Temnorod et al. v. Commissioner

VoIP Pioneers Face $3 Million Capitalization Dispute

At stake for a group of S corporation shareholders is approximately $800,000 in tax deficiencies stemming from the IRS's disallowance of over $3 million in deductions claimed by their company, Broadvox. The central conflict revolves around whether payments made to "cure" defaults with telecom giants like AT&T and Verizon during a bankruptcy asset acquisition can be immediately deducted as cost of goods sold (COGS) or must be capitalized. The Tax Court sided with the IRS, determining that these payments were indeed capital expenditures and could not be deducted, a decision that will impact the shareholders' tax liabilities.

From Bankruptcy to Buyout: The Infotelecom Deal

The dispute over Broadvox's deductions stems from a complex series of transactions involving Voice over Internet Protocol (VoIP) services and a bankruptcy proceeding. In the early 2000s, Messrs. Temnorod and Blumin, the shareholders of Broadvox, pioneered the commercial use of VoIP, which routes phone calls over the internet rather than traditional phone lines. Seeing an opportunity due to the high cost of long-distance calls on traditional phone lines, they initially operated through Broadvox, LLC (BV LLC).

To service VoIP calls, BV LLC needed to route traffic through a Competitive Local Exchange Carrier (CLEC), which then connected to Incumbent Local Exchange Carriers (ILECs) like AT&T and Verizon. Because only CLECs can enter into interconnection agreements with ILECs, BV LLC passed its customers’ calls to various CLECs for a fee. In 2004, Temnorod and Blumin formed their own CLEC, Infotelecom, allowing them to directly connect with ILECs. Infotelecom was wholly owned by Infotelecom Holdings, LLC, and treated as a disregarded entity for tax purposes. Subsequently, the ownership of BV LLC was reorganized under a holding company, BV Holding, which was in turn owned by Brivia Communications Corp., later renamed Broadvox, Inc.

BV LLC and Infotelecom formalized their relationship with a Carrier Service Agreement (CSA) in 2008. Under the CSA, Infotelecom accepted call traffic from BV LLC's VoIP customers and routed those calls, interconnecting with third parties as necessary. Section 13 of the CSA stipulated that BV LLC would promptly pay Infotelecom for all access charges, reciprocal compensation, and taxes billed by or remitted to a third party, associated with BV LLC’s traffic.

Infotelecom entered into interconnection agreements with AT&T and Verizon. However, disputes soon arose. Infotelecom contended that it was providing only "information services," but AT&T and Verizon insisted on classifying the traffic as long-distance services, leading to disagreements over rates and growing payment differentials, or "deltas." Despite these disagreements, Infotelecom billed BV LLC at rates equal to or only slightly above what it paid AT&T and Verizon, and it never passed through these "deltas" to BV LLC under the terms of the CSA.

By early 2011, these accumulated "deltas" became substantial, prompting AT&T to threaten service disconnection and termination of the interconnection agreements unless Infotelecom escrowed approximately $3 million. Infotelecom responded by initiating legal proceedings against AT&T, but in October 2011, it voluntarily filed for Chapter 11 bankruptcy protection. In the bankruptcy proceedings, AT&T submitted unsecured creditor claims of approximately $10.2 million, and Verizon submitted claims of approximately $13.9 million.

To resolve the bankruptcy, Infotelecom filed a plan proposing the sale of its assets, including the assignment of its interconnection agreements, to BV Holding. As part of this plan, a stipulated order with AT&T required Infotelecom to pay $1,562,004 (the "AT&T Cure") to settle its unsecured creditor claims. A similar agreement with Verizon stipulated that the purchaser of Infotelecom's assets (either BV Holding or another bidder) would pay Verizon $1.6 million (the "Verizon Cure").

On or around April 20, 2012, Infotelecom and BV Holding executed an Asset Purchase Agreement, outlining BV Holding's acquisition of substantially all of Infotelecom's assets, contingent on bankruptcy court approval and auction procedures. This agreement addressed "Cure Costs," defining them as amounts necessary for the assumption and/or assignment of the interconnection agreements. The agreement specified that Infotelecom would be responsible for all Cure Costs, except for the Verizon Cure, which BV Holding would assume. The purchase price included a cash component of $1,630,000, the assumption of certain liabilities, including the Verizon Cure, and the waiver of pre-petition claims filed by BV LLC.

COGS vs. Capital: The Classification Battle

Following the Infotelecom deal, a dispute arose over how Broadvox classified the $3.1 million in cure payments on its 2012 tax return.

Petitioner's Argument: Broadvox claimed the $3.1 million payments, which were used to cure defaults on interconnection agreements with AT&T and Verizon, were properly classified as 'Cost of Goods Sold' (COGS). Alternatively, Broadvox argued that these payments were deductible as ordinary and necessary business expenses under Section 162. Section 162 allows taxpayers to deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Broadvox asserted that the payments were made to resolve existing liabilities and save the business, characterizing them as payments for 'previously purchased services.'

