In the
United States Court of Appeals
For the Seventh Circuit
____________________
No. 22-2012
HOOPS, LP and HEISLEY MEMBER, INC., Tax Matters Partner,
Petitioners-Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
____________________
Appeal from the United States Tax Court
No. 11308-18.
____________________
ARGUED JANUARY 19, 2023 — DECIDED AUGUST 9, 2023
____________________
Before BRENNAN, SCUDDER, and KIRSCH, Circuit Judges.
SCUDDER, Circuit Judge. Hoops LP seeks a $10.7 million tax
deduction for deferred compensation that it owed to two of
its employees at the close of the 2012 tax year. Under 26 U.S.C.
§ 404(a)(5), an accrual-based taxpayer like Hoops can only deduct deferred compensation expenses in the tax years when it
pays its employees or contributes to certain qualified plans,
such as a trust or pension fund.
2 No. 22-2012
Hoops did not do either, however. Instead in 2012 the firm
sold substantially all its assets and liabilities. As part of the
transaction, the buyer assumed Hoops’s $10.7 million deferred compensation liability. Hoops viewed this $10.7 million amount as a deemed payment to the buyer to compensate
it for assuming the deferred compensation obligation. So
Hoops took a tax deduction under Treasury Regulation
§ 1.461-4(d)(5)(i) on its 2012 partnership return, claiming the
buyer’s assumption of the $10.7 million liability as an ordinary business expense deductible at the time of sale.
The Internal Revenue Service denied the deduction, and
the Tax Court upheld the disallowance. The Tax Court determined that § 404(a)(5) of the Tax Code barred Hoops from
claiming a deduction for deferred compensation in the 2012
tax year because the firm did not pay the employees during
that year. We agree and affirm.
I
A
Hoops is a limited partnership that formed in 2000 to acquire a National Basketball Association franchise, the Vancouver Grizzlies, which later became the Memphis Grizzlies.
In October 2012 Hoops sold the Grizzlies to Memphis Basketball, LLC. At that time Hoops owed two players, Mike Conley
and Zach Randolph, deferred compensation for their strong
performance in the 2009, 2010, and 2011 seasons. Conley and
Randolph accrued $12.6 million in total deferred compensation for those seasons, which Hoops promised to pay sometime after 2012. But Hoops never paid the deferred compensation to either player. Instead, as part of the asset sale, Memphis Basketball assumed Hoops’s liability for the $12.6 million
No. 22-2012 3
owed to them. Hoops later calculated the liability to be $10.7
million at its discounted present value.
In computing its gain on the 2012 sale, Hoops reported to
the IRS that it realized $419 million in the transaction, of
which Memphis Basketball paid $200 million in cash and
assumed $219 million in liabilities. See 26 C.F.R. § 1.1001-1.
Included in the liabilities was the $10.7 million (discounted)
deferred-compensation obligation. In Hoops’s view,
Memphis Basketball’s assumption of the obligation to pay
Conley and Randolph was reflected in the purchase price:
Memphis Basketball paid Hoops $10.7 million less because it
undertook Hoops’s liability. Stated yet another way, Hoops
believed that the $10.7 million was a “deemed payment” it
made to Memphis Basketball to compensate it for the deferred
compensation that remained owed to the two players.
B
In September 2013 Hoops filed Form 1065, its partnership
tax return, for the 2012 tax year, using the accrual method of
accounting. Hoops made no reference to the $10.7 million
deferred-compensation liability that the buyer had assumed
in the 2012 sale.
The following month Hoops filed Form 1065X, an
amended partnership tax return, for the 2012 tax year. On this
amended return, Hoops claimed a $10.7 million deduction for
the deferred compensation owed to Conley and Randolph.
Hoops believed that Treasury Regulation § 1.461-4(d)(5)(i)
permitted an acceleration of the $10.7 million deduction to the
date of the sale.
In a final partnership administrative adjustment letter issued in 2018, the IRS disallowed the $10.7 million deduction.
