In the recent decision of Temnorod v. Commissioner, T.C. Memo. 2025-127, the United States Tax Court addressed the tax treatment of payments made by an acquiring entity to settle the liabilities of a related party in bankruptcy. The case serves as a critical reminder to tax professionals regarding the hierarchy of the Internal Revenue Code (the Code)—specifically, that capitalization requirements under section 263 generally supersede deduction provisions under section 162.

The Facts and the Transaction

The dispute centered on Broadvox, Inc. (Broadvox), an S corporation engaged in the telecommunications service industry. The petitioners were shareholders of Broadvox who reported losses passed through from the entity’s 2012 tax return.

The controversy arose from the business relationship between Broadvox and a related entity, Infotelecom, LLC (Infotelecom). Broadvox, a Voice over Internet Protocol (VoIP) provider, routed calls through Infotelecom, a competitive local exchange carrier (CLEC). Infotelecom held interconnection agreements with major carriers, specifically AT&T and Verizon. A significant dispute developed regarding "deltas"—payment differentials between what Infotelecom paid and what the major carriers claimed was owed—eventually leading Infotelecom to file for Chapter 11 bankruptcy in 2011.

In 2012, Broadvox’s disregarded entity, Broadvox Holding Co., LLC (BV Holding), executed an Asset Purchase Agreement (APA) to acquire substantially all of Infotelecom’s assets out of bankruptcy. A condition of the acquisition and the reorganization plan was the payment of "Cure Costs" to settle Infotelecom’s debts to AT&T and Verizon. Specifically, BV Holding paid $1,600,000 to Verizon and approximately $1,562,000 to AT&T (collectively, the "Asset Purchase Agreement Payments").

Broadvox reported these payments totaling $3,162,000 as Cost of Goods Sold (COGS) on its 2012 Form 1120S, generating a substantial loss that flowed through to the shareholders. The IRS disallowed this treatment, determining the payments were capital expenditures related to the acquisition of assets.

The Taxpayers’ Request for Relief

The petitioners presented two primary arguments to support the immediate reduction of gross income. First, they maintained the position taken on the return that the payments constituted COGS.

Second, and more substantively, the petitioners argued that if the payments were not COGS, they were deductible ordinary and necessary business expenses under section 162. Their theory relied on the premise that the payments were made to resolve Broadvox’s own potential derivative liability. They argued that without the payments, AT&T and Verizon would have pursued Broadvox directly for the unpaid "deltas" or forced a Chapter 7 liquidation of Infotelecom, which would have exposed Broadvox to liability under a carrier service agreement. Thus, they contended the origin of the claim was the protection of Broadvox’s business, not merely the acquisition of assets.

Court’s Analysis of the Law

The Tax Court’s analysis proceeded in two phases: the applicability of COGS to service providers and the statutory priority of capitalization over deduction.

Regarding COGS, the Court reaffirmed that this concept is strictly limited to manufacturing, merchandising, or mining businesses. Citing Guy F. Atkinson Co. of Cal. v. Commissioner, the Court noted that service providers generally cannot reduce gross receipts by COGS because they do not produce material products.

The Court then addressed the conflict between section 162 deductions and section 263 capitalization. The Court emphasized the "priority-ordering directive" found in the Code: section 161 allows deductions "subject to the exceptions provided in... [section 263]," while section 261 strictly prohibits deductions for items specified in the capitalization rules. Relying on Commissioner v. Idaho Power Co. and INDOPCO, Inc. v. Commissioner, the Court established that if an expenditure falls under both section 162 and section 263, the capitalization requirement of section 263 takes precedence.

To determine if the payments were capital in nature, the Court applied the "process of acquisition test" derived from Woodward v. Commissioner. This test asks whether the expenditure originated in the process of acquiring the asset. The Court also reiterated the principle from David R. Webb Co. v. Commissioner that payments of a preceding owner’s obligations by an acquirer are capital expenditures that become part of the cost basis of the acquired property, regardless of the tax character the payment would have had for the prior owner,.

Finally, the Court invoked the Danielson rule and the "strong proof" rule. These doctrines generally bind taxpayers to the form of their transaction and the specific allocations set forth in their contracts unless they can prove mistake, fraud, or undue influence (under Danielson) or provide strong proof that the allocation contradicts economic reality.

Application of Law to the Facts

The Court summarily rejected the COGS argument, finding that the Broadvox Group was purely a provider of telecommunication services and did not sell material products.

Regarding the characterization of the payments, the Court looked to the explicit terms of the Asset Purchase Agreement. Section 3.1 of the APA defined the "Purchase Price" to include the "Assumed Liabilities," which specifically listed the Verizon Cure. Furthermore, the bankruptcy court’s confirmation order found that the consideration paid (including the cure costs) constituted "fair and reasonable" value for the assets. The Tax Court found no ambiguity in these documents that would allow the petitioners to escape the form of the transaction under the Danielson or strong proof rules.

The Court acknowledged the petitioners’ argument that the payments helped Broadvox avoid its own potential liability. However, the Court held that even if the payments served a dual purpose—resolving Broadvox’s liability and acquiring Infotelecom’s assets—the capitalization rules control. The liabilities paid were primarily Infotelecom’s, and their satisfaction was an explicit condition of the asset sale. The Verizon stipulated order and the APA made the "Cure" a prerequisite for the transaction. Therefore, the payments were directly related to the acquisition of a capital asset.

Conclusions

The Tax Court upheld the Commissioner’s determination in full. The Court concluded that:

Service Providers Cannot Claim COGS: Broadvox, as a service provider, was not entitled to treat the settlement payments as a cost of goods sold.
Capitalization Trumps Deduction: Because the payments to AT&T and Verizon were directly related to the acquisition of Infotelecom’s assets and the assumption of its liabilities, they were capital expenditures under section 263.
Strict Statutory Ordering: Even if the payments could arguably be classified as business expenses under section 162 (to protect the taxpayer’s business), section 263 takes precedence. Since the origin of the expenditure was the asset acquisition process, capitalization was mandatory.

The Court ruled that the entire $3,162,000 must be capitalized into the basis of the acquired assets rather than deducted in the year of payment.

Prepared with assistance from NotebookLM.