Temnorod et al. v. Commissioner

Millions in VoIP Losses Disconnected by Tax Court

The shareholders of Broadvox, an S corporation, faced significant tax deficiencies totaling over $1 million combined for the sample years under scrutiny. This stemmed from the IRS disallowing a $7.8 million loss deduction claimed by the company. At the heart of the matter was whether payments made during a bankruptcy asset sale could be immediately deducted as Cost of Goods Sold (COGS) to offset income. The Tax Court sided with the IRS, enforcing strict capitalization rules for asset acquisitions; meaning the shareholders were not allowed to deduct the losses on their individual income tax returns.

The 'Delta' Dispute and the Bankruptcy Buyout

Following the disallowed loss deduction, the Tax Court delved into the specifics of the underlying transactions. The story begins in the early 2000s, when Messrs. Temnorod and Blumin sought to capitalize on the emerging Voice over Internet Protocol (VoIP) technology. They initially conducted their business through Broadvox, LLC (BV LLC), formed in 2001. Their strategy hinged on exploiting the difference in regulatory treatment between traditional long-distance calls and VoIP calls, the latter of which they argued should be categorized as "information services" and thus not subject to higher long-distance rates charged by incumbent local exchange carriers (ILECs) like AT&T and Verizon.

To service its customers, BV LLC relied on competitive local exchange carriers (CLECs) to connect calls to ILECs, as only CLECs could enter into interconnection agreements with ILECs. In 2004, Temnorod and Blumin formed their own CLEC, Infotelecom, allowing them to directly interconnect with ILECs. Infotelecom was wholly owned by Infotelecom Holdings, LLC. The ownership structure then evolved, with BV Holding formed to hold all membership interests in BV LLC. BV Holding was, in turn, wholly owned by Brivia Communications Corp., which later changed its name to Broadvox, Inc.

BV LLC and Infotelecom formalized their relationship with a Carrier Service Agreement (CSA) in 2008. Under the CSA, Infotelecom would route BV LLC's VoIP traffic and bill BV LLC for associated charges, including "inter or intrastate access charges, reciprocal compensation, and/or any other charges, surcharges and/or taxes" billed by third parties, such as AT&T and Verizon.

A dispute arose concerning interconnection rates with AT&T and Verizon. Infotelecom contended its traffic constituted "information services," while AT&T and Verizon insisted on charging higher long-distance rates. This resulted in growing payment differentials, or "deltas." Infotelecom did not pass these "deltas" on to BV LLC. By early 2011, AT&T threatened service disconnection unless Infotelecom escrowed approximately $3 million. Infotelecom initially responded with legal action but ultimately filed for Chapter 11 bankruptcy protection in October 2011. In the bankruptcy proceedings, AT&T filed unsecured creditor claims of approximately $10.2 million, and Verizon filed claims of approximately $13.9 million.

Infotelecom filed a bankruptcy plan in February 2012, proposing to sell its assets, including its interconnection agreements, to BV Holding. The proposed asset purchase agreement stipulated BV Holding would pay $1 million to Infotelecom and $1 million to Infotelecom's bankruptcy trust.

In March 2012, the bankruptcy court approved a settlement (the "AT&T stipulated order") under which AT&T would settle its claims for a $1,562,004 payment from Infotelecom, termed the "AT&T Cure." A similar agreement was reached with Verizon in April 2012 (the "Verizon stipulated order"), with BV Holding agreeing to pay Verizon $1.6 million, termed the "Verizon Cure."

An Asset Purchase Agreement executed around April 20, 2012, formalized BV Holding's purchase of Infotelecom's assets, subject to bankruptcy court approval and auction procedures. The agreement defined "Cure Costs" as amounts needed to be paid for the assumption of assigned contracts. The agreement stipulated that Infotelecom would be responsible for all Cure Costs except the Verizon Cure, which BV Holding would assume. The purchase price included $1,630,000 in cash, the assumption of certain liabilities, and the waiver of certain pre-petition claims. These assumed liabilities included allowed administrative expense claims, priority unsecured claims, and the Verizon Cure.

Service Costs or Asset Purchase? The Classification Battle

The core dispute centered on whether the $3.16 million in payments constituted ordinary business expenses or capital expenditures. Broadvox included $1,562,000 of the Cash Purchase Price (roughly equal to the AT&T Cure) and the $1,600,000 Verizon Cure, a total of $3,162,000, as cost of goods sold on its 2012 Form 1120S. The Commissioner examined Broadvox’s 2012 tax return and disallowed the inclusion of any of the Asset Purchase Agreement Payments in cost of goods sold. This led to a re-evaluation of the petitioners' individual tax liabilities.