4 No. 22-2012
Hoops, through its tax matters partner, then petitioned the
Tax Court for review.
C
The Tax Court upheld the IRS’s disallowance, homing in
on 26 U.S.C. § 404(a)(5), which governs the deductibility of
deferred compensation to nonqualified plans. Because the
claimed deduction reflected deferred compensation that
Hoops had not paid to a qualified trust or pension plan, the
Tax Court explained that § 404(a)(5), by its plain terms, precluded Hoops from taking the deduction until the players
were paid.
The Tax Court also rejected Hoops’s position that Treasury Regulation § 1.461-4(d)(5)(i) allowed it to accelerate the
deduction to the year of the asset sale to Memphis Basketball.
Section 461 of the Tax Code and its implementing regulations,
the Tax Court explained, direct accrual-method taxpayers to
look first to other relevant provisions of the Code before applying the timing provision. In following that direction here,
the Tax Court determined § 404(a)(5) to be the applicable
Code provision governing the plan Hoops had for deferred
compensation owed to Conley and Randolph. Following the
rule set forth in § 404(a)(5), then, the Tax Court determined
that § 404(a)(5)’s specific deferred-compensation provision
prevailed over the regulation in § 1.461-4(d)(5)(i), and that
Hoops therefore could not take the deduction in 2012.
Hoops now appeals.
No. 22-2012 5
II
A
Taxpayers can generally deduct all ordinary and
necessary business expenses paid or incurred during the tax
year, including employee salaries. See 26 U.S.C. § 162(a)(1).
For accrual-based taxpayers like Hoops, these expenses are
usually deductible during “the taxable year in which all the
events have occurred that establish the fact of the liability,
[when] the amount of the liability can be determined with
reasonable accuracy and economic performance has
occurred.”
26 C.F.R. § 1.461-1(a)(2); see also
26 U.S.C. § 461(a),
(h). As a practical matter, this means accrual-based taxpayers
can normally deduct employment related expenses as
employees render services. This differs from the cash method
of accounting, which allows taxpayers to make deductions
only at the time the taxpayer pays the expense. See
26 U.S.C.
§ 461(a);
26 C.F.R. § 1.461-1(a)(1). So accrual-method
taxpayers tend to take their deductions sooner than cashmethod taxpayers because many taxpayers make payments
after services are rendered.
A different set of rules addresses deductions for employee
compensation paid pursuant to a deferred-payment plan. In
a separate provision of the Tax Code, § 404, Congress provided that employers may claim deductions for deferred compensation as employee services are rendered only if compensation is paid pursuant to a qualified plan that meets certain
requirements, such as holding the funds in trust. See 26 U.S.C.
§ 404(a)(1)–(4). Employers that do not pay deferred compensation into and pursuant to a qualified plan cannot claim deductions until the compensation is actually paid and
6 No. 22-2012
“includible in the gross income of employees” participating
in the plan.
Id. § 404(a)(5).
Notice the effect § 404(a)(5)’s deductibility timing direction has on the application of ordinary accrual rules. While
§ 404 applies equally to taxpayers regardless of accounting
method, it effectively instructs all employers using deferred
compensation plans to use cash accounting. That is so because
§ 404(a)(5) allows employers to take their deductions only
when they contribute to qualified plans (by making payments
for services rendered) or when they pay the compensation.
See id.
By regulating deferred compensation plans this way, Congress “create[d] financial incentives for employers to contribute to qualified plans while providing no comparable benefits
for employers who adopt plans that are unfunded.” Albertson’s, Inc. v. Comm’r, 42 F.3d 537, 543 (9th Cir. 1994). Congress
gave accrual-method employers a choice. On one hand, they
can contribute deferred-compensation payments to a qualified plan and take deductions as they make these payments.
On the other hand, employers can forego the costs of a qualified payment plan, with the tradeoff that they may not take
any deduction until they make the payments to their employees (past or present). In this way, § 404(a)(5) establishes what
we might call a “matching rule” between employee and employer, where Congress intended for employers to deduct deferred compensation expenses and employees to report income in the same tax year. See id.
