When visualizing the impact of tax reform (as enacted by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97) on sports franchises, one may first think of Major League Baseball, the National Football League, the National Hockey League, and the National Basketball Association. However, organizations in many other sports are also affected, such as the WNBA, golf, tennis, professional soccer, professional boxing, UFC, martial arts, bowling, auto racing, NASCAR, and rugby.
The new rules also apply to minor league teams (outside of tax-exempt college sports programs) and tangentially affect the individuals who participate in athletic competitions such as athletes, coaches, and team managers in these sports, especially current and former athletes who have formed businesses to earn money for endorsements, appearances, summer camps, and more.
This discussion focuses on two of the most notable business provisions in the TCJA affecting sports franchises. The first item relates to new like-kind exchange provisions under Sec. 1031, and the second one relates to the qualified business income (QBI) deduction under Sec. 199A, since most sports franchises are organized as flowthrough entities for income tax purposes.
Sec. 1031
Sec. 1031 has been an important tool for sports franchises, as teams are regularly trading players to improve the perceived level of talent and enhance the teams' chances of winning. Every trade has winners and losers, but, in the case of the winners, the gain was historically considered tax-free so long as a team did not also receive cash consideration in the exchange.
A player trade generally involves assuming the arriving players' compensation, including salary, bonus, options, and more, while the team is generally relieved of the departing players' compensation. In some instances, cash is included in the trade to even out the value of the contracts exchanged. When a team receives cash, the cash is not considered qualified exchange property and is therefore categorized as "boot" in the transaction, resulting in that team's being required to recognize the boot received in the transaction as taxable income.
By way of background, the term "property" for these purposes under pre-TCJA law comprised both real property and personal property, including intangible personal property such as intellectual property, which includes player contracts (see Rev. Rul. 67-379 and Rev. Rul. 71-137). As a result, professional sports teams have historically been entitled to nonrecognition treatment under Sec. 1031 for player trades.
In an unfortunate development for sports franchises, post-TCJA, nonrecognition treatment for like-kind exchange purposes now applies only to real property held for productive use in a trade or business, i.e., land and buildings; exchanges of intangible property occurring after Dec. 31, 2017, are outside the scope of Sec. 1031. Accordingly, sports franchises are required to recognize gain or loss on a player trade equal to the difference between the fair market value of property exchanged measured on the date of the sale or exchange relative to the team's tax basis in the player contract (e.g., legal fees to negotiate the contract, upfront contractual payments or obligations to the athletes that are being amortized over the life of the contract, and other miscellaneous capitalized intangible costs).
The playing field has now changed as professional sports teams must generally recognize taxable gain on the appreciation in value of a traded player's contract, even if no cash is involved in the transaction. The realized gain is now considered recognized immediately for all player trades that occur on or after Jan. 1, 2018.
Most sports franchises are strategic in timing player trades to take advantage of an elevation in performance right before the trade, so as to receive the most value in the exchange. As a result, a gain on a player trade generally occurs when an athlete's performance improves. Therefore, the better a player has performed over time, the higher the player's value along with the potential gain to the team as a result of the trade.
To determine the actual value of the player contracts for tax reporting purposes, sports franchises should engage independent professional valuation firms that specialize in these valuations, as a unique skill is required that takes into account actuarial values based on factors such as player age, amounts paid to other players with similar statistics, increased marketing/sponsoring value versus lowered performance, and more. The value that is established for these purposes should be consistently reported by both sides to the trade to prevent possible adjustments to value and tax assessments upon IRS examination.
Fortunately, the impact of gain recognition is only one of timing since any gain recognized on the exchange will generally result in additional tax basis for those player contracts that were transferred to the team. The additional tax basis is generally amortizable over the life of the new player contract(s). Therefore, while teams lose because nonrecognition treatment under Sec. 1031 is no longer available, teams win in that the trade's upfront cost will be offset by amortization deductions over the life of the new contract. If a player whose contract was newly acquired were to be traded once again or were to sustain injuries that rendered him or her unable to compete, the team should be in a position to recover the capitalized cost sooner.
In an effort to avoid time-consuming and complex disputes between professional sports teams and the IRS regarding the value of personnel contracts and draft picks when it comes to determining the proper amount of gain or loss to be recognized for federal income tax purposes on the trade of one or more personnel contracts or draft picks, the IRS has provided a safe harbor under Rev. Proc. 2019-18. The safe harbor allows professional sports teams to treat certain player and staff-member contracts and draft picks as having a zero value for determining gain or loss to be recognized on the trade of player or staff-member contracts or draft picks.
