Hellwig: Hoops And The Tax Treatment Of Nonqualified Deferred Compensation Obligations Transferred In The Sale Of Employer’s Assets

Brant J. Hellwig (NYU), Exploring Hoops, 181 Tax Notes Fed. 89 (Oct. 2, 2023):

The Seventh Circuit recently issued its opinion in Hoops LP v. Commissioner [77 F.4th 557 (7th Cir. 2023)] concerning the tax treatment of nonqualified deferred compensation obligations that are transferred in connection with the sale of the employer’s assets. The appellate court affirmed the determination of the Tax Court [T.C. Memo. 2022-9] that, despite the inclusion of the deferred compensation obligations in the amount realized by the original employer upon the sale of its assets, section 404(a)(5) requires the original employer to defer its deduction for the deferred compensation to when the compensation is actually paid by the purchaser and included in the employee’s gross income. ...

Conclusion
The opinions of both the Tax Court and the Seventh Circuit in Hoops upholding the IRS’s invocation of section 404(a)(5) despite an intervening sale of the employer’s trade or business appear reasonable on the surface. Section 404(a)(5) provides the rule for the nonqualified deferred compensation context, and the terms of the statute are not ambiguous. However, the application of section 404(a)(5) to defer a deduction to a tax year after the employer disposes of the assets making up its trade or business runs counter to a reasonable measurement of net income.

Because Congress likely did not contemplate the circumstance at issue in Hoops when enacting section 404(a)(5), perhaps there is an opening to achieve the correct result — that is, to apply general tax principles to permit a deduction of the present value of the deferred obligations when assumed by the purchaser of the franchise. The Tax Court and the Seventh Circuit, however, did not view this unique context as providing any daylight for avoiding the terms of section 404(a)(5).

If section 404(a)(5) is indeed inescapable in this setting, the amount of the deferred compensation obligations assumed by the purchaser should not be included in the amount realized by Hoops on the disposition of its business. Because those payment obligations provided no tax benefit to Hoops, the assumption of those obligations should not give rise to a tax detriment. That second-best resolution of the tax consequences of the deferred compensation arrangement in this context, although not ideal, is far superior to deferring the original employer’s deduction to a year subsequent to its exit from the revenue-generating activity.