B
It is against this backdrop that Hoops filed its Form 1065X
for the 2012 tax year claiming a $10.7 million deduction for
No. 22-2012 7
the deferred-compensation liability that Memphis Basketball
assumed in the 2012 sale. Everyone agrees that if the sale of
the Grizzlies never happened, § 404(a)(5) would have prevented Hoops from claiming the deduction in 2012 because
no payments had been made to a qualified plan or to the two
players. The question we must answer, then, is this: Did
Hoops’s sale, and Memphis Basketball’s assumption of its liability, change the tax treatment of the $10.7 million in deferred compensation under the otherwise clear rule Congress
supplied in § 404(a)(5)?
Hoops contends that it did. The partnership points to a
separate part of the Tax Code, § 461, and its implementing
regulation in § 1.461-4(d)(5)(i), to claim that an earlier deduction was permitted even though the deferred compensation
was not paid in 2012 to either Mike Conley or Zach Randolph.
Remember that Hoops uses the accrual method of accounting.
For ordinary business expenses, that means Hoops cannot
claim an expense deduction until “economic performance”
occurs. 26 U.S.C. § 461(h)(1). When it comes to services generally, economic performance occurs as services are provided
(for example, as a building is cleaned, painted, or repaired).
See
id. § 461(h)(2)(A)(i). The same is generally true for employee services—that economic performance occurs as an employee works, provided all other Tax Code provisions and
Treasury Regulations are followed, including § 404(a)(5). See
26 C.F.R. § 1.461-4(d)(2). By playing in the 2009, 2010, and
2011 basketball seasons, Conley and Randolph rendered employment services meeting the economic performance requirement of § 461(h)(2)(A)(i), thus deductions follow so long
as they are paid, as required by § 404(a)(5). See id.
8 No. 22-2012
According to Hoops, the economic performance requirement is important here because still another rule governs the
deduction of liabilities assumed as part of an asset sale. Hoops
relies on Treasury Regulation § 1.461-4(d)(5)(i), which provides the following:
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.
26 C.F.R. § 1.461-4(d)(5)(i).
Hoops believes that the phrase “but for the economic performance requirement” in § 1.461-4(d)(5)(i) is expansive. Everyone agrees Hoops could not deduct the deferred compensation liability in 2012 because of § 404(a)(5). By viewing
§ 404(a)(5) and its deductibility timing limitation as an economic performance requirement, then, Hoops insists that
§ 1.461-4(d)(5)(i) allows it to accelerate that deduction regardless of whether the players have been paid, as otherwise required by § 404(a)(5). To Hoops, the specific context of the asset sale—and therefore Treasury Regulation § 1.461-
4(d)(5)(i)—trumps all other considerations, even the uncontested factual point that the underlying obligation is one for
deferred compensation under § 404(a)(5).
No. 22-2012 9
The Tax Court rejected Hoops’s view of the interaction between § 404(a)(5) and Treasury Regulation § 1.461-4(d)(5)(i).
The starting point for the Tax Court was 26 U.S.C. § 461(h),
which sets forth general deductibility rules for accrual-method taxpayers. Walking through that provision and its
regulations, the Tax Court observed that the parties agreed all
requirements for deduction were met, including economic
performance, in 2012. But from there the Tax Court reasoned
that Hoops could not take a deduction until addressing any
other “[a]pplicable provisions of the Code, the Income Tax
Regulations, and other guidance published by the Secretary”
that “prescribe the manner in which a liability that has been
incurred is taken into account.”
26 C.F.R. § 1.461-1(a)(2)(i).
The Tax Court then identified § 404(a)(5) as one such applicable provision of the Code controlling Hoops’s deduction of
the deferred-compensation liability. Because § 404(a)(5) disallowed the deduction until the tax year in which Conley and
Randolph received payment, the Tax Court affirmed the IRS’s
final partnership administration adjustment letter denying
the deduction.
