Synopsis

Background

United States tax law provides rules for determining when parties must recognize gain or loss from certain transactions. Section 1001 of the Internal Revenue Code (IRC) provides that gain is recognized when the amount a party realizes on the transaction is greater than that party’s adjusted basis in money or property given up. The amount a party realizes includes money and the fair market value of the property it receives in the transaction. The basis of property is generally the cost of the property, with certain exceptions, per IRC Section 1012.

These tax rules apply to trades made between professional sports teams for personnel contracts and draft picks. It is common in the professional sports world for teams to trade personnel contracts and draft picks to accommodate the shifting needs of their organizations and team objectives. The IRS recognized the need for accurate fair market values of personnel contracts and draft picks to calculate gains and losses for the sports teams making these trades.

However, determining fair market value for these contracts and draft picks can be difficult. Their values often fluctuate based on player performance, the changing needs of the team, the changing needs of other teams, a player’s effect on fan attendance, and the number of years until a player becomes a free agent and can sign a contract with any team in the league. Considering this, the IRS has offered a safe harbor for teams making these trades, simplifying the gain or loss analysis.

Safe harbor requirements

The safe harbor allows teams to treat certain personnel contracts and rights to draft players as having a zero value for determining gain or loss for federal income tax purposes.

To come within the safe harbor and get the zero-value treatment, trades of personnel contracts and draft picks by professional sports teams must meet all of the following criteria:

1. All parties to the trade must use the safe harbor and treat the trade as such on their federal income tax returns

2. Only personnel contracts, draft picks, and cash may be transferred in the trade

3. No personnel contract or draft pick may be an amortizable Section 197 intangible asset

4. Cash is the only item resultant from the trade that is permitted to be reflected on the financial statements of the trading teams

Teams should be sure to retain books and records to substantiate that all requirements have been met to qualify for the safe harbor.

Zero value

Gain results when the amount realized is greater than the basis of the contract or draft pick. Loss results when the basis in the contract or draft pick is greater than the amount realized. Giving each team a zero value in the trade under the safe harbor simplifies, and at times eliminates, the gain or loss recognized for federal income tax purposes.

For example, Team A trades a player contract to Team B for a draft pick. If both teams qualify for the safe harbor, then each team is deemed to have received zero value in the trade. Neither team recognizes gain or loss on the trade and each team would take a basis of zero in the property received.

Cash paid in the trade

Trades of personnel contracts and draft picks sometimes include cash. A team that receives cash in a trade includes the cash in its amount realized. For example, Team C trades a player contract and $10 to Team D for a draft pick. Both Team C and Team D qualify for the safe harbor which deems the value of both the player contract and the draft pick to each be zero. However, Team D is considered to have received $10 cash for a draft pick it gave up of zero value. Therefore, Team D would recognize $10 of gain. Team C would not recognize any gain.

A team that pays cash in a trade takes a basis in the contract or draft pick received equal to the amount of cash it paid. In the above example, Team C would take a basis in the draft pick of $10 because Team C paid $10, along with the contract that was valued at zero, to get the draft pick. Team C may then depreciate the draft pick over its useful life and get $10 of depreciation deductions. Alternatively, Team C’s basis in the contract could reduce the gain recognized by C on a subsequent sale of the contract.

If a team paid cash in a trade and received multiple personnel contracts or draft picks, then the team must allocate the cash paid to the basis of all the contracts or draft picks received. The basis must be allocated equally to each contract or draft pick received. For example, if Team E pays $30 for three different draft picks, Team E would allocate $10 to the basis of each draft pick received.

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Contact

Stephen Gregory, Director, National Tax

959.200.7021

Michael Billet, National Tax

646.601.7717

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