Temnorod v. Commissioner

The $3.1 Million Capitalization Clash

At stake is $3.162 million in tax deficiencies stemming from a dispute over the proper tax treatment of payments made during a complex asset acquisition. The Tax Court sided with the IRS against shareholders of Broadvox, Inc., a pioneer in Voice over Internet Protocol (VoIP) technology. The court determined that payments totaling $3.162 million, made to resolve bankruptcy disputes during the acquisition of assets from a related company, must be capitalized rather than deducted as ordinary business expenses or treated as Cost of Goods Sold (COGS). This decision impacts the shareholders of Broadvox, as losses from the S corporation flow through to their individual tax returns.

From Innovation to Insolvency

The case centered on payments made in connection with the bankruptcy of Infotelecom, a Competitive Local Exchange Carrier (CLEC). In the early 2000s, Messrs. Temnorod and Blumin, the individuals behind Broadvox, Inc. (Broadvox), helped to pioneer Voice over Internet Protocol (VoIP) technology. They initially conducted business through Broadvox, LLC (BV LLC), formed in 2001, motivated by the cost disparity between long-distance and local calls. At the time, incumbent local exchange carriers (ILECs) like AT&T and Verizon were permitted by the Federal Communications Commission (FCC) to charge relatively high rates for accepting long-distance calls routed through traditional phone lines. Temnorod and Blumin believed that because VoIP calls were sent through internet connections rather than traditional phone lines, they should be categorized as "information services," thus exempting them from the higher long-distance rates.

To handle its customers' VoIP call traffic, BV LLC needed to route calls through a CLEC, as only CLECs could enter into interconnection agreements with ILECs. BV LLC was not a CLEC itself. Consequently, BV LLC passed its customers’ calls to various CLECs for a fee, who then passed the calls to an ILEC when needed.

In 2004, Temnorod and Blumin formed Infotelecom to act as their own CLEC. Unlike BV LLC, Infotelecom could enter into interconnection agreements (ICAs) with ILECs directly. Infotelecom was wholly owned by Infotelecom Holdings, LLC, and treated as a disregarded entity for federal income tax purposes. The ownership of BV LLC was then reorganized under a holding company, BV Holding, which was in turn wholly owned by Brivia Communications Corp., later renamed Broadvox, Inc. (Broadvox) in 2007.

BV LLC and Infotelecom entered into a Carrier Service Agreement (CSA) on June 1, 2008, under which 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 necessary. The agreement stipulated that BV LLC would promptly pay Infotelecom all access charges, reciprocal compensation, and other charges billed to Infotelecom by a third party associated with BV LLC’s traffic.

Infotelecom entered into interconnection agreements with AT&T and Verizon. Infotelecom maintained that it was providing "information services" to the ILECs, since its call traffic passed through the internet. However, AT&T and Verizon insisted the traffic constituted long-distance services. Over several years, Infotelecom paid AT&T and Verizon less than the ILECs believed they were owed under the interconnection agreements, resulting in growing payment differentials. Infotelecom billed BV LLC at rates at or slightly above what it paid AT&T and Verizon and never passed the accumulating differentials (deltas) to BV LLC, despite having the contractual right to do so under the CSA.

By early 2011, AT&T demanded that Infotelecom escrow approximately $3 million, threatening service disconnection and termination of the interconnection agreements. Infotelecom initially responded by initiating proceedings against AT&T in federal court and before 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 Infotelecom’s bankruptcy proceedings, AT&T submitted unsecured creditor claims totaling approximately $10.2 million, and Verizon submitted unsecured creditor claims totaling approximately $13.9 million.

The Price of Admission: The 'Cure' Payments

Infotelecom initially responded by initiating proceedings against AT&T in federal court and before 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 Infotelecom’s bankruptcy proceedings, AT&T submitted unsecured creditor claims totaling approximately $10.2 million, and Verizon submitted unsecured creditor claims totaling approximately $13.9 million.

An Asset Purchase Agreement (APA) executed around April 20, 2012, outlined the terms for BV Holding's acquisition of substantially all of Infotelecom's assets. For BV Holding, Broadvox's subsidiary, to acquire Infotelecom's assets, it had to address outstanding debts to AT&T and Verizon. These payments were termed "Cure Costs," defined in Section 1.10 of the APA as "amounts that must be paid and obligations that otherwise must be satisfied . . . in connection with the assumption and/or assignment of the Assigned Contracts.”

