S Corporation Can't Deduct Asset Acquisition Costs as Cost of Goods Sold

(Parker Tax Publishing December 2025)

The Tax Court held that an S corporation, operating as a telecommunications service provider, could not treat as cost of goods sold payments that it made to acquire assets of a business in bankruptcy that was owned by several of the S shareholders. The court concluded that under the asset purchase agreement, all components of the payments were directly related to the acquisition of the business's assets, and the taxpayer was bound by the form of the asset purchase transaction. Temnorod v. Comm'r, T.C. Memo. 2025-127.

Background

Broadvox, Inc. (Broadvox), a Voice over Internet Protocol (VoIP) service provider, is an S corporation. It reported a loss on its 2012 Form 1120S, which was in turn reported by its shareholders on their 2012 Forms 1040. Subsequent litigation regarding the loss involved five of Broadvox's eight shareholders, including Andre Temnorod who owned 43 percent of Broadvox.

The 2012 loss stemmed from transactions relating to the 2011 Chapter 11 bankruptcy of Infotelecom, LLC (Infotelecom), which was wholly owned by Infotelecom Holdings, LLC, an entity in which Temnorod and other Broadvox shareholders owned interests. In connection with Infotelecom's bankruptcy proceedings, a wholly owned subsidiary of Broadvox purchased substantially all of Infotelecom's assets. In 2012, under the terms of an Asset Purchase Agreement and Infotelecom's plan of reorganization, Broadvox paid $1,660,754 to Infotelecom and $1,600,000 to Verizon Communications, Inc. (Verizon), and agreed to assume certain liabilities in exchange for all of Infotelecom's assets. Infotelecom used some of the cash it received from the Asset Purchase Agreement and reorganization plan to pay AT&T, Inc. (AT&T) $1,562,004. Both Verizon and AT&T had submitted significant claims as creditors in Infotelecom's bankruptcy.

On its 2012 Form 1120S, Broadvox reported the $1,600,000 payment to Verizon and $1,562,000 of the $1,660,754 payment to Infotelecom, for a total of $3,162,000, as cost of goods sold. In total, Broadvox reported a $7,792,736 loss largely stemming from these transactions and in turn reported those losses of the 2012 Schedule K-1s of its shareholders. The IRS audited Broadvox's 2012 return and disallowed the $3,162,000 increase to cost of goods sold after concluding that those payments should have been capitalized.

Temnorod and the other shareholders petitioned the Tax Court, arguing that while Broadvox was a service provider, the Asset Purchase Agreement payments at issue were for "cost of sales" and thus equivalent to cost of goods sold. They maintained that the $3,162,000 was inextricably linked to Broadvox's trade or business and represented payments for "previously purchased services." Alternatively, the shareholders asserted that the Asset Purchase Agreement payments were ordinary and necessary business expenses since Broadvox paid or incurred a total of $5,438,048 (including assumed liabilities) under the terms of the Asset Purchase Agreement but only $2,276,048 of this amount was consideration for Infotelecom's assets. Thus, the shareholders contended that the remaining $3,162,000 was paid in settlement of Broadvox's potential liability to Verizon and AT&T and was therefore a deductible business expense.

The IRS countered Broadvox's theory in part by pointing to Section 3.1 of the Asset Purchase Agreement which provided that "the purchase price for the Business and the Acquired Assets shall be the aggregate of" the cash purchase price, the assumed liabilities, and Broadvox's waiver of its unsecured claims against Infotelecom. The IRS argued that, under the "Danielson rule," which is based on the Third Circuit's decision in Comm'r v. Danielson, 378 F.2d 771 (3d Cir. 1967), Broadvox must be held to the tax consequences agreed to in connection with Infotelecom's bankruptcy. The IRS also cited the "strong proof rule," which provides that strong proof must be adduced by parties to a transaction, where the parties have specifically set out certain covenants in a contract, in order to overcome such covenants.

Broadvox argued that neither the Danielson rule nor the "strong proof rule" applied to Section 3.1 of the Asset Purchase Agreement because that provision did not unambiguously allocate the purchase price among the various elements of Infotelecom's consideration.

Analysis

The Tax Court rejected Broadvox's arguments and readily concluded that all components of the Asset Purchase Agreement payments were directly related to the acquisition of Infotelecom's assets and thus not deductible as cost of goods sold. Cost of goods sold, the court explained, is linked to mining, manufacturing, or merchandising products and is not applicable in services industries. It was clear to the court that Broadvox was in the business of providing telecommunication services to customers, and not in the business of creating or selling any material products. Therefore, the court said, the payments Broadvox made to resolve Infotelecom's liabilities to Verizon and AT&T had to be capitalized.

Addressing the form of the transaction and its implications, the court cited the Danielson rule in agreeing with the IRS that when a taxpayer signs a contract unambiguously specifying the consideration for a purchase or purchases, the taxpayer generally is bound by that specification for tax purposes, absent extraordinary circumstances. The taxpayers, the court concluded, did not provide proof that the Asset Purchase Agreement was the result of mistake, undue influence, fraud, or duress which would allow the court to ignore its provisions stating that the payments at issue were for the acquisition of Infotelecom's assets.

For a discussion of the tax rules relating to the sale of a business, see Parker Tax ¶118,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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