A History of Tax Sheltering For Sports Team Ownership

It all traces back to a September 1934 court ruling that settled a battle between the Pittsburgh Pirates and the IRS.

In those days, MLB contracts had a one-year term with a standard renewal option (called a “reverse clause”). The reverse clause gave the player’s team the right to renew the contract each year upon expiration at a salary to be negotiated between the parties. If they were unable to agree on a salary, the team could, within certain limitations, fix the player’s salary. Although the team could not force the player to accept the renewal, it did hold the exclusive right to his services and could prevent him from playing for any other team. The player was, in effect, bound to his team for his entire professional career. For teams exercising their renewal options, players effectively had two choices: accept or retire from the game of baseball.

Player contracts were therefore valuable assets, which were bought and sold for cash amongst MLB teams. For tax purposes, the Pirates expensed the cost of the contracts they bought in the year incurred.

The IRS disagreed. Its position was that the Pirates were purchasing not only the right to use the services of the player for a year, but also the right, at its option, to continue to use his services for the entirety of his career. Therefore, the cost of the contracts should not be deducted in full in the year of purchase, but rather capitalized onto the balance sheet and then depreciated over the length of his projected career (contracts at the time had an average life of three years).

The court sided with the Pirates on the grounds that there was no guarantee that the purchasing team would be able to utilize its renewal rights, as nothing could prevent the player from quitting pro baseball(1).

More than a decade later, the ruling would give flamboyant baseball entrepreneur Bill Veeck an idea that would forever change the economics of team ownership, not just in baseball, but in all team sports. He would employ the ruling to fabricate a tax shelter designed exclusively for sports team owners, and then utilize specious logic to convince the IRS of its legality.

The idea came to Veeck just after World War II, as he was purchasing the Cleveland Indians in 1946. Veeck was interested in applying the 1934 ruling to the purchase of a team rather than just a player contract.

When a company is purchased, U.S. tax law requires the purchaser to allocate the purchase price among all of the various assets and liabilities actually acquired in the transaction, in proportion to their fair market values(2). But buying a sports team isn’t like buying a factory full of machines; you don’t get many physical assets. Instead, what you get is a series of intangible assets which are more difficult to define. You get the team’s franchise and territorial rights, its right to share in the revenues from broadcast contracts of the league, its right to local broadcast rights, a stadium contract, a right to concession income, the right to draft players, the rights to the services of the players the team has under contract, and so on.

The problem with these intangible assets was that, according to tax rules at the time, they were not depreciable. In general, to be depreciable, an asset needed to decline in value by a determinable amount, and needed to do so over a period of time that could be estimated with reasonable accuracy. These assets didn’t qualify.

The creative mind of Veeck, however, reasoned that there was nothing in the tax code preventing a new owner from assigning the vast majority of the purchase price to the supposed value of player contracts the team owned. Veeck was hoping to leverage the 1934 ruling to convince the IRS that such player contracts could be immediately expensed, to create a huge tax loss carryover for the team, which could then be used to offset future taxable income.

The IRS (shockingly) accepted Veeck’s logic, but instead required that the amount assigned to player contracts be capitalized as an asset and then depreciated over the expected useful playing lives of players acquired, a practice sanctioned under IRC 167. Since the average playing career of a pro athlete was said to be five years, the entire amount of the value ascribed to the “player contracts” asset was to be depreciated over five years (though the IRS accepted depreciation periods as short as two and a half years in some cases).

This non-cash depreciation charge, which would come to be known as the Roster Depreciation Allowance (RDA), could be used to show a large pretax loss for tax purposes despite large real-life profits which, if the team were to be structured as a pass through entity (e.g., S Corporation or partnership) could then be passed onto the owners’ personal income tax returns. With the top marginal tax rate for individuals hovering around 91 percent at the time, it would serve as a substantial tax shelter for the five years.

Reduced to its core, the theoretical value of the “player contracts” asset lied in the talent level of the underlying players. No other industry (as far as I am aware) has ever assigned a quantifiable value to the talent level of its employees and then written them off as depreciable assets. When word of Veeck’s idea swept through the offices of pro sports, it revolutionized the economics of sports ownership. What began as a ludicrous concept dreamed up from Veeck’s accountant’s office was to become a five-year cash windfall for new owners across all professional sports leagues.

