IRS Provides Safe Harbor for Pro Sports Teams' Trades of Personnel Contracts and Draft Picks

(Parker Tax Publishing May 2019)

The IRS has provided a safe harbor for a professional sports team to treat personnel contracts and rights to draft players as having a zero value for purposes of determining gain or loss to be recognized on the trade of a personnel contract or a draft pick. The IRS explained that the safe harbor's purpose is to avoid highly subjective, complex, lengthy and expensive disputes between professional sports teams and the IRS regarding the value of personnel contracts and draft picks for the purpose of determining the gain or loss to be recognized on the trade of one or more personnel contracts or draft picks. Rev. Proc. 2019-18.

Applicable Law

Code Sec. 61(a)(3) provides that gross income generally means all income from whatever source derived, including gains from dealings in property. Code Sec. 165(a) allows a deduction for any loss not compensated for by insurance or otherwise. Under Code Sec. 165(b), the basis for determining the amount of the deduction for any loss is the adjusted basis provided in Code Sec. 1011. Code Sec. 167(a) allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in a trade or business or held for the production of income. Reg. Sec. 1.167(a)-3(a) provides that if an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period of time, the length of which can be estimated with reasonable accuracy, the asset may be the subject of a depreciation allowance.

Under Code Sec. 1001(a), gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis and loss is the excess of the adjusted basis over the amount realized. Under Code Sec. 1001(b), the amount realized is generally the sum of any money received, plus the fair market value of the property (other than money) received. Code Sec. 1001(c) provides that except as otherwise provided, the entire amount of gain or loss determined on a sale or exchange of property is recognized. The basis of property is generally its cost under Code Sec. 1012.

Code 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. Code Sec. 1245(a)(1) generally provides that, upon the disposition of Code Sec. 1245 property, the amount by which the lower of (1) the recomputed basis of the property, or (2) the amount realized in the case of a sale, exchange, or involuntary conversion, or the fair market value of the property in the case of any other disposition, exceeds the adjusted basis of such property is treated as ordinary income. Such gain is recognized notwithstanding any other income tax provision of the Code.

Trades of Personnel Contracts and Draft Picks by Professional Sports Teams

Professional sports teams generally engage the services of players and staff members, such as managers and coaches, through the use of employment contracts that provide compensation in return for future performance of services for a defined period of time (personnel contracts). During the term of a personnel contract, the contract's value may fluctuate based on a variety of factors, including player performance, the changing needs of the team, the changing needs of other teams, a player's effect on fan attendance, and other considerations. From time to time, teams trade one or more personnel contracts to other teams. Trades may include the transfer of a right to draft players in the league's player draft (draft pick) or a cash payment. Some trades involve only draft picks.

In general, a team does not agree to a trade unless it believes that it is receiving something of equal or greater value to what it is giving up in light of the team's circumstances and priorities at the time. The exact value that a team places on the future performance of services by the personnel it is receiving in a trade is highly subjective and may be influenced by the team's specific needs at the time rather than by whether the compensation provided for under the contract is viewed as being at market value, over market value, or under market value. In addition, judgments as to whether the amount of compensation is at, above, or below what a willing third-party would pay at a particular point in time to the personnel member for services to be performed in the future are highly subjective. As a result of these and other factors, it is unusually difficult to assign an objective monetary value to the personnel contracts or draft picks.

In order to avoid highly subjective, complex, lengthy, and expensive disputes between professional sports teams and the IRS regarding the value of personnel contracts and draft picks for the purpose of determining the proper amount of gain or loss to be recognized on the trade of one or more personnel contracts or draft picks, Rev. Proc. 2019-18 provides a safe harbor permitting teams to treat the value of traded personnel contracts and draft picks as zero if certain conditions are satisfied.

Safe Harbor

For a team making a trade of a personnel contract or draft pick within the scope of Rev. Proc. 2019-18, the value of the personnel contract or draft pick is treated as zero and, as a result, no gain or loss is recognized on the trade for federal income tax purposes.

The safe harbor applies only if:

(1) the parties to the trade that are subject to U.S. federal income tax treat the trade on their respective federal income tax returns consistent with Rev. Proc. 2019-18;

(2) no team transfers property other than a personnel contract, draft pick, or cash;

(3) no personnel contract or draft pick is an amortizable Code Sec. 197 intangible; and

(4) the financial statements of teams that are parties to a trade do not reflect assets or liabilities resulting from the trade other than cash.

A team receiving cash in a trade includes the cash in the amount realized under Code Sec. 1001. Because the value of each personnel contract or draft pick is treated as zero, a team that does not receive cash in a trade has an amount realized of zero. Under Code Sec. 1012, a team providing cash to another team in a trade has a basis in the contract or draft pick received equal to the cash provided. Because the value of each contract or draft pick is treated as zero, a team that provides no cash in the trade has a zero basis in the contract or draft pick received in the trade. A team providing cash in a trade for two or more contracts or draft picks must allocate its basis to each contract or draft pick received in the trade by dividing the basis by the number of contracts or draft picks received.

Under Code Sec. 1001 and Reg. Sec. 1.167(a)-8, a team trading a contract or draft pick recognizes gain to the extent of the excess of the amount realized over any unrecovered basis of the personnel contract or draft pick traded, subject to the rules of Code Sec. 1231 and Code Sec. 1245. Under Code Sec. 1001, Code Sec. 165, and Reg. Sec. 1.167(a)-8, a team trading 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 Code Sec. 1231. A team's unrecovered basis in a personnel contract or draft pick is the team's basis in such contract or draft pick as determined under Code Sec. 167(c).

Rev. Proc. 2019-18 applies only to trades of personnel contracts or draft picks among teams in professional sports leagues and has no application to other transactions. In addition, Rev. Proc. 2019-18 does not apply to trades of a team for another team or a sale of a team.

For a discussion of the rules for measuring the gain or loss on a sale or exchange, see Parker Tax ¶110,140.

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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