The IRS outlined the following requirements for using the safe harbor with respect to trades of personnel contracts and draft picks:
- The parties to the trade that are subject to federal income tax in the United States must treat the trade on their respective federal income tax returns consistent with the revenue procedure;
- Each team that is a party to the trade must transfer and receive a personnel contract or draft pick. In the trade, no team may transfer property other than a personnel contract, draft pick, or cash;
- In the trade, no personnel contract or draft pick may be an amortizable Sec. 197 intangible; and
- The financial statements of teams that are parties to the trade must not reflect assets or liabilities resulting from the trade other than cash.
In general, except as discussed below, a professional sports team making a trade of a personnel contract or draft pick that meets the requirements of the safe harbor will recognize no gain or loss for federal income tax purposes because the contract value of each personnel contract or draft pick is treated as zero under the revenue procedure.
However, under Sec. 1001 and Regs. Sec. 1.167(a)-8, a team making a safe-harbor trade of a personnel contract or draft pick recognizes gain to the extent of the excess of the amount realized over the unrecovered basis (if any) of the personnel contract or draft pick traded, subject to the rules of Sec. 1231 and Sec. 1245. Under Sec. 1001, Sec. 165, and Regs. Sec. 1.167(a)-8, a team making a trade of a personnel contract or draft pick recognizes a loss to the extent of the excess of the unrecovered basis of the personnel contract or draft pick traded, over the amount realized, subject to the rules of Sec. 1231.
Sec. 1231 provides rules for determining whether gain or loss on sales or exchanges of property used in a trade or business is capital or ordinary. Sec. 1245 generally provides that ordinary income could result from the disposition of Sec. 1245 property as a result of past depreciation deductions.
Under Sec. 1012, a team providing cash to another team in a trade has a basis in the personnel contract or draft pick received equal to the cash the team provides in the trade. A team providing cash to another team in a trade for two or more personnel contracts or draft picks must allocate its basis to each personnel contract or draft pick received from such team in the trade by dividing the basis by the number of personnel contracts or draft picks received from the team.
Since the contract value of each personnel contract or draft pick is treated as zero for purposes of Rev. Proc. 2019-18, a team that provides no cash in the trade has a zero basis in the personnel contract or draft pick received in the trade.
Rev. Proc. 2019-18 is effective only for agreements involving trades of personnel contracts or draft picks entered into by a professional sports team after April 10, 2019. However, a team may choose to apply the revenue procedure in any open tax year. Moreover, the revenue procedure applies only to player trades or draft picks but does not apply to trades of a team for another team or a sale of a team.
Sec. 199A
Treasury and the IRS issued final Sec. 199A regulations on Jan. 18, 2019, addressing the QBI deduction (T.D. 9847). The effect of this deduction is to provide taxpayers, including recipients of Schedules K-1 from flowthrough entities, with a maximum marginal individual income tax rate of 29.6%, versus a maximum marginal individual income tax rate of 37% without the 20% QBI deduction.
The final regulations are effective on Feb. 8, 2019, but may be relied upon by taxpayers for tax years ending in calendar year 2018. Additionally, 2018 calendar-year taxpayers may also rely on the proposed regulations issued on Aug. 16, 2018. The final regulations provide much-needed clarification to the proposed regulations, many of which affect sports franchises.
The Sec. 199A deduction allows all taxpayers, other than C corporations, with taxable income (before computing the QBI deduction) at or below a threshold amount, a Sec. 199A deduction equal to the lesser of:
- The combined QBI amount of the taxpayer, or
- An amount equal to 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the net capital gain of the taxpayer for that tax year.
For 2018, the threshold amount was equal to $315,000 for joint filers ($321,400 for 2019) and $157,500 for all other taxpayers ($160,725 for married individuals filing separate returns, and $160,700 for single individuals and heads of household for 2019). Limitations to the deduction are phased in over a range of $100,000 for joint filers and $50,000 for all other taxpayers on taxable income above the threshold amount. The threshold amounts are subject to annual inflation adjustments.
The combined QBI amount is generally equal to the sum of: (1) 20% of the taxpayer's QBI with respect to each qualified trade or business, plus (2) 20% of the aggregate amount of qualified real estate investment trust dividends and qualified publicly traded partnership income of the taxpayer for the tax year.