At the end of the five years, the player contracts would be completely written off, and the tax shelter would disappear. But the team could then be sold to someone else, who could then proceed to do the same thing (i.e., write off most of his or her purchase price over five years). If each succeeding owner were to sell out when the tax advantages were exhausted, there would be no end to the tax sheltering opportunity. As such, between 1950 and 1975, the average pro sports team remained in the hands of a single ownership entity for just 11.7 years(3).

There is no doubt that this innovation was a stroke of pure genius on the part of Veeck, but it seems readily apparent that it was all made possible because the IRS simply made what was perhaps a huge mistake when it bought his notion that player contracts acquired when buying a team should be treated as a depreciable asset. Three of the more obvious reasons why player contracts should not be treated as depreciable assets are as follows:

First, it is not entirely clear that the “player contracts” asset should even have really existed at all – while it is relatively easy to conceive a value in player contracts, team owners do not own players as they might own, say, a chair, or a Lexus.

Second, even if the “player contracts” asset should have existed, it is not entirely clear that it actually ever declines in value – while the existing players on a roster at any given time will surely decline in production eventually, they will ultimately be replaced by new and better players in an ever-evolving cycle that will theoretically last forever.

Third, and most importantly, the mere concept only works because under the Veeck scheme, player costs are double-counted, since the salaries and the player development costs that create the depreciable “player contracts” asset are already treated as expenses at market-determined values.

Nevertheless, the RDA persisted.

Since player contracts qualified for such valuable short-term depreciation write-offs, new owners would, of course, assign as much as possible of the purchase price for their new teams to player contracts. There weren’t many restrictions placed on the allocation of value to purchased assets at the time. New owners needed only to submit to a nebulous and subjective IRS test of “reasonableness.” This led to some of the most interesting mental gymnastics by owners and league officials in the history of pro sports.

During the 1950s and 1960s, there were no indications that sports teams encountered any problems with the IRS in connection with the tax shelter, and owners were assigning the great bulk of the purchase price of teams – as much as 99 percent – to player contracts.

It took until the early 1970s before the IRS finally began to look with some suspicion at what was going on in sports. In 1970, in what appears to be the first serious attempt by the IRS to limit or eliminate the Veeck tax shelter, the IRS took a stand against future MLB Commissioner Bud Selig.

When a group led by Selig bought the bankrupt Seattle Pilots baseball team in April of 1970 for $10.8 million and moved it to Milwaukee, the 35-year-old used car dealer allocated $100,000 of the purchase price to equipment and supplies, $500,000 to the value of the franchise including league membership, and $10.2 million to the 149 players that he bought. Allocating 94 percent of the purchase price to the “player contracts” asset and then depreciating the value of that asset over five years would produce a tax shield on more than $2 million of income per year ($10.2 million / 5 years).

With the top marginal tax rate for individuals hovering around 70 percent at the time, Selig stood to earn as much as $7.1 million in future tax offsets over a five-year period. Essentially, the IRS would be funding up to 66 percent of the purchase price in the form of future tax breaks!

The IRS objected. It disallowed the entire $10.2 million allocation, arguing that the players’ contracts had zero value. It reasoned that the value of the team lied not in the player contracts but in owning the franchise itself. The franchise was a non-depreciable asset. Not only was its useful life span indeterminate but also its value, as we have seen, tends to increase over time (into the billions of dollars these days).

Selig sued the IRS, and prevailed in court. The judge ruled that: “The tax laws permit owners to write off (depreciate) the cost of the player contracts that they purchase and to write off as an expense the cost of developing new players. This in effect enables the owners to double up on expenses (allowing owners to depreciate player contracts AND expense player salaries) during the first five years of operation (the period of depreciation of the player contracts asset).”

The judge was apparently saying that having made the massive mistake of allowing new owners to depreciate the “player contracts” asset many years prior, the IRS was condemned to having its mistake persist forever. It was an IRS error that couldn’t be corrected by the judicial system.

Eventually, however, the issue would spill over into the social consciousness and, ultimately, into the legislative branch of government.

In the 1970s, concern about potential abuses of pro sports franchise ownership had risen to the point at which Congress felt it necessary to take corrective action against overstating the basis for depreciation, allowing owners to claim large tax losses despite large positive cash flows.

The Tax Reform Act of 1976 was unveiled in October, which specified that no more than 50 percent of the purchase price of a sports franchise could be allocated to the “player contracts” asset, unless a rare exemption was granted if an owner provided a reason for exceeding that amount (IRC 1056(d)). It was a material change that significantly hollowed the tax shelter. It was seen by some as an unfair singling out of sports franchises; no other industry had such specific restrictions placed on the allocation of assets in determining a business’s worth. The tax shelter would still be huge, but only about half as huge.

