Andre Temnorod & Brianna Temnorod, et al. v. Commissioner

Broadvox Shareholders Denied $3M Deduction for Bankruptcy 'Cure' Payments

Shareholders of Broadvox face significant tax deficiencies (totaling over $1 million across the group) after the Tax Court rejected their $3.16 million Cost of Goods Sold deduction. Judge Copeland ruled that payments made to settle a related bankrupt company's debts to AT&T and Verizon were capital acquisition costs, not deductible business expenses.

The VoIP Gamble and the 'Delta' Dispute

The Tax Court's decision hinged on the history of Broadvox and its related entities. In the early 2000s, Messrs. Temnorod and Blumin sought to exploit a loophole in telecommunications regulations by pioneering Voice over Internet Protocol (VoIP) phone calls. They recognized that incumbent local exchange carriers (ILECs) like AT&T and Verizon charged high rates for long-distance calls routed through traditional phone lines. Temnorod and Blumin believed that because VoIP calls used internet connections, they should be classified as "information services," subject to lower rates.

To deliver its VoIP services, Broadvox, LLC (BV LLC), the original entity used by Temnorod and Blumin, needed to route calls through a competitive local exchange carrier (CLEC). CLECs are regulated by the FCC and state public utility commissions, though historically with less stringent rate regulations than ILECs. Only CLECs can enter into "interconnection agreements" with ILECs. BV LLC, not being a CLEC itself, passed its customers’ calls to various CLECs for a fee, who in turn would pass the calls to an ILEC when needed.

In 2004, Temnorod and Blumin formed their own CLEC, Infotelecom. Unlike BV LLC, Infotelecom could enter into interconnection agreements with ILECs directly. BV LLC and Infotelecom formalized their relationship with a Carrier Service Agreement (CSA) in 2008. Under the CSA, Infotelecom would accept call traffic from BV LLC’s VoIP customers and route the calls to the intended recipients, interconnecting with third parties (including ILECs) as needed. Section 13 of the CSA stipulated that BV LLC would pay Infotelecom for "all inter or intrastate access charges, reciprocal compensation, and/or any other charges, surcharges and/or taxes billed to INFOTELECOM by a third party... associated with any of [BV LLC’s] traffic."

Infotelecom then entered into interconnection agreements with AT&T and Verizon. A dispute soon arose. Infotelecom argued that it was providing "information services" to the ILECs, while AT&T and Verizon insisted the traffic was long-distance services. This disagreement led to payment differentials, or "deltas," that grew over several years. Despite these mounting "deltas," Infotelecom never exercised its rights under section 13 of the CSA to pass these charges through to BV LLC, billing BV LLC at rates equal to or not substantially above the rate it paid AT&T and Verizon. By early 2011, AT&T demanded that Infotelecom escrow approximately $3 million, threatening service disconnection and termination of the interconnection agreements. AT&T claimed that Infotelecom was obligated to escrow this amount under the terms of their agreement. Infotelecom initially responded by commencing proceedings against AT&T in federal court and before several state public utility commissions. However, in October 2011, Infotelecom voluntarily filed for chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Ohio. In connection with Infotelecom’s bankruptcy, AT&T submitted unsecured creditor claims totaling approximately $10.2 million, and Verizon submitted unsecured creditor claims totaling approximately $13.9 million.

The Deal: Buying Assets, Inheriting Debts

As Infotelecom navigated its chapter 11 bankruptcy, it proposed selling its assets, including interconnection agreements, to BV Holding. The proposed asset purchase agreement stipulated that BV Holding would pay $1 million to Infotelecom and another $1 million to Infotelecom’s bankruptcy trust. AT&T and Verizon, as unsecured creditors, reached separate agreements with Infotelecom to settle their claims for approximately $1.6 million each, amounts referred to as the AT&T Cure and Verizon Cure, respectively.

On or around April 20, 2012, Infotelecom and BV Holding formalized their arrangement with an Asset Purchase Agreement (APA). This agreement outlined BV Holding's acquisition of substantially all of Infotelecom's assets, contingent on bankruptcy court approval and adherence to auction procedures. The APA also covered the assignment of contracts, notably the interconnection agreements, to BV Holding. Section 1.10 of the APA defined "Cure Costs" as the necessary payments and obligations for assuming and/or assigning the contracts.

Section 2.4(a) clarified that Infotelecom would handle all Cure Costs, except the Verizon Cure, which was BV Holding's responsibility. Crucially, Section 3.1, titled "Purchase Price," defined the total price for the assets. It stated that the purchase price included (a) $1,630,000 in cash, (b) the amount of the "Assumed Liabilities," and (c) the waiver of certain pre-petition claims. Section 5.1 defined "Assumed Liabilities" to include all allowed administrative expense claims, priority unsecured claims in Infotelecom’s bankruptcy case, and the Verizon Cure. The contract language explicitly included the Verizon Cure as part of the purchase price via the "Assumed Liabilities" definition.

COGS vs. Capitalization: The Legal Battle

As detailed previously, the Asset Purchase Agreement included the Verizon Cure as part of the purchase price via the "Assumed Liabilities" definition. On its 2012 Form 1120S, Broadvox included $1,562,000 of the cash purchase price (roughly equal to the AT&T Cure) and the $1,600,000 Verizon Cure, totaling $3,162,000, as cost of goods sold (COGS). Broadvox reported an overall loss of $7,792,736 for its 2012 tax year. Section 1366(a)(1) directs S corporation shareholders to take into account their pro rata shares of the corporation’s loss for the tax year. The Commissioner examined Broadvox’s return and disallowed the inclusion of these payments in COGS.