QBI for each qualified trade or business is generally defined to mean any item of domestic income, gain, loss, and deduction attributable to a qualified trade or business (QTB). A QTB is further defined to include any trade or business except for a specified service trade or business (SSTB).
Additionally, taxpayers with taxable income (calculated before the QBI deduction) in excess of the threshold amount may be subject to a limitation based on W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified property (wages and capital limitation) attributable to the QBI generated from each QTB. The limitation is equal to the greater of 50% of the taxpayer's share of W-2 wages, or 25% of the taxpayer's share of W-2 wages plus 2.5% of the taxpayer's share of UBIA. Taxpayers with taxable income exceeding the threshold amount may also be subject to an exclusion (or a partial exclusion if their income falls within the applicable phase-in range) for QBI generated from an SSTB.
While calculating the QBI deduction and applying the wages and capital limitation as well as the SSTB exclusion can be very difficult, the final regulations provide much-needed guidance for most businesses, including sports franchises. Despite the additional guidance, specific facts and circumstances will require prudent judgments by tax practitioners as some unanswered questions remain.
This discussion focuses on determining what constitutes a trade or business for purposes of Sec. 199A when it comes to sports franchises, as opposed to the calculation of the deduction and the allocation of wages and expenses, which are critical elements for determining the benefits to the owners of a franchise conducted as a flowthrough entity.
Determination of a trade or business for purposes of Sec. 199A: Many of the comments received by the IRS from the proposed regulations were to request clarification of the definition of "trade or business." Since determining whether an activity is considered a trade or business for Sec. 199A purposes, as opposed to an SSTB, is a first step in securing a possible tax benefit, this determination is of paramount importance.
For purposes of determining whether a trade or business exists, the IRS refers to many factors, including two Supreme Court decisions involving whether an activity rises to the level of a qualified Sec. 162 trade or business.
In Higgins, 312 U.S. 212 (1941), the Supreme Court noted that courts have established certain elements and two definitional requirements to determine the existence of a QTB. The first relates to a profit motive, and it requires the taxpayer to enter into and carry on the activity with a good-faith intention to make a profit or with the belief that a profit can be made from the activity. The second relates to the scope of the activities and is said to require considerable, regular, and continuous activity.
Next, in Groetzinger, 480 U.S. 23 (1987), the Supreme Court concluded with respect to gambling that if one's gambling activity is pursued full time, in good faith, and with regularity for the production of income for a livelihood and is not a mere hobby, it is considered a trade or business.
With these two Supreme Court decisions as a foundation, Treasury and the IRS acknowledge that an entity can conduct more than one QTB within a relevant passthrough entity (RPE), so the Service would expect to see the maintenance of different methods of accounting for each trade or business under Regs. Sec. 1.446-1(d).
This guidance is of particular importance to sports franchises seeking to identify and support the existence of multiple trades or businesses, especially where at least one may be considered an SSTB as listed in Sec. 199A(d)(2), which includes the field of athletics.
Since it would be difficult to establish that trades or businesses are separate and distinct unless a complete and separable set of books and records is kept, sports franchises should be proactive in creating a formal separation, as opposed to attempting to allocate the respective amounts of income and deduction after the books have already been closed for the RPE. It may therefore be best to house the separate trades or businesses in disregarded entities within each RPE, such as qualified Subchapter S subsidiaries or single-member limited liability companies, with each business accounted for separately to clearly meet these requirements on a go-forward basis.
The final regulations differentiate the rules when it comes to separate trades or businesses within a single RPE versus those that are separately regarded legal entities. When businesses are in separate RPEs, the proposed regulations stated that a trade or business that provides more than 80% of its property or services to an SSTB is treated as an SSTB if there is 50% or more common ownership of the trades or businesses. In cases in which a trade or business provides less than 80% of its property or services to a commonly owned SSTB, the portion of the trade or business providing the property to the commonly owned SSTB would be treated as part of the SSTB with respect to the related parties.
The final regulations are more generous and provide some opportunities, especially to owners of new franchise teams as a result of league expansions, or for franchise teams that will be acquired by strategic investors who wish to set up separate acquisition vehicles for each trade or business, especially when rollover equity is a consideration. This is because the final regulations remove the 80% rule and provide that if a trade or business provides property or services to an SSTB, and there is 50% or more common ownership of the trade or business, the portion of the trade or business providing property or services to the 50% or more commonly owned SSTB will be treated as a separate SSTB with respect to related parties. The final regulations also clarify through an example that the rule applies only to those who meet the 50% test.