Tax rules for purchased intangibles were fundamentally changed in 1993, when IRC 197 was enacted as part of the Omnibus Budget Reconciliation Act of 1993. IRC 197 effectively mandated that (with limited exceptions) all purchased intangible assets could be amortized, and all over a 15-year period. The new amortization rules, which are still in effect today, would apply with immediate effect to acquisitions of intangibles in all industries except one: the sports industry, which was explicitly carved out from the law(4). Once again, the sports industry was specifically targeted for exclusion from an otherwise ubiquitous tax law.

Over the decade that followed, new sports team owners adjusted to their more stringent rules regarding amortization of player contracts by shifting their purchase price allocations. They would, of course, fully leverage the 50 percent allowable under the law allocated to the “player contracts” asset (and amortize it over five or so years accordingly). Attributing the other 50 percent of the purchase price, however, became something of an art form. In the context of the sports industry, the franchise was still considered a non-amortizable asset (though fully amortizable, as per IRC 197, in every other industry), so, instead, new owners began to attribute the remaining 50 percent to an ever expanding list of newly thought of intangible assets, including such things as media rights, facility naming rights, stadium lease agreements, concession agreements, sponsorship agreements, luxury suite contracts, season ticket holder lists, etc.

Substantial disputes arose between owners and the IRS concerning the allocations of purchase price to such intangible assets, whether such intangible assets were amortizable, and, if so, over what period of time, and got increasingly intense over the years. Naturally, new owners tended to identify and allocate large amounts of their purchase prices to assets said to have short useful lives, while the IRS tended to allocate large amounts of value to intangible value for which no determinable useful life could be shown, and would deny any amortization for those allocations of the purchase price.

By the turn of the century, the process of convincing the IRS to grant tax deductions for any of their intangible assets (even the 50 percent deduction to the “player roster” asset) became increasingly more difficult, as local auditors usually assigned to random projects were replaced by national auditors who specialized in the finances of sports teams. The IRS even established a dedicated sports franchise office in Plantation, Florida.

Unlike decades past where a local revenue agent would be star struck because the taxpayer was a local sports team, and the local agent had no experience in this complicated tax arena, the examinations were quarterbacked by exceedingly competent IRS personnel. They demanded that purchase price allocations not be arbitrarily assigned by owners with a clear bias, but rather supported by proper valuation techniques. In 2003, the IRS even sent a 15-page memo to those that audit teams to be aware of the latest government standards as it applied to taxing franchises, detailing the exact compliance guidelines for how such audits should proceed.

The most highly contentious area became the valuation and potential for amortization of media rights. With the purchase of a sports franchise, an owner acquires certain media rights, including the current broadcast contracts and the right to enter into future broadcast contracts. The IRS’ position was that media rights were non-amortizable. While the then-current broadcast contracts acquired cover distinct periods (i.e., the life of the contract itself), the IRS contended that the “media rights” asset represented by these contracts was the team’s perpetual right to share in and to receive national and local broadcast revenue. That asset, they argued, would continue on indefinitely, as the contract would either be renewed with the current broadcaster as it expired or it would be replaced with a contract from a competing broadcaster. Therefore, since the “media rights” asset neither declined in value over time nor had a specific and quantifiable life, they could not be amortized.

Owners disagreed with the IRS. As the “media rights” asset became an increasingly large allocation of purchase price, what followed was a series of lawsuits brought by owners looking to recover as close to the full value of their tax shelters as possible. Considerable IRS resources were being devoted to case by case resolutions. The dollar outlays were substantial. Taxpayers likewise devoted considerable attention, and thus money, to the issue. Something needed to be done.

Things changed dramatically in late 2003, when Congress enacted the American Jobs Creation Act of 2004. The new law, in part, struck down all the previous sections of the tax code which were unique to sports franchises (including the repeal of IRC 1056(d)), bringing the sports industry in line with the rest of the business world. Intangible assets for sports franchises would now be handled as they would in any industry; they would be amortized over 15 years, a practice sanctioned under IRC 197.

Purchase price allocations among various intangible assets have effectively been rendered irrelevant because all intangible assets are now handled equally. The need to create unique intangible assets is gone. The vast majority of the purchase price for sports franchises can be allocated to just one intangible asset: goodwill. Goodwill is generated when a buyer pays more for a company than the fair market value of its net assets; it is, by definition, the excess of the purchase price over the net assets of the company.