The petitioners, shareholders of Broadvox, argued that these payments, totaling $3,162,000, were inextricably linked to Broadvox’s business. They argued these payments represented payments for "previously purchased services," essentially arguing they were equivalent to cost of goods sold. Petitioners alternatively asserted that these payments were ordinary and necessary business expenses deductible under Section 162. Section 162 allows a deduction for ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. The shareholders argued only $2,276,048 of the total $5,438,048 paid under the Asset Purchase Agreement was for the assets themselves. The remaining $3,162,000, they contended, was paid to settle potential liabilities to Verizon and AT&T arising from "deltas" under interconnection agreements. Without the bankruptcy settlements, Verizon and AT&T might have pursued Broadvox for these debts or sought to convert Infotelecom’s bankruptcy to a Chapter 7 liquidation, potentially exposing Broadvox to further liability.

The IRS countered by pointing to section 3.1 of the Asset Purchase Agreement, which explicitly stated that the purchase price included the cash purchase price, the assumed liabilities (including the Verizon Cure), and the Broadvox Group’s waiver of its unsecured claims against Infotelecom. The IRS invoked the "Danielson rule," arguing that the taxpayers should be held to the tax consequences of the agreements they signed in connection with Infotelecom’s bankruptcy. The Danielson rule generally prevents a taxpayer from challenging the tax consequences of an unambiguous agreement unless they can provide evidence admissible in a contract dispute to alter its construction (e.g., fraud, mistake, duress). The IRS also argued that a buyer's intent is irrelevant when determining whether expenses related to an acquisition are capitalizable, citing Arkansas Best Corp. v. Commissioner. Furthermore, the IRS argued that any liabilities assumed in connection with the acquisition of assets must be capitalized. Capitalization is governed by Section 263(a), which generally forbids a deduction for amounts paid for permanent improvements or betterments made to increase the value of any property.

Court: Contracts Matter, Capitalization Rules

Judge Copeland first addressed Broadvox's attempt to claim cost of goods sold (COGS). He explained that the Broadvox Group was in the business of providing telecommunication services, not creating or selling physical products. Citing Guy F. Atkinson Co. of Cal., 82 T.C. 269 (1984), he noted that COGS is applicable to businesses involved in mining, manufacturing, or merchandising products, not service industries. Thus, the court rejected the leap that Broadvox was entitled to reduce gross income via COGS.

The court then turned to the form of the transaction. Referencing the "Danielson rule" derived from Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), Judge Copeland stated that a taxpayer is generally bound by the unambiguous terms of a contract absent extraordinary circumstances (mistake, undue influence, fraud, duress, etc.). Some courts apply the "strong proof rule" instead, which requires a party challenging a contract's allocation to provide "strong proof" that the allocation lacked an independent basis in fact. Here, the court found no ambiguity in the Asset Purchase Agreement (APA), which listed the payments as consideration for the acquisition of Infotelecom's assets. Judge Copeland noted the bankruptcy court's finding that the purchase price constituted "full, adequate consideration and reasonably equivalent value for the Acquired Assets," supporting the enforceability of the APA.

Finally, Judge Copeland addressed capitalization. Even if the payments settled liabilities, he stated, they were "directly related" to the asset acquisition and must be capitalized under Section 263(a). Section 263(a) generally forbids a deduction for amounts paid for permanent improvements or betterments made to increase the value of any property. The judge reasoned that the liabilities were assumed as a condition of acquiring Infotelecom’s assets, referencing Lychuk v. Commissioner, 116 T.C. 374 (2001), which held that costs directly related to an asset acquisition must be capitalized. Therefore, even if the payments could potentially have been deductible under Section 162, which allows deductions for ordinary business expenses, the capitalization requirement of Section 263 took precedence, according to Sections 161 and 261.

Warning for Bankruptcy Buyouts

The Tax Court's decision serves as a stark warning for taxpayers engaged in mergers and acquisitions, particularly those involving distressed entities in bankruptcy. The court's denial of Broadvox's deduction underscores the critical importance of clearly defining the nature of payments within an Asset Purchase Agreement. How payments are characterized—whether as part of the "purchase price" for assets or as a separate settlement of liabilities—directly dictates their tax treatment.

In this case, Broadvox sought to retroactively recharacterize payments initially defined as part of the asset purchase to achieve a more favorable tax outcome. However, the court, citing Lychuk v. Commissioner, 116 T.C. 374 (2001), emphasized that costs directly related to acquiring assets must be capitalized under Section 263(a), which disallows deductions for capital expenditures. This capitalization requirement takes precedence over Section 162, which allows deductions for ordinary business expenses, according to Sections 161 and 261.

Future taxpayers should be aware that the IRS and the courts are unlikely to allow recharacterizations of transaction terms after the fact, even if those recharacterizations would result in a lower tax liability. The Danielson rule (from Commissioner v. Danielson, 3d Cir. 1967) and the "strong proof" rule used by the Tax Court prevent taxpayers from challenging the tax consequences of their own agreements unless they can demonstrate fraud, mistake, duress, or that the agreement lacked an independent basis in fact. Therefore, careful consideration and precise drafting of Asset Purchase Agreements are essential to ensure the desired tax treatment is achieved from the outset.