As a result of the change in the final regulations, owners of the QTB providing services or property to the SSTB who are not part of the common ownership calculation will not be subject to the SSTB "taint" on the QBI generated from the QTB. While this may create planning opportunities, care should be taken to ensure compliance with the complex common ownership rules of Secs. 267(b) and 707(b).
The proposed regulations included an anti-abuse rule intended to limit the ability of taxpayers to separate their SSTB and non-SSTB income into two trades or businesses to benefit from the Sec. 199A deduction for the non-SSTB activity. The rule provided that if a trade or business has both 50% or more common ownership with an SSTB and shared expenses with an SSTB, then the trade or business is treated as incidental to, and part of, the SSTB, if the gross receipts of the trade or business are 5% or less of the total combined gross receipts of the trade or business and the SSTB in a tax year. One favorable provision in the final regulations is the removal of this anti-abuse rule primarily due to administrative difficulty and potential over-inclusiveness.
While these taxpayer-favorable changes to the common ownership rule have a potentially positive impact on newly acquired teams, it would be extremely difficult to break up a sports franchise operating as an S corporation into components in a tax-free manner under Sec. 355, for a variety of reasons. Most notably, there will continue to be commonality of ownership in a spinoff (as opposed to a split-up) since shares in the spun-off company are distributed pro rata to the ultimate team ownership, thus preventing the needed ownership separation. Also, the tax savings of undertaking a spinoff would seem to indicate that there was primarily a tax-avoidance purpose for the separation as opposed to a required corporate business purpose.
Moreover, failure to qualify a split-up as tax-free could result in a Sec. 311(b) gain equal to the value of the separated trade or business assets relative to the S corporation's tax basis in those business assets in addition to a taxable distribution (for a spinoff) subject to the Sec. 1368 rules for S corporations, or a taxable redemption (for a split-off) to the redeemed shareholder. In both instances, the S corporation's accumulated adjustments account would be reduced dollar for dollar in the case of a spinoff and by a percentage of the total amount in the case of a redemption.
Application of Sec. 199A to sports franchises: Treasury and the IRS received a number of comments around the meaning of the term "athletics" specifically in the context of professional sports teams. In the preamble to the proposed regulations, Treasury commented, "While sports club and team owners are not performing athletic services directly, that is not a requirement of Section 199A, which looks to whether there is income attributable to a trade or business involving the performance of services in a specified activity, not who performed the services." As such, no changes were made in the final regulations to the meaning of the term athletics for purposes of Sec. 199A.
More specifically, while Congress articulated its views on what constitutes athletics, the preamble to the final regulations also included a very specific example from Regs. Sec. 1.199A-5(b)(3)(vii), Example 7, which provides as follows:
C is a partner in Partnership, which solely owns and operates a professional sports team. Partnership employs athletes and sells tickets and broadcast rights for games in which the sports team competes. Partnership sells the broadcast rights to Broadcast LLC, a separate trade or business. Broadcast LLC solely broadcasts the games. Partnership is engaged in the performance of services in an SSTB in the field of athletics within the meaning of section 199A(d)(2) or paragraphs (b)(1)(vii) and (b)(2)(viii) of this section. The tickets sales and the sale of the broadcast rights are both the performance of services in the field of athletics. C is a passive owner in Partnership, and C does not provide any services with respect to Partnership or the sports team. However, because Partnership is engaged in an SSTB in the field of athletics, C's distributive share of the income, gain, deduction, and loss with respect to Partnership is not eligible for a deduction under section 199A.
While the final regulations retain the treatment of professional sports clubs and team owners as trades or businesses within the field of athletics, the door was left ajar when it comes to making a factual determination as to whether these teams are conducting multiple trades or businesses, and whether any such business falls outside of the meaning of athletics. It may be possible that the facts and circumstances support identification of multiple trades or businesses within a single RPE.
The preamble to the regulations provides that if the owners, for example, have a separate entity that is not engaged in the performance of services in an SSTB in the field of athletics, then "a professional sports club's operation of an athletic team is [an SSTB]," and further specifically outlined in Example 7, "[i]ncome from that trade or business [includes] income from ticket sales and broadcast rights." On the other hand, the "provision of services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public" is not an athletic SSTB.