The new bill simplified the rules so drastically for the sports industry that administrative enforcement costs for the IRS have been driven to nearly zero, since no real legal challenges need to be raised. While the new provision has produced another windfall for sports owners – effectively allowing them to amortize their full purchase prices – lawmakers argued at the time that it would actually increase tax revenue by $382 million over 10 years. The logic they employed was that while owners would now be able to amortize a substantially larger percentage of their purchase prices, creating a substantially larger write-off, the tax shelter would be extended over a substantially longer write-off period. It would take 15 years to realize the full benefit. They reasoned that the result would be a decrease in franchise turnover and, in turn, a less dramatic utilization of the tax shelter. While a study was never completed to establish whether they were correct, sports team owners do tend to hold onto their purchases for a substantially longer period of time these days. Whether or not that has anything to with the revised tax laws cannot be known.

These rules remain in effect today. Sports teams can amortize the entire portion of the purchase price which is allocated to intangible assets over 15 years.

How It All Works

So here’s how it all works: Say, for example, a certain basketball team projects to generate around $100 million of annual basketball-related pretax income (perhaps not an unreasonable assertion for some after the new national, and local, media rights deal kick in). Under normal circumstances, the owner would owe about $39.4 million in taxes every year on that $100 million of pretax income (with the highest marginal individual tax rate currently set at 39.6 percent).

But now let’s say I decide to set up a new S Corporation (a pass-through entity) to purchase the team from that owner for $2 billion. Let’s conservatively say that my tax accountant allocates 90 percent of the purchase price to all the various intangible assets (including goodwill). I now get to deduct $120 million in amortization expenses ($2 billion * 90 percent / 15 years) from the pretax income generated by the team because I bought it. As far as the IRS is concerned, my team is no longer generating $100 million of pretax income; instead, it’s losing $20 million.

What really happened? The $100 million of pretax profit isn’t really lost; the cash is still sitting in my bank account. It’s just that I am able to recognize a paper loss according to allowable IRS rules. So I get to enjoy the $100 million of profit tax free!

But it gets better. Because my team is structured as a pass through entity, the extra $20 million amortization shield goes straight through to my personal 1040 income tax return, and shields other taxable income as well.

It all gets recognized on my tax forms as follows: I enter the $120 million of amortization expenses on IRS Form 4562 (Depreciation and Amortization), line 44. Line 44 then gets transferred to Form 1120S (U.S. Income Tax Return for an S Corporation), line 19. Line 19 then gets added to all the other operating expenses, and subtracted from all revenues, of the S Corporation to generate the $20 million loss for the team on line 21. Line 21 then gets transferred to Schedule K-1, line 1, which then gets transferred from by business tax forms to my personal tax forms on Schedule E (Form 1040), line 41. Finally, line 41 gets transferred to Form 1040 line 17. My personal tax return now reflects a $20 million loss from my S Corporation, which can be utilized to offset any other income I may have generated from outside sources. This same process repeats itself for the next 15 years.

For each of the next 15 years, the tax shelter will save me from paying taxes on the first $120 million of income I generate, whether it is from my basketball team or otherwise(5). At the highest current marginal tax rate of 39.6 percent, I will avoid paying up to $47 million in taxes every year!

By the time the 15 years expires, the shelter will save me from paying taxes on $1.8 billion of income, saving me from paying out up to $710 million in taxes(6)!

Let me say that again: Because I bought my team for $2 billion (and made the purchase price allocations I did), I will not have to pay $710 million in future taxes(7)!

Fair or Unfair?

Is this magnitude of savings inherently unfair?

One can no longer credibly argue that I would be violating tax laws in leveraging the tax shelter described above, or even be deftly maneuvering just inside of them. I would simply be utilizing tax structuring techniques that are available to any business in any industry in the U.S.

It is completely reasonable to question the wisdom of allowing a wealthy purchaser of a sports team to offset some or all of the taxes on his income generated both from the team and other sources — but again, that’s not unique to sports.

