Temnorod et al. v. Commissioner

VoIP Pioneers Denied $3.1M Write-Off for Bankruptcy Buyout Costs

What's at stake when a company facing bankruptcy is bought out? For shareholders of Broadvox, Inc., a pioneer in Voice over Internet Protocol (VoIP), the answer is a $3.162 million tax dispute. Broadvox reported a total loss of $7.7 million stemming from transactions related to the bankruptcy of a related company, Infotelecom, LLC. The core issue was whether payments made to AT&T and Verizon to acquire Infotelecom's assets could be immediately deducted as "Cost of Goods Sold" (COGS) or business expenses. The Tax Court ruled against the shareholders and in favor of the IRS. These payments constituted capital expenditures under Section 263 of the Internal Revenue Code, and thus had to be capitalized. Section 263 disallows current deductions for capital expenditures; instead, these costs are added to the asset's basis and recovered through depreciation or amortization. The ruling triggered substantial tax deficiencies for Broadvox's shareholders.

The Interconnection Trap: How the Debt Arose

Broadvox, LLC, founded in the early 2000s by Messrs. Temnorod and Blumin, pioneered Voice over Internet Protocol (VoIP) phone calls. The company routed calls using a competitive local exchange carrier (CLEC), Infotelecom. Only CLECs could enter into interconnection agreements with incumbent local exchange carriers (ILECs) like AT&T and Verizon. Thus, Broadvox relied on CLECs such as Infotelecom to connect calls through the ILECs, whose customers were often the intended recipients of Broadvox's customer's calls. In 2004, Temnorod and Blumin formed their own CLEC, Infotelecom, to directly connect with ILECs.

BV LLC and Infotelecom entered into a Carrier Service Agreement (CSA) in 2008, stipulating that Infotelecom would route BV LLC's VoIP traffic, interconnecting with third parties, including ILECs, as needed. The agreement mandated BV LLC to promptly pay Infotelecom all charges billed by third parties associated with BV LLC’s traffic.

Under interconnection agreements with AT&T and Verizon, Infotelecom maintained that it was providing "information services," as its call traffic passed through the internet, not traditional phone lines. However, AT&T and Verizon insisted that the traffic constituted long-distance services. This disagreement led to growing "deltas"—unpaid disputed amounts—as Infotelecom paid AT&T and Verizon less than they claimed was owed. Despite these disputes, Infotelecom billed BV LLC at rates not substantially above what it paid the ILECs and did not pass the accumulating deltas back to BV LLC as it could have under the CSA.

By early 2011, AT&T threatened Infotelecom with service disconnection unless it immediately placed approximately $3 million in escrow. Infotelecom initially responded by initiating legal proceedings, but in October 2011, it filed for Chapter 11 bankruptcy protection. AT&T subsequently filed unsecured creditor claims for approximately $10.2 million, and Verizon filed claims for about $13.9 million in Infotelecom's bankruptcy case.

In 2012, Infotelecom proposed a bankruptcy plan to sell its assets, including its interconnection agreements, to Broadvox's subsidiary, BV Holding. As part of this deal, BV Holding agreed to pay "Cure Costs" to settle the debts owed to AT&T and Verizon. Specifically, the "AT&T Cure" was $1,562,004, while the "Verizon Cure" amounted to $1,600,000.

Arguments: COGS vs. Capitalization

The central legal conflict revolved around whether the $3.1 million in payments made to AT&T and Verizon by Broadvox's subsidiary, BV Holding, could be treated as currently deductible expenses or whether they had to be capitalized as part of the asset acquisition. The petitioners, Broadvox, argued that they were in the business of providing telecommunications services. They contended that the payments were either "cost of goods sold" or ordinary and necessary business expenses deductible under Section 162. Section 162 allows deductions for ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Broadvox argued that the payments were inextricably linked to their business and represented payments for "previously purchased services." They asserted that these payments settled potential liabilities to Verizon and AT&T, who might have pursued Broadvox for Infotelecom's debts under the interconnection agreements, thus avoiding a potential Chapter 7 bankruptcy for Infotelecom. In essence, they claimed the payments were to protect the business, not to purchase assets.

