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I recently published an article in the Journal of Corporate Taxation, "Tax Court Holds That Acquisition Expenditures Paid to Creditors of Bankrupt Corporation Must Be Capitalized", (WG&L), Mar/Apr 2026, which analyzes the Tax Court's recent decision in Temnorod v. Commissioner, T.C. Memo. 2025-127 (12/8/2025). This article can be accessed online through RIA Checkpoint and on WESTLAW. I am the editor-in-chief of Corporate Taxation and serve as its Columnist on Cross-Border (international) developments. I thought a summary of the case posted on this blog would be helpful.

The Tax Court in Temnorod v. Commissioner, T.C. Memo. 2025-27 examined whether certain costs, in whole or in part, incurred by the purchaser of assets as part of a Chapter 11 proceeding from an affiliate company are presently deductible, are not currently deductible or, alternatively, represent a cost of goods sold. The Tax Court's holding and analysis in Temnorod, supra, reminds tax professionals and their clients (taxpayers) that the capitalization rules of Section 263 override the business deduction rules under Section 162 in determining the tax acquisitions to acquisition costs. In many business planning and transactions, expenditures are attempted to be deducted by the parties to the transaction in computing taxable income. In various instances, as reflected in a legion of case law, the Service may disagree and claim that the acquisition expenses in question must be capitalized. Section 263(a)(1) and the INDOPCO regulations deny a deduction of a capital expenditure related to tangible or intangible property. The judicial principle that the rules requiring capitalization “override” the deductibility of a business expense is based on the Congressional intent that deductions are matters of legislative grace with the taxpayer bearing the burden of proof on entitlement to claimed deductions consistent with Congressional intent. Even where capitalization is required, there are a number of provisions in the Code which allow for the amortization of capital expenses, including cost recovery allowances. See, e.g., Sections 167(a), 168, 197, 248, 1016(a)(1).

In some instances, the expenditure in question may neither be capital in nature or a deductible expense. It may constitute a cost of goods that offsets gross receipts in computing gross income. Cost of goods sold has the effect of a business deduction in computing gross income from sales but it not an expense or deduction. See Reg. 1.162-1(a). The regulations do not set forth a specific definition of costs of goods sold but an important reference point is Reg. 1.61-3(a):

“In general. In a manufacturing, merchandising, or mining business, “gross income” means the total sales, less the costs of goods sold, plus any income from investments and from incidental or outside operations or sources. Gross income is determined without subtraction of depletion allowances based on a percentage of income to the extent that it exceeds cost depletion which may be required to be included in the amount of inventoriable costs as provided in Reg. 1.471-11 and without subtraction of selling expenses, losses or other items not ordinarily used in computing costs of goods sold or amounts which are of a type for which a deduction would be disallowed under section 162(c), (f), or (g) in the case of a business expense. The costs of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer...”

In computing costs of goods sold, as otherwise applies in claiming a business expense deduction, the taxpayer must prove the amount expended for purchases of goods acquired for resale. For accrual basis manufacturers required to account for inventories and for costs of goods sold, the taxpayer must be able to identify the costs of merchandise on hand at year end so that such costs may properly be capitalized as an asset. Costs in year-end inventory are not charged against current revenues but are carried forward, as inventory assets, to future periods and charged against revenues when the inventoriable items are actually sold, retired, or abandoned. An important limitation is that a taxpayer engaged in a trade or business involving the performance of services, however, is not entitled to a costs of goods sold deduction.

Returning to capital versus ordinary business expense, a long-standing judicial rule of construction is employed by the courts in distinguishing a business deduction from a capital expenditure. Such rule asks whether the expenditure in issue: (1) [c]reates or enhances a separate and distinct asset; and (2) produces a significant future benefit; or (3) is incurred 'in connection with the acquisition of a capital asset, which includes expenditures incurred in the process of acquiring a capital asset". Sections 263, 263A. See INDOPCO, Inc. v. Comm'r, 503 US 79 (1992). A corollary to this principle is that in general, costs incurred in the acquisition or disposition of a capital asset must be treated as capital expenditures. Comm'r v. Lincoln Savings & Loan Assoc., 403 US 345 (1971) (expenditure that “serves to create or enhance...a separate and distinct asset” required to be capitalized); Comm'r v. Idaho Power Co., 418 U.S. 1 (1974) (capitalization required of equipment depreciation incurred during construction of capital facilities regardless of Section 167(a)); Woodward v. Comm'r, 397 US 572 (1970).