Section 2.4(a) of the APA stipulated that Infotelecom would be responsible for all Cure Costs, "including those relating to AT&T and its affiliates but specifically excluding any Cure Costs payable in connection with the assumption and assignment of the Verizon ICAs (the “Verizon Cure”), and [BV Holding] shall have no liability therefore or otherwise in connection therewith other than in respect of the Verizon Cure." In other words, BV Holding was responsible only for Verizon's cure costs, while Infotelecom was responsible for AT&T's.

Section 5.1 of the APA further clarified that the "Assumed Liabilities" included the Verizon Cure, along with all allowed administrative expense claims and priority unsecured claims in Infotelecom’s bankruptcy case. In essence, to assume Infotelecom's interconnection agreements with Verizon and AT&T, BV Holding, through the APA, agreed to pay off Infotelecom's debts to Verizon (approximately $1.6 million) and Infotelecom paid off AT&T (~$1.5M). These "Cure Costs" were the price of admission for acquiring Infotelecom's assets and assuming its contractual obligations.

COGS vs. Capitalization: Drawing the Battle Lines

The core of the reporting dispute centered on how Broadvox treated the $3.162 million in "Cure" payments on its 2012 tax return. Broadvox classified this entire sum as "Cost of Goods Sold" (COGS), directly reducing its gross receipts and generating a reported loss of $7,792,736 for the year. This, in turn, affected the individual petitioners, who, as S corporation shareholders, reported their pro rata shares of Broadvox's loss on their individual tax returns, as mandated by Section 1366(a)(1). Section 1366(a)(1) directs S corporation shareholders to account for their proportionate share of the corporation’s loss for the tax year.

The petitioners argued that these payments were, in essence, a settlement of potential liabilities and the prevention of future lawsuits from Verizon and AT&T. They contended that these payments were for "previously purchased services" that were inextricably linked to Broadvox's business and should be considered either COGS or, at the very least, deductible business expenses. Section 162(a) allows a deduction for "ordinary and necessary" expenses paid or incurred during the taxable year in carrying on any trade or business.

The IRS, however, took a different view. The Commissioner argued that the $3.162 million in "Cure" payments were part of the purchase price for acquiring Infotelecom's assets, including the interconnection agreements with Verizon and AT&T, and therefore had to be capitalized. The IRS also pointed to inconsistencies between Broadvox's tax returns and its financial statements, where the acquired asset values and liabilities assumed were reported differently.

Bound by the Deal: The Danielson Rule

The IRS, however, took a different view. The Commissioner argued that the $3.162 million in "Cure" payments were part of the purchase price for acquiring Infotelecom's assets, including the interconnection agreements with Verizon and AT&T, and therefore had to be capitalized. The IRS also pointed to inconsistencies between Broadvox's tax returns and its financial statements, where the acquired asset values and liabilities assumed were reported differently.

Addressing the cost of goods sold (COGS) argument first, the court noted that the Broadvox Group was in the business of providing telecommunication services, not creating or selling material products. The court cited Guy F. Atkinson Co. of Cal., 82 T.C. 269, 298 (1984), which established that COGS is linked to mining, manufacturing, or merchandising products, not applicable to service industries. Therefore, the court refused to allow Broadvox a reduction in gross income for COGS.

Next, the court turned to the form of the transaction. The Commissioner invoked the "Danielson rule," stemming from Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967). The Danielson rule states that when a taxpayer signs a contract unambiguously specifying the consideration for a purchase, the taxpayer is generally bound by that specification for tax purposes, absent extraordinary circumstances. To challenge the tax consequences, the taxpayer must adduce proof that would be admissible in an action between the parties to the agreement to alter the contract or show its unenforceability because of mistake, undue influence, fraud, duress, etc.

The court also referenced the "strong proof rule," which some courts employ instead of the Danielson rule. This rule, articulated in Ullman v. Commissioner, 264 F.2d 305, 308 (2d Cir. 1959), requires "strong proof" to overcome a contractual allocation of value when the parties have specifically set out the covenants and assigned values within the contract. The Tax Court, in Major v. Commissioner, 76 T.C. 239, 247 (1981), clarified that this requires proving the alleged alternative allocation beyond a mere preponderance of the evidence.