Neither sports clubs nor owners need to perform athletic services for the business to "involve" athletic services. Ticket and broadcast licensing revenue does not qualify as QBI, whereas regional sports networks or cable networks (e.g., such as the MSG Network, SYN, the Mid-Atlantic Sports Network, and Pac-10) should qualify, subject to anti-abuse rules, since they provide teams with additional off-the-field revenues by providing media rights, outside of the traditional broadcast revenue for the teams they represent, while heavily promoting the teams they carry, which feeds into new revenues in other qualifying areas.
While not explicitly addressed in the example, it is possible for related-party stadium rental income to qualify as QBI, since the preamble makes it clear that a professional sports club may operate more than one trade or business. For example, the IRS agrees that concession services generally would not be a trade or business of performing services in the field of athletics, thus opening the door for yet another QTB.
When performing this analysis for a sports franchise, the trade-or-business-level application needs to be identified first, using the Sec. 162 trade-or-business standard before applying any of the other functional or related-party rules needed to qualify for a QBI deduction. It is necessary to examine whether the particular income-producing activity is its own trade or business, or if it is part of a larger trade or business for purposes of testing the activity's QTB status.
The revenue streams that need to be evaluated include sponsorships, qualifications of which may depend on the reputation or skill of those doing the sponsorship; the stadium/arena; income from areas outside of the stadium/arena including parking lot revenue; third-party entertainment events; programs for fans that may depend on player involvement; media guides; merchandising and licensing activities containing team logos; income received from leaguewide revenue for which the underlying source of the revenue is for broadcast rights or merchandising; and any Schedules K-1 received by the league (where an independent analysis would need to have been performed by the league's tax representatives). The owners would also need to consider the application of limitations at each trade or business level as well as at the owner level for team operations.
In terms of expense allocations, each entity must use a reasonable method to allocate items across multiple trades or businesses if it conducts more than one trade or business and has items of QBI that are properly attributable to more than one trade or business. A reasonable method should be developed based on all of the relevant facts and circumstances. A different methodology is available for separate items of income, gain, deduction, and loss, but each methodology must be reasonable and consistently applied from one tax year to another such that it clearly reflects the income and expenses of each trade or business. If the business maintains separate books and records, these methods may already have been established, which may make it easier to support the allocation.
Sports franchises should be careful when performing reasonable allocations of an athlete's wages, which may be needed to increase the W-2 base for each trade or business but which could hurt the categorization of that business in that an allocation of a portion of the athlete's W-2 wages could automatically disqualify the business as an SSTB.
When applying these rules to sports franchises, it is important to note that an owner's reasonable compensation from an S corporation, or Sec. 707(a) and 707(c) payments from a partnership, are not considered QBI for purposes of calculating the deduction.
Once the partner or shareholder receives all of the Schedules K-1 from the respective businesses, it must be considered whether it makes sense to aggregate the activities at the shareholder or partner level. To aggregate, there must be 50% or more ownership for the majority of the tax year as determined under Secs. 267(b) and 707(b), and two of the following three requirements must be met: all of the businesses (1) provide similar products, property, or services that are customarily offered together; (2) share facilities or centralized business elements such as accounting and legal personnel; and (3) are operated in coordination with or in reliance upon others in the aggregated group.
An annual statement is required to disclose the entities being aggregated. Despite the annual reporting requirement, the choice to aggregate is irrevocable and cannot be changed from year to year unless there is a material change in circumstances. However, new entities can be added to the existing group if they meet the above requirements.
The final regulations also clarified that the aggregation rules are applied at the trade or business level, such that RPEs can make the aggregation election as well as individuals. This differs from the proposed regulations, which only allowed individuals to elect to aggregate entities. It is important to note that none of the aggregated trades or businesses can be an SSTB. Moreover, the aggregated trades or businesses must report items within the same tax year (i.e., one business can't have a fiscal year while another business has a calendar year).
Implications
Sports franchises have been granted a partial victory in that the final QBI regulations reinforce and expand the many opportunities that sports franchises have to separate trades or businesses to maximize each owner's QBI deduction and reduce overall taxable income. At the same time, sport franchise owners find themselves in the loss column when it comes to player trades and the revised like-kind exchange rules. Given the complexities of these new rules, owners of sports franchises should consult with their tax advisers to find the winning strategy when it comes to navigating these changes.
EditorNotes
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.