C
After taking our own fresh look at the Tax Code, we agree
with the Tax Court that Hoops cannot take the $10.7 million
deduction in the 2012 tax year. See Freda v. Comm’r, 656 F.3d
570, 573 (7th Cir. 2011). Section 404(a)(5) leaves us with a firm
conviction of Congress’s intent to treat the deductibility of
deferred-compensation salary plans differently than ordinary
service expenses—and that this special treatment prevails
over any general provisions otherwise applicable to liabilities
assumed in asset sales. Tax deductions are a matter of
legislative grace. See INDOPCO, Inc. v. Comm’r,
503 U.S. 79,
10 No. 22-2012
84 (1992). As the party seeking the deduction, Hoops fell short
of proving entitlement to the $10.7 million deduction in 2012.
See
id.
On appeal Hoops contends, as it did in the Tax Court, that
the acceleration provision in Treasury Regulation § 1.461-
4(d)(5)(i) renders the economic performance requirement that
it sees as embedded with § 404(a)(5) as satisfied in a way that
allowed Hoops to take the $10.7 million deduction for deferred compensation in 2012. In making this argument, Hoops
urges us to recharacterize the $10.7 million amount as a
“deemed payment” made to Memphis Basketball in the assetsale transaction and not as a deferred-compensation liability.
By doing so, Hoops contends that the amount is an ordinary
business expense deductible in 2012, when Conley and Randolph rendered their services and Hoops implicitly paid for
those services in setting the sale price to Memphis Basketball.
We are not persuaded.
We begin with Hoops’s claim that Treasury Regulation
§ 1.461-4(d)(5)(i) controls over § 404(a)(5) of the Tax Code.
The parties agree that a faithful interpretation of the Tax Code
requires specific provisions to prevail over general ones. See
Gozlon-Peretz v. United States, 498 U.S. 395, 407 (1991) (“A
specific provision controls one of more general application.”);
see also Bloate v. United States,
559 U.S. 196, 207 (2010) (same).
In reviewing the statute and its regulations, we see more
evidence in the text supporting the Commissioner’s view that
§ 404(a)(5)’s specific regulation of nonqualified deferred-compensation plans must prevail over § 1.461-4(d)(5)(i)’s
broader treatment of assumed liabilities in connection with
the sale of businesses more generally.
No. 22-2012 11
Taking a closer look at § 404 of the Tax Code and Treasury
Regulation § 1.461-4(d)(5)(i) shows us that the plain and
highly specific direction supplied by § 404(a)(5) resolves this
case. The statute uses mandatory language and itself provides
a controlling rule. Start with the general rule that “if compensation is paid or accrued on account of any employee under a
plan deferring the receipt of such compensation, such contributions or compensation shall not be deductible under this
chapter.” 26 U.S.C. § 404(a) (emphasis added). The statute
goes on to list the exceptions and limitations, including for
employees paid by nonqualified plans. For those employees,
an employer specifically cannot take a deduction until “the
taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan.”
Id. § 404(a)(5).
Now compare that language with the Treasury Regulation
that Hoops believes controls. By its terms, § 1.461-4(d)(5)(i)
accelerates only those deductions that a taxpayer cannot take
because the economic performance requirement has not been
met. But we have already explained that under § 461(h)
economic performance of services occurs as employees
render them. Therein lies the fundamental flaw in Hoops’s
argument: it was not § 461(h)’s economic performance
requirement that prevented Hoops from taking the deduction
in 2012, but the rule in § 404(a)(5) governing nonqualified
deferred-compensation plans. Hoops’s decision not to pay the
players in 2012 and its decision not to contribute to a qualified
plan precluded its ability to claim the deduction that same tax
year. Hoops cannot assert that either of these are economic
performance barriers as that term is defined in 26 U.S.C.
§ 461(h)—but that is what Hoops would need to prove to
show that the acceleration provision of Treasury Regulation
12 No. 22-2012
§ 1.461-4(d)(5)(i) applies. We cannot agree with Hoops that
the definition of economic performance sweeps broadly
enough to include the specific, deferred-compensation
provision in § 404(a)(5).