It is completely reasonable to question the effectiveness of the tax laws that allow it to occur in the first place. An asset, in theory, should only be amortizable if it declines in value over time. This, in theory, should be true of any asset of any kind in any industry. But IRC 197 allows just about any acquired intangible asset to be amortized, whether it declines in value or not. Before its enactment, taxpayers and the IRS fought over the legitimacy of amortization deductions for various intangibles. Taxpayers sought to establish that the intangibles had an ascertainable value with a limited useful life, the length of which could be ascertained with reasonable accuracy. The IRS attempted to refute these contentions. By allowing one standard amortization deduction for an expansive list of intangibles, Congress settled a heavily litigated area of tax law. But standardizing the process to remove any judgment effectively allows for the amortization of certain intangible assets that in reality probably shouldn’t be amortized (e.g., goodwill).

It is perhaps also reasonable to wonder whether sports teams should be treated differently than other businesses in other industries. Sports franchises are somewhat unique in that the assets they compromise are almost exclusively intangible in nature. They, therefore, benefit inordinately from IRC 197.

***

There is no doubt that sports franchise owners benefit considerably by tax shelters afforded under current tax laws, and do so to a much larger extent than most other businesses in most other industries. But they are not handled any differently by the IRS than any other business in any other industry. Maybe they should be.

Notes:

This post has no applicability to the current Miami Heat. The tax benefits described herein apply only to owners upon the purchase of their franchises. Micky Arison’s father, Ted Arison (and two other men, Billy Cunningham and Lewis Schaffel), paid $32.5 million in expansion fees to bring the Heat to South Florida in 1988. I would therefore imagine the elder Mr. Arison already realized the full value of the shelter on his $32.5 million purchase price (according to tax rules at the time, up to $6.5 million per year for five years). I would further imagine that when the younger Mr. Arison purchased the team from his father for $68 million in 1995, he structured the transaction as a stock purchase (I have several reasons for this supposition), which wouldn’t have allowed for a step-up in the basis of the company’s assets. I could certainly be wrong but, either way, the tax benefits of the shelter that would’ve been attributable to the Heat would’ve expired many years ago. So when you read this, please understand that the Heat is not currently benefiting from the tax shelter described above (anymore).

Also, this post utilizes the term “amortize” and “depreciate” interchangeably. They both effectively mean the same thing — the write-off of an asset over a period of time. The term “depreciate” is used for tangible assets, while the term “amortize” is used for intangible assets. However, some tax rules over the years that applied to both tangible and intangible assets referenced IRC sections under the heading of depreciation. For every reference to the term, I’ve tried to utilize the word applicable to the section of the tax code that applies to their usage.

1. This ruling was later overturned in 1967; purchases of player contracts for cash were made to be written off over the expected useful playing lifetime of the player (IRC 167).
2. Applies to transactions structured as an asset acquisition (IRC 1060) or as a stock acquisition with a Section 338 election (IRC 338).
3. Owners leveraged not only the RDA but also related tax laws. Upon purchase, they would ascribe virtually all of the value of the team to the player contracts and virtually nothing to the franchise itself, in order to maximize the RDA. Upon sale they would reverse the allocation, ascribing virtually all of sale proceeds to the franchise and virtually nothing to the player contracts (implying that the value of the team at the time of purchase was the player contracts, but the value at the time of sale was the franchise itself). This structure allowed them to avoid “depreciation recapture” rules, which state that if you deduct the depreciation of an asset from a taxpayer’s ordinary income, the taxpayer has to report any gain from the disposal of that asset as ordinary income, not as a capital gain. The reallocation therefore made it so that the “player contracts” asset (the one for which the owner was recording depreciation expenses) would be sold at a loss, while the “franchise” asset (for which no depreciation expenses were recorded) would recognize the gain and qualify for capital gains treatment. In effect, buyers and sellers would allocate the purchase proceeds of the same team in the exact opposite way — sellers would allocate most of the proceeds to the “franchise” asset and very little to the “player contracts” asset to avoid depreciation recapture, whiles buyers would allocate most of the proceeds to the “player contracts” asset and very little to the “franchise” asset to maximize the RDA. The loophole was closed (though not perfectly) in the Tax Reform Act of 1976, which required the allocations to be identical for buyer and seller.
4. IRC 197 Section (e)(6) read: “…the term “section 197 intangible” shall not include… “A franchise to engage in professional football, basketball, baseball, or other professional sport, and any item acquired in connection with such a franchise.”
5. If I don’t generate that much in any given year, I can carry over my losses to future years.
6. This assumes the highest marginal tax rate remains constant over the next 15 years, at 39.6 percent.
7. This assumes the team is structured as a pass-through entity. If not, the owner would potentially face a double taxation (corporate and personal).