Facts: Temnorod v. Commissioner

The case involved the deductibility of an operating loss reported by an S corporation, Broadvox, Inc. (Broadvox), for its 2012 tax year which loss was allocated among the shareholders for reporting on their individual returns under the Subchapter S provisions. Several shareholders, and the named petitioners in this case, claimed a net operating loss carryback to their 2010 tax year. The 2012 operating loss was generated as a result of its acquisition in a bankruptcy reorganization of an affiliated entity, Infotelecom, LLC (Infotelecom). Infotelecom is wholly owned by Infotelecom Holdings which had filed for federal bankruptcy relief under Chapter 11 in 2011. In turn, Infotelecom Holdings was owned by the three major shareholders of Broadvox, again co-petitioners in the case were, including the leading named petitioner, Andre Temnorod. Andre was a 50% member in Holdings, and two other individuals were 25% members. Broadvox a related entity engaged in a voice over internet protocol business which routed calls from customers through Infotelecom which had entered into interconnection agreements with AT&T and Verizon. The two major carriers claimed that Infotelecom owed more than $3M in payment differentials on the amounts paid and what the carriers stated was owed.

As part of Infotelecom's bankruptcy proceedings, Broadvox Holding Co., LLC (BV Holding) purchased substantially all of Infotelecom's assets. Under the terms of the asset purchase agreement (“APA”) which was court approved under Infotelecom's plan of reorganization, BV Holding paid, at closing, approximately $1.6M to Infotelecom for its assets and an additional $1.6M to Verizon Communications, Inc. (Verizon), a major creditor of Infotelecom. It further agreed to assume certain liabilities, including a second claim for unpaid licensing access fee owed to AT&T. The seller, Infotelecom, used a portion of the sale proceeds to pay AT&T, for its unpaid licensing fees in the amount of $1.56M. Infotelecom's obligations to pay such licensing fee claims, referred to as “cure costs”.

On Broadvox's 2012 Form 1120S, it treated both the $1.6M payment made by its single member entity, BV Holding, under the APA to Verizon as well as Infotelecom's required payment of $1.56M to AT&T, or the aggregate amount of $3.16M, to pay off cure cost claims of the seller as “costs of goods sold”. This directly reduced its taxable income. Overall, Broadvox reported an operating loss of $7.8M for 2012. As shareholders in the S corporation, the co-petitioners reported their pro rata shares of Broadvox's loss on their respective original and amended 2012 Forms 1040 in accordance with Section 1366(a)(1). In 2016 Infotelecom Holdings, LLC, amended its 2012 return to reclassify the proceeds from the sale of goodwill of $3.16M inadvertently recorded as “gross receipts”, explaining that “the return has been amended to properly classify proceeds from the sale of goodwill of $3,162,000 inadvertently recorded as gross receipts.”

Upon audit and review of the 2012 return, the Service disallowed Broadvox's claimed increase to costs of goods sold of $3.16M and required such amounts to be capitalized. Notices of deficiency were issued by the Service to each shareholder of Broadvox, who then filed petitions with the Tax Court. The Service further disallowed the net operating loss carryback to 2010 with respect to the three majority shareholders for their proportionate shares of the reported 2012 loss either, as first reported, as a reduction in “gross receipts” or alternatively as chargeable to costs of goods sold. The issue for determination in the case was whether the approximate $3.16M in payments realized by the seller for “cure cost” obligations to AT&T and to Verizon were with respect to the buyer, part of costs of goods sold, a deductible business expense, or instead were required to be capitalized.

The petitioner-shareholders of the buyer maintained that even though their trade or business was telecommunications services, the payments made for the Verizon cure costs should still be treated as “costs of sales” and reflected in costs of goods sold. In the alternative, petitioners maintained that the subject expenses were otherwise deductible under Section 162(a). The petitioners' rationale was that such payments were inextricably linked to Broadvox's “previously purchased services”. The Court noted, as had the government, that the petitioners did not explain, however, how such costs were incurred in the manufacture or production of goods. Since the seller was engaged in a service business, it could not have “costs of goods sold”.

