusion upon assumption
After determining that the deduction was not allowed in the year of sale, the taxpayer attempted to address the whipsaw of income inclusion without a deduction, through the income side of the equation.7 The court denied those arguments as well, holding that assumption of the deferred compensation liability was consideration in the year of sale under section 1001 and Reg. section 1.1001-2(a)(1).8
In coming to their decision, the court noted the taxpayer’s contention that reasoning within Focht v. Commissioner9 should allow the taxpayer to exclude the liability from proceeds in the year of sale.10 Focht addressed the assumption of deductible liabilities in a section 351 transaction, and held that if the liability had not yet, but would result in a deduction, the liability should not represent a liability for purposes of applying section 357(c). However, without addressing the decision or its analysis, the court held the liability is includable in proceeds in the year of assumption.11 The court went on to both cite as support for inclusion and also distinguish from section 404 deferral, the decision in Commercial Security Bank v. Commissioner.12 Commercial Security Bank involved a cash basis taxpayer that was required to include the assumption of accounts payable into the proceeds of the sale because the liabilities were assumed but was allowed a corresponding deduction upon the assumption.
What does it mean?
The conclusion that the court reached on the deferral of deduction under section 404(a)(5) is not surprising. Perhaps more concerning to note is the determination the court made regarding immediate inclusion of the liability in the sales proceeds. While this position is certainly the position the IRS often asserts, the agreement by the court is notable.
If read broadly enough to apply outside of the deferred compensation, the decision could suggest that all contingent liabilities are included in the proceeds on any asset sale irrespective of a corresponding deduction. The taxpayer in Hoops argued Reg. section 1.461-4(d)(5), which did not override section 404(a)(5); however, there are many contingent liabilities assumed in asset sales that do not meet the requirements of Reg. section 1.461-4(d)(5). Remember that for Reg. section 1.461-4(d)(5) liabilities must first meet the all events test, and economic performance then occurs with the assumption. For liabilities that do not fit neatly within this regulation, reliance on assumption as establishing the deduction is not an easy argument. With this concern in mind, the facts in the case could support a narrower read. The court noted the parties’ agreement that all services necessary to create the obligation had occurred, resulting in a liability that was arguably fixed and determinable and includable as proceeds in the year of sale.13 This fact could distinguish liabilities such as deferred compensation from liabilities where services or property are delivered post transaction and the ultimate cost of such performance are more difficult to determine.
Impact on advance payments/deferred revenue?
One area of particular concern could be the treatment of the assumption of a cost of performance liability related to advance payments for future property or services in a taxable asset sale. The buyer in such a transaction is assuming a liability to perform on advance payments, which is a liability and as such arguably has realized proceeds in the year of the transaction. Assuming that were the case, would the seller be allowed a corresponding deduction? Buyer has assumed a liability in the acquisition of assets constituting a trade or business, so arguably payment of a liability has occurred. However, has the liability satisfied the all events test? Arguably the liability only satisfies the all events test as incurred post transaction by the buyer upon performance. In a report on this subject, the New York State Bar suggests that an offsetting deduction should be allowed in the event income is recognized in the year of the transaction upon assumption.
The NYSBA Report notes that there are generally two established methods for determining a buyer’s tax consequences when assuming deferred revenue. Under one such approach, the so-called Assumption Method, the buyer would include the deferred revenue in the basis of acquired assets but only as and when such liability becomes fixed or is otherwise taken into account for tax purposes (i.e., when the all events test is satisfied). As to the seller, under the Assumption Method, the assumption of the deferred revenue is treated like any other assumed contingent liability. That is, the seller includes the liability in its amount realized based upon its value at sale and treats the transaction as closed. The NYSBA Report reads that “[d]epending on the type of liability, the seller usually claims an offsetting deduction or increase in basis.” The NYSBA Report cites to Commercial Security Bank v. Commissioner, 15 supra, James M. Pierce Corp. v. Commissioner,16; Reg. section 1.461-4(d)(5)(i); Reg. section 1.461-4(g)(1)(ii)(C); and Ginsburg, Levin & Rocap, Mergers, Acquisitions & Buyouts.17
A separate argument from what was argued in Hoops regarding income recognition would be to defer the income recognition until the liability is satisfied. This position is based upon the view that, like contingent consideration paid in an asset sale, recognition of the liability assumption is eligible for deferral until the contingent liability is satisfied. This position would address the disparity in treatment of the assumption of a contingent liability as payment in the year assumed, while allowing deferral on the receipt of contingent consideration. Certainly, questions exist regarding the application of section 453 installment sales in this situation; however, deferral appears appropriate in this case.
The treatment of assumed contingent liabilities in an asset sale is not entirely clear. With respect to assumption of liabilities for deferred compensation deductions subject to the section 404(a)(5) timing rule, income inclusion without a current deduction is a possibility. The case also reinforces the need to consider the impact of all contingent liability assumption in an asset sale, particularly those that would not result in deductibility upon assumption under Reg. section 1.461-4(d)(5). Taxpayers involved in the sale of the assets of a business should obtain appropriate tax advice prior to closing and reporting such a sale.
1T.C. Memo. 2022-9 (Feb. 23, 2022).
2Id. at 11.
3Id. at 13.
4See Reg. section 1.461-4(d)(5).
5Hoops at 9.
6Id. at 11.
7Id. at 12.
8Id. at 13.
968 T.C. 223 (1977).
10Hoops at 12-13.
11Id. at 13.
1277 T.C. 145 (1981); Hoops at 13.
13Id at 10.
14See New York State Bar Association Tax Section Report on Treatment of “Deferred Revenue” by the Buyer in Taxable Asset Acquisitions (Jan. 7, 2013) (the NYSBA Report).
16326 F.2d 67 (8th Cir. 1964).
This article was written by Nick Gruidl and originally appeared on 2022-02-28.
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