IRS Argument: The IRS contended that the $3.1 million in payments were not COGS or deductible expenses, but rather part of the purchase price for assets acquired under the Asset Purchase Agreement. Therefore, the payments should be capitalized rather than immediately deducted. The IRS invoked the Danielson rule, a legal principle stating that a party can only challenge the tax consequences of their own agreement if the agreement is unenforceable due to mistake, undue influence, fraud, or duress. The IRS argued that Broadvox was bound by the form of the transaction as laid out in the Asset Purchase Agreement, which explicitly listed these cure payments as assumed liabilities and part of the purchase price. The IRS highlighted a discrepancy between Broadvox's tax returns, which treated the payments as COGS, and Infotelecom Holdings LLC's amended return, which stated that proceeds from the sale of goodwill were "inadvertently recorded as gross receipts."

Court Rules: Acquisition Context Demands Capitalization

Following arguments regarding undue influence, fraud, or duress, Judge Copeland addressed the core tax classification disputes. The IRS maintained that Broadvox was bound by the form of the transaction as laid out in the Asset Purchase Agreement, which explicitly listed these cure payments as assumed liabilities and part of the purchase price. The IRS highlighted a discrepancy between Broadvox's tax returns, which treated the payments as COGS, and Infotelecom Holdings LLC's amended return, which stated that proceeds from the sale of goodwill were "inadvertently recorded as gross receipts."

Judge Copeland sided with the IRS, delivering a blow to Broadvox's attempts to deduct the payments as Cost of Goods Sold (COGS). The court first rejected Broadvox's COGS argument outright, citing Guy F. Atkinson Co. of Cal. v. Commissioner, 82 T.C. 275 (1984). The court emphasized that COGS is strictly tied to businesses involved in creating or selling tangible products, such as manufacturing, merchandising, or mining. Because the Broadvox Group provided telecommunication services, not material goods, the court found that they could not claim COGS.

The court then turned to the form of the transaction. Citing Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), Judge Copeland invoked the "Danielson rule," which states that a taxpayer is generally bound by the unambiguous terms of a contract they sign, absent extraordinary circumstances. The Danielson rule allows a taxpayer to challenge the tax consequences of an agreement only by proving mistake, undue influence, fraud, or duress. Alternatively, the court noted that some jurisdictions apply the "strong proof rule," requiring taxpayers to offer "strong proof" to overcome the allocations explicitly stated in their contracts, as defined in Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959).

Judge Copeland determined that neither standard helped Broadvox. Despite Broadvox’s claims of ambiguity in the Asset Purchase Agreement, the court found no ambiguity. The court determined that Broadvox failed to prove the agreement resulted from mistake, undue influence, fraud, or duress, a prerequisite for sidestepping the Danielson rule. The court highlighted the bankruptcy court's finding that the purchase price constituted "full, adequate consideration" for the acquired assets.

Finally, the court addressed the interplay between deduction and capitalization. Even if the payments resolved Infotelecom’s liabilities, the court reasoned that they were directly related to Broadvox's acquisition of Infotelecom's assets. Referencing Internal Revenue Code (IRC) Section 263, which requires capitalization of expenditures that create a benefit lasting more than one year, Judge Copeland stated that capitalization was required. The court then explained that even if a payment could be deductible under a provision like Section 162, which allows deductions for ordinary and necessary business expenses, capitalization requirements take precedence. The court cited IRC Sections 161 and 261, which establish this "priority-ordering directive," as well as Commissioner v. Idaho Power Co., 418 U.S. 1 (1974). The court highlighted the Verizon and AT&T cure payments were negotiated to resolve Infotelecom's liabilities, not Broadvox's, in the asset acquisition.

Impact: The High Cost of Cure Payments

This case reinforces that 'cure' costs paid to assume contracts in bankruptcy sales are capital expenditures, not deductible expenses. The court's decision highlights the reach of the 'Danielson rule,' which, although not explicitly invoked here, embodies the principle that taxpayers often are held to the deal structure they sign. While the Danielson rule, established in Commissioner v. Danielson, generally prevents a party from challenging the tax consequences of their own agreement unless there is a showing of mistake, undue influence, fraud, or duress, the principle here is similar: Broadvox negotiated and executed an asset purchase agreement and now must live with the tax consequences of that structure. In this instance, that means they cannot recharacterize payments made to assume contracts as something other than what they were -- part of the cost of acquiring the assets. More broadly, the case affirms that even if a payment might otherwise be deductible under Section 162, which allows deductions for ordinary and necessary business expenses, capitalization requirements take precedence.

The key takeaway for future taxpayers is that when acquiring assets, liabilities assumed as part of the deal are part of the asset's basis, not an immediate write-off. This is because Section 263 disallows immediate deductions for amounts paid for assets with a useful life beyond one year. As the court emphasized, this falls under the "priority-ordering directive," meaning capitalization under Section 263 always trumps deductibility under Section 162 when an expenditure relates to the acquisition of an asset.