More attention was given by Judge Copeland, who presided over the trial and issued the Court's Memorandum decision, to the petitioners' alternative argument that the cure costs paid were deductible under Section 162(a) for that portion of the APA amount realized ($5.44M) over the portion of the purchase price attributable to Infotelecom's assets ($2.28M). The deductible amount claimed under the alternative approach was therefore $3.16M, which again was the aggregate amount paid to Verizon and AT&T. In support of their position, the petitioners argued that had the chapter 11 plan not been effectuated, Broadvox would have been liable to pay the cure cost claims for breach of contract directly as part of a chapter 7 plan of liquidation. Were that the case, such payment would not be required to be capitalized and added to its asset basis but instead would be deductible in computing taxable income. Treatment as a Section 162 deduction should therefore result, ad arguendo, in the same outcome as reported by the taxpayer-petitioners and eliminate the proposed deficiencies in tax. Such "what if" argument advanced by the petitioners was rejected.

Tax Court Rules in Favor of the Government

The Tax Court quickly resolved the claimed costs of goods sole deduction. Judge Copeland stated that "[A]threshold characteristic of costs of goods sold is that the expense is part of a business of creating or selling material products, i.e., mining, manufacturing, or merchandising products. In contrast, costs of goods sold are not applicable to service industries such as telecommunication services as was the business of Infotelecom. Judge Copeland summarily dismissed the costs of goods sold argument made by the petitioners.

The Court next addressed whether the petitioners could allocate a portion of the purchase price for the assets among the contractual claims of the two major carries and then allow each payment made to the carriers as a deductible business expense. The Court employed the well-known Danielson Rule (and "strong proof exception") and therefore the seller was required by the terms of the APA to capitalize the expenses attributable to the cure costs. Judge Copeland cited the Tax Court's precedent in Major v. Commissioner, 78 T.C. 238 (1989)("where one alleges that an allocation is actually other than that contained in a contract, that party must prove it beyond a mere preponderance of the evidence--he must present 'strong proof' that that allocation [the proposed] is correct based on the intent of the parties and the economic realities"). The taxpayers argued that since the APA did not specifically allocate the purchase price among the various elements of Infotelecom's consideration, the petitioners were permitted to make such allocation in light of the contractual ambiguity notwithstanding the Danielson Rule. However, the Tax Court made a fact-finding that there was no ambiguity present in this case. It further held that the “strong proof” exceptions were not present. Instead, the opposite was true as the opinion noted that the APA was “thoroughly vetted by the bankruptcy court and other creditors”.

In the alternative, even if the Court were to find that a certain level of ambiguity was present in the purchase price allocation in the APA, it still would that the full amount of the APA payments had to be capitalized because paying the seller's cure costs were a material part of the overall asset purchase transactions. Here the buyer's payments to satisfy the seller's cure cost obligation to Verizon and AT&T were directly related to their acquisition of Infotelecom's assets requiring capitalization. Where a payment falls under both a deduction provision and a capitalization provision, then capitalization is required citing the Supreme Court's decision in Commissioner v. Idaho Power Co., 418 US 1 (1974) (construction related costs, including equipment depreciation) and its prior decision in Lychuk v. Commissioner, 116 T.C. 374 (2001). Moreover, the payment of an obligation of a preceding owner of property by the person acquiring such property is part of the buyer's cost basis and must be capitalized.

As part of Judge Copeland's decision, she noted certain facts on the record on which its holding was based, including the negotiations by the parties in settlement of the cure costs to the major carries, there were amounts allocated under the APA to the cure payments, and observed that the argument made by the petitioners that the cure costs would have been deductible by the selling company had it remained in business was not determinative. Therefore the $3.16M in cure cost payments and debt assumption were required to be capitalized and were not deductible.

THIS POST IS FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY AND MAY NOT BE RELIED UPON BY THE READER AS LEGAL OR TAX ADVICE. READERS ARE ENCOURAGED TO CONSULT WITH THEIR TAX ADVISORS ON THE MATTERS RAISED IN THIS POST.