There is more. Treasury Regulation § 1.461-4(d)(2)(iii)
states that “the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under section 404 (employer contributions to a plan of deferred
compensation).” The express reference—in conditional
terms—to § 404 further defeats Hoops’s position. By its terms,
the regulation tells us that economic performance is satisfied
and liabilities are therefore deductible if the other requirements of § 404 are also met. In this way, the regulation expressly directs taxpayers to return to § 404 before confirming
that a deduction is available under the acceleration provision,
showing the emphasis placed on taxpayers meeting
§ 404(a)(5)’s specific requirements for amounts owed under
nonqualifying deferred compensation plans.
Note too the absence of any reference in § 404 to the assetsale provisions in § 461. Under § 404(a)(5), Congress allowed
a deduction for deferred compensation “in the taxable year in
which an amount attributable to the contribution is includible
in the gross income of employees participating in the plan.”
The implementing regulation, Treasury Regulation § 1.404(a)-
12(b)(1), provides further that deductions are permitted “only
in the taxable year of the employer in which or with which
ends the taxable year of an employee in which an amount attributable to such contribution is includible in his gross income as compensation, and then only to the extent allowable
under section 404(a).” Neither provision contains an exception for asset sales, nor do they reference § 461 and accrual
No. 22-2012 13
method accounting. These observations reflect and give effect
to Congress’s clear intent in passing § 404 in the first place—
to displace the accrual method with an approach that requires
employers to choose between qualified plan payments and
earlier deductions. Hoops gives us no reason to believe that
Congress allowed employers to get out of this choice by selling their liabilities and claiming them as ordinary business expenses.
Hoops’s insistence on calling the assumed deferred compensation a “deemed payment” loses sight of the substance of
what transpired. No question it sold its assets, and the transaction entailed Memphis Basketball assuming a liability. But
not just any liability—instead, a liability for deferred compensation based on services already rendered by two players in
prior seasons. And, as we have explained, it is this “substance
of [the] transaction [that] is more important than its form.”
Illinois Power Co. v. Comm’r, 792 F.2d 683, 689 (7th Cir. 1986);
see also Jacobs v. Comm’r,
45 T.C. 133, 135 (1965). Had no sale
occurred, Hoops could not have deducted the $10.7 million in
deferred compensation owed the two players because they
were not paid in 2012. The reason for that outcome has nothing to do with the operation of the economic performance
rule, though: indeed, both players had played in past seasons
and thereby earned the deferred compensation. Rather, what
would disallow the deduction in the no-sale circumstance is
the limitation Congress imposed in § 404(a)(5) on Hoops’s decision not to contribute to a qualified plan and not to pay the
players before the sale. And, so too, on the actual facts: it is
§ 404(a)(5) and not anything about the asset sale or economic
performance rule that precludes the deduction in the 2012 tax
year.
14 No. 22-2012
Given Conley and Randolph were not paid their deferred
compensation in 2012, the plain text of § 404(a)(5) instructs
that Hoops cannot take a deduction for that liability in that
tax year. We see no basis, in the Tax Code or its regulations,
to deviate from this clear rule.
D
Hoops also urges us to consider the practical implications
of our interpretation. Even though Hoops could claim a deduction in the tax year when Conley and Randolph are ultimately paid, the firm contends that there is a possibility it
could lose the deduction altogether—for example, if the buyer
never pays the players or otherwise fails to communicate that
the players were paid. Hoops believes such a result is inequitable.
Perhaps so. But any risk of losing the deferred-compensation deduction is foreseeable, especially given the
clear instructions from Congress in § 404(a)(5). We agree with
the Commissioner’s suggestion that Hoops could have
avoided this tax-deduction problem in many ways—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. Simply
put, parties can, and do, account for tax risk as an economic
matter by negotiating contractual provisions to minimize and
compensate for such financial contingencies. This case
presents no reason to conclude otherwise, especially given
Congress’s direct and specific regulation of deferred
compensation.
With these closing observations, we AFFIRM.