Broadvox argued that neither the Danielson rule nor the strong proof rule applied because the Asset Purchase Agreement (APA) did not unambiguously allocate the purchase price among the various elements of Infotelecom's consideration. However, the court disagreed, finding no ambiguity. The court noted Broadvox's argument regarding the lack of specific allocation to liability releases. Nevertheless, Broadvox failed to provide proof that the APA was the result of mistake, undue influence, fraud, or duress. Further, the bankruptcy court itself had found that the purchase price constituted "full, adequate consideration and reasonably equivalent value for the Acquired Assets."

The court emphasized that, in general, taxpayers are bound by the form of the transaction that they chose, citing Commissioner v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974). Broadvox could not now disavow the structure of its own agreement to achieve a more favorable tax outcome. The court found Broadvox's situation similar to that in G.C. Services Corp. v. Commissioner, 73 T.C. 406, 411–12 (1979), where the Tax Court held there was an unambiguous allocation of the entire purchase price to the asset purchased despite a provision for mutual release from liability. Therefore, the court determined that the "Cure" payments were indeed part of the purchase price, aligning with the form of the transaction memorialized in the APA.

Acquisition Costs, Not Business Expenses

The court then moved to its second major rationale, emphasizing the priority of capitalization. Even if the "Cure" payments settled liabilities, the court determined they were incurred in the "process of acquisition." The court explained that even if a payment by BV Holding to resolve Broadvox Group's potential liabilities to Verizon and AT&T might otherwise give rise to a deduction under Section 162, which allows deductions for ordinary and necessary business expenses, further inquiry was still required. The court reasoned that the payments primarily resolved Infotelecom's liabilities to Verizon and AT&T.

Critically, these payments were directly related to BV Holding's acquisition of Infotelecom's assets. The court cited Lychuk v. Commissioner, 116 T.C. 386 (2001), underscoring that such costs must be capitalized. The Tax Court then articulated a bedrock principle of tax law: If a payment arguably falls under both a deduction provision and a capitalization provision, the capitalization provision prevails. Citing Sections 161 and 261, as well as Commissioner v. Idaho Power Co., 418 U.S. 1 (1974), the court reinforced that Section 263 takes precedence. Section 263 disallows deductions for capital expenditures, ensuring that costs associated with acquiring or improving assets are added to the asset's basis rather than being immediately expensed.

The Tax Court emphasized that the Verizon and AT&T "Cure" payments were negotiated between Infotelecom and those respective entities to settle disputes over interconnection agreement deltas. Broadvox argued that the tax status of such a payment should be determined by the "origin of the claim" doctrine, established in United States v. Gilmore, 372 U.S. 39 (1963). The "origin of the claim" doctrine dictates that whether an expense is a deductible "business" expense depends on the origin and character of the claim with respect to which the expense was incurred, rather than its potential consequences. However, the court found that here, the origin of the claim was Infotelecom's liability, assumed by BV Holding in the asset acquisition. Therefore, all components of the Asset Purchase Agreement Payments were directly related to the acquisition of Infotelecom’s assets. The court noted, for example, that the Verizon Cure was an explicit condition of BV Holding’s acquisition.

The court concluded that the payments BV Holding made to resolve Infotelecom’s liabilities to Verizon and AT&T were capitalizable. Under the David R. Webb Co. principle, the payment of an obligation of a preceding owner of property by the person acquiring such property is a capital expenditure that becomes part of the cost basis of the acquired property. Even if the payments resolved the Broadvox Group's own potential liabilities and would, absent other considerations, give rise to a deduction under Section 162, Section 263 dictates that these payments are still capitalizable because they were properly allocable to resolving Infotelecom's liabilities, and that resolution was directly related to the asset sale. As Section 263 takes precedence over Section 162, Broadvox was required to capitalize the entirety of BV Holding’s payments to Infotelecom and Verizon.

The Tax Court's decision carries a clear impact for taxpayers acquiring distressed assets. Such taxpayers must capitalize "cure" payments as part of the asset's basis, rather than deducting them immediately, reinforcing the importance of structuring acquisitions carefully to avoid unintended tax consequences. The court's ruling reinforces the principle that the form of a transaction, as memorialized in the Asset Purchase Agreement, will generally govern its tax treatment absent compelling evidence to the contrary. The court found Broadvox's situation similar to that in G.C. Services Corp. v. Commissioner, 73 T.C. 406, 411–12 (1979), where the Tax Court held there was an unambiguous allocation of the entire purchase price to the asset purchased despite a provision for mutual release from liability. Therefore, the court determined that the "Cure" payments were indeed part of the purchase price, aligning with the form of the transaction memorialized in the APA.