Petitioner's Argument: The taxpayers argued the $3.16 million payments should be classified as cost of goods sold (COGS) or, alternatively, as deductible business expenses. They contended that these payments were made to "forestall" potential lawsuits and settle existing liabilities, stemming from "previously purchased services," rather than simply to acquire assets.

IRS Argument: The IRS countered by emphasizing the principle of form over substance. The Asset Purchase Agreement (APA) explicitly identified these "Cure" payments as part of the consideration exchanged for the assets. Therefore, the IRS argued, under Internal Revenue Code (IRC) Section 263, these payments must be capitalized. Section 263(a) generally prohibits deducting "[a]ny amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate," effectively requiring such expenditures to be added to the property's basis and depreciated over time. The IRS maintained that the explicit language of the APA was determinative, regardless of the taxpayer's characterization.

Bound by the Contract: The Court's Ruling

The Tax Court sided with the IRS, disallowing Broadvox's claimed deductions. First, the court rejected Broadvox's attempt to treat the payments as cost of goods sold (COGS). COGS is a reduction in gross receipts related to the production of sales of goods. Referencing Guy F. Atkinson Co. of Cal., 82 T.C. 269 (1984), the court emphasized that COGS applies to businesses engaged in mining, manufacturing, or merchandising products. Broadvox, as a telecommunications service provider, did not fit this description.

Turning to the heart of the dispute, the court invoked the Danielson rule and the "strong proof" rule to uphold the unambiguous language of the Asset Purchase Agreement (APA). The Danielson rule, stemming from Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), generally binds a taxpayer to the explicit terms of a contract unless they can prove "mistake, undue influence, fraud, duress, etc." that would render the agreement unenforceable in a standard contract dispute. Similarly, the "strong proof" rule, articulated in Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959), requires a taxpayer to present strong evidence to overcome an allocation of value explicitly stated in a contract.

The court found no ambiguity in the APA's allocation of the purchase price to the acquisition of Infotelecom's assets. While Broadvox argued that the agreement also encompassed liability relief, the court stated that Broadvox failed to prove the APA resulted from "mistake, undue influence, fraud, or duress." It highlighted that the bankruptcy court had already determined the purchase price constituted "full, adequate consideration" for the assets. Even if the "strong proof" rule permitted Broadvox to argue an alternative allocation, the court concluded the APA was thoroughly vetted.

Finally, even if ambiguity did exist, the court stated that the payments must be capitalized. The IRS argued, under Internal Revenue Code (IRC) Section 263, that the payments were related to resolving Infotelecom’s liabilities and acquiring Infotelecom’s assets. Section 263(a) generally prohibits deducting amounts "paid out for new buildings or for permanent improvements or betterments made to increase the value of any property," effectively requiring such expenditures to be capitalized and depreciated over time. Referencing Lychuk v. Commissioner, 116 T.C. 374 (2001), the court explained that payments tied to an asset acquisition must be capitalized. Even if some portion of the payment could arguably be deductible under Section 162, which allows deductions for ordinary and necessary business expenses, the court held that capitalization under Section 263 takes precedence. Sections 161 and 261 reinforce this principle. Therefore, Broadvox was required to capitalize the entirety of the payments.

The Price of Structure

The Tax Court's decision underscores a critical lesson for taxpayers involved in mergers and acquisitions, particularly those emerging from bankruptcy proceedings. Referencing Lychuk v. Commissioner, 116 T.C. 374 (2001), the court explained that payments tied to an asset acquisition must be capitalized. Even if some portion of the payment could arguably be deductible under Section 162, which allows deductions for ordinary and necessary business expenses, the court held that capitalization under Section 263 takes precedence. Sections 161 and 261 reinforce this principle. Therefore, Broadvox was required to capitalize the entirety of the payments.

This case serves as a warning: the specific structure of an Asset Purchase Agreement can have significant tax consequences. If a company explicitly agrees to pay "Cure Costs" – that is, costs to bring contracts current – as part of acquiring assets, the IRS and the Tax Court are likely to view those payments as acquisition costs, which must be capitalized, rather than ordinary operating expenses, which can be deducted. The court’s decision highlights the importance of carefully considering the tax implications of contract language in M&A transactions and bankruptcy buyouts. The form of the contract, ultimately, binds the tax treatment.