The IRS countered that the payments were explicitly part of the purchase price for assets under the bankruptcy agreement. Citing Section 3.1 of the Asset Purchase Agreement, the IRS noted that the purchase price included the cash purchase price, assumed liabilities (including the Verizon Cure), and Broadvox's waiver of its unsecured claims against Infotelecom. The IRS invoked the "Danielson rule" and the "strong proof rule." The Danielson rule, stemming from Commissioner v. Danielson, prevents a taxpayer from challenging the tax consequences of an agreement unless they can prove unenforceability due to mistake, fraud, undue influence, or duress. Similarly, the strong proof rule holds taxpayers to the tax consequences of the agreements they sign unless they can provide strong proof to the contrary. The IRS emphasized the administrative burden of allowing taxpayers to escape the form of their self-structured transactions. They argued that Broadvox's intent was irrelevant, citing cases like Arkansas Best Corp. v. Commissioner, and that the payments were "in connection with" the asset acquisition, thus requiring capitalization. The IRS further pointed out inconsistencies between the purchase price allocation in Broadvox's original tax returns and their financial statements.

Court: Services Don't Have COGS, and Contracts Matter

The Tax Court sided with the IRS, offering three key reasons for disallowing Broadvox's $3.1 million write-off.

First, the court rejected Broadvox's attempt to claim cost of goods sold (COGS). The court emphasized that the Broadvox Group was in the business of providing telecommunication services, not manufacturing or merchandising products. Citing Guy F. Atkinson Co. of Cal., the court stated that COGS is generally linked to mining, manufacturing, or merchandising products and is not applicable in service industries. The court refused to allow Broadvox to reduce its gross income through COGS, given its business model.

Second, the court invoked the "Danielson rule." This rule, established in Commissioner v. Danielson, generally binds a taxpayer to the unambiguous terms of a contract they've signed. Under the Danielson rule, a taxpayer can only challenge the tax consequences of an agreement if they provide proof admissible in court that would alter the agreement's construction or show its unenforceability due to mistake, undue influence, fraud, or duress. The Asset Purchase Agreement explicitly defined the payments as part of the "Purchase Price" for acquiring Infotelecom's assets. The court found no ambiguity in this allocation, even considering arguments about liability release. The court noted the bankruptcy court's finding that the Purchase Price constituted “full, adequate consideration and reasonably equivalent value for the Acquired Assets.” Because the taxpayers failed to prove the agreement was unenforceable, the court refused to let them ignore the form of their own transaction.

Third, the court addressed the capitalization issue under Section 263. Section 263 disallows current deductions for capital expenditures; instead, these costs must be capitalized. The court stated that even if the payments were viewed as settlements of potential liabilities to Verizon and AT&T, these liabilities were assumed to acquire assets. Applying the "process of acquisition" test, the court found that costs directly related to acquiring assets, including assumed liabilities, must be capitalized. Critically, the court emphasized that Section 263 takes precedence over Section 162, which allows deductions for ordinary and necessary business expenses, citing Sections 161 and 261 and Commissioner v. Idaho Power Co. Therefore, even if the payments could potentially be deductible under Section 162, the fact that they were directly related to the asset acquisition meant they had to be capitalized.

What This Means for Bankruptcy Buyouts

This case serves as a cautionary tale for future taxpayers involved in mergers and acquisitions, particularly those involving distressed companies and bankruptcy asset purchases. The Tax Court’s decision reinforces the principle that "cure costs"—payments made to resolve a bankrupt entity's liabilities as a condition of acquiring its assets—are generally treated as capital expenditures rather than deductible business expenses. These costs are considered part of the acquisition price and must be capitalized.

The court's emphasis on the form of the contract is particularly important. Taxpayers are bound by the agreements they enter into and cannot easily recharacterize payments to achieve a more favorable tax outcome, absent proof of mistake, fraud, undue influence, or duress under the Danielson rule.

The Tax Court also underscored the priority of Section 263, which mandates capitalization, over Section 162, which allows deductions for ordinary and necessary business expenses. Even if payments might otherwise be deductible under Section 162, if they are directly related to the acquisition of a capital asset, Section 263 requires capitalization. The court explicitly cited Sections 161 and 261 and Commissioner v. Idaho Power Co. to support this principle.

Ultimately, the Tax Court sided with the IRS, holding that Broadvox was not entitled to reduce its 2012 taxable income by $3,162,000, nor could it treat those payments as cost of goods sold. Decisions will be entered for the IRS.