Contracts with No Tax Value or Basis

Reading Time: 7 minutes

By: Steven C. Dilley, Contributor to the South-Western Federal Taxation series

Professional sports teams have their players and management under contract, and these player contracts are often traded for other teams’ player contracts. The media refers to these transactions as trades of the players, but they are not, they are trades of the player contracts.

Example: Football Team A has linebacker L under contract for the current season and the two following seasons. L’s contract pays him $10 million per year. L is not performing up to expectations, so Team A trades L to Team B for a fourth-round future professional football draft choice. No cash is involved in the transaction.

For Federal tax purposes, Team A had not capitalized any of the cost of L’s contract. How does Team A compute the gain or loss from disposition of L’s contract? How does Team B compute the basis of L’s contract?

The IRS recently answered these questions in Rev. Proc. 2019-18 (2019-18 IRB 1077). It created a safe harbor that allows both sides of the transaction to have no amount realized and, therefore, no realized or recognized gain or loss.

What Is Safe Harbor?

There are four requirements for the safe harbor:

3.01. All parties to trade must use safe harbor. 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 this revenue procedure

3.02. Only personnel contracts, draft picks, and cash. 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

3.03. No amortizable Section 197 intangibles. In the trade, no personnel contract or draft pick may be an amortizable §197 intangible

3.04. Accounting treatment. The financial statements of teams that are parties to the trade must not reflect assets or liabilities resulting from the trade other than cash

Analyzing Safe Harbor Requirements

Requirement 3.01 requires that the parties both use the safe harbor. In other words, call the tax accountant first before executing the trade! Requirement 3.02 requires that there be no other assets, but the contracts and cash involved in the trade. For instance, Team B in our example could not provide L with ownership of a home in his new town.

Requirement 3.03 says that no §197 intangible can be involved. Code §197 intangibles are often created when the team is purchased by a new owner because player contracts are usually a major portion of what is purchased. Such contracts are amortized over 15 years and the amortization is subject to §1245 recapture.

Requirement 3.04 says that (in effect) financial accounting for the trade must conform to the tax accounting. That is a harsh requirement because “fair value” accounting would seem to require a gain or loss to be recognized. If that is the case, the safe harbor cannot be used by a sports team that is using generally accepted accounting principles.

Application of the Safe Harbor

There are five results of using the safe harbor (see Section 4.02 of the revenue procedure).

(1) No gain or loss on a trade. Except as provided in paragraph (5), below, for a professional sports team making a trade of a personnel contract or draft pick within the scope of this revenue procedure, because the contract value of each personnel contract or draft pick is treated as zero for purposes of this revenue procedure, no gain or loss is recognized on the trade for federal income tax purposes.

(2) Receipt of cash in a trade, computing amount realized. Under §1001, a team receiving cash in a trade includes in amount realized the cash the team receives from another team in the trade. Under this revenue procedure, because the contract value of each personnel contract or draft pick is treated as zero for purposes of this revenue procedure, a team that does not receive cash in a trade has an amount realized of zero.

(3) Providing cash in a trade, computing basis. Under §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. Under this revenue procedure, because the contract value of each personnel contract or draft pick is treated as zero for purposes of this revenue procedure, a team that provides no cash in the trade has a zero basis in the personnel contract or draft pick received in the trade.

(4) Providing cash in a trade for multiple personnel contracts or draft picks, allocating basis. 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.

(5) Trades of personnel contracts or draft picks, determining gain or loss. Under §1001 and Reg. §1.167(a)-8, a team making a trade of a personnel contract or draft pick recognizes gain to the extent of the excess of the amount realized under Section 4.02(2), over the unrecovered basis (if any) of the personnel contract or draft pick traded, subject to the rules of §§1231 and 1245.

Again, let’s analyze each of these five results.

(1) Means that the contract given up has no value and, as long as no cash is received, no gain or loss is realized. The contract given up usually has no basis because nothing was capitalized when the contract was entered into.

(2) Means that if cash is received, there is a gain recognized to the extent of that cash because the basis of the contract given up is zero.

(3) Means that the team paying cash has a basis in the contract received equal to the cash paid. This basis would not be amortizable under §197 because it does not meet any of the requirements of being amortizable under that Code section. Since the contract has a limited life, it is amortizable under §167.

(4) Means that if multiple contracts are involved and cash is received or paid, the allocation is simply done based on the number of contracts, not, for instance, their relative fair market value or tax basis.

(5) Means that in the usual case where the contract disposed of has no basis, any cash received will result in a recognized gain. The gain is treated under the rules for §§1231 and 1245.

Losses

If the contract given up has a tax basis, that tax basis is treated as a loss under §1231.

Examples: The revenue procedure has several examples. Two are reproduced here and then analyzed. There is a total of five examples.

Example 1. Trade with no cash. In 2018, Team A trades Player Contract 1 to Team B for Player Contract 2. The teams apply the safe harbor in this revenue procedure. Under Section 4.02(1), neither Team A nor Team B has an amount realized or gain on the trade because neither team received cash in the trade. Under Section 4.02(3), Team A has a $0 basis in Player Contract 2, and Team B has a $0 basis in Player Contract 1.

Example 2. One team provides cash in the trade. The facts are the same as in Example 1, except Team A trades Player Contract 1 and $10x to Team B for Player Contract 2. Under section 4.02(1), Team A has no amount realized or gain on the trade because Team A did not receive cash in the trade. Under Section 4.02(2), Team B has a $10x amount realized on the trade because Team B received $10x from Team A in the trade. Under Section 4.02(5), Team B must recognize $10x of gain, the excess of Team B’s $10x amount realized over its $0 basis in the Player Contract 2 it traded. Team B’s $10x gain is subject to the rules of §§1231 and 1245. Under Section 4.02(3), Team A has a $10x basis in Player Contract 2, the amount of cash Team A provided to Team B in the trade. Team A’s $10x basis is recovered through depreciation under Reg. §1.167(a)-3(a) over the life of Player Contract 2. Under Section 4.02(3), Team B has a $0 basis in Player Contract 1 because Team B provided no cash to Team A in the trade.

Neither in Example 1 nor Example 2, is the actual amount that will be paid the players relevant. In Example 2 since Team B paid $10x in cash, it does have a basis in Player Contract 1 while Team A has a $10x recognized gain.

Questions Raised by the Revenue Procedure

What if either team had previously capitalized the player contracts for financial accounting purposes? Are both teams then ineligible for the safe harbor? In other words, is the “financial accounting conformity” requirement retroactive or just prospective? The revenue procedure says “[t]he financial statements of teams that are parties to the trade must not reflect assets or liabilities resulting from the trade other than cash [emphasis supplied]. So, it seems only prospective application is required. But what if this financial conformity is a change in financial accounting method?

Also, player trades are often made “on the fly”—especially close to trading deadlines. How are the parties going to agree to both use the safe harbor in those circumstances when using it may compromise their tax and financial accounting?

Ideas for Class Assignments

Internet Research

There are numerous blog posts, sports websites, etc. related to professional sports. Have your students access some of these sources to find recent examples of professional sport team trades and apply the Rev. Proc. to the facts of those examples.
Have the students conduct tax research to determine if the IRS has issued any further explanations of these provisions. If there are any, discuss their implications in class.
Have the students determine under what circumstances player contracts have a tax basis and are amortizable under §167 and/or §197.
Have the students determine under what circumstances there would be recognized gains and losses from disposition of player contracts and then research the treatment of recognized gains and losses from disposition of player contracts under §1245 and §1231.

Tax Policy

What are the policy issues related to not having dispositions of player contracts cause recognized gains and losses? Have the students discuss how the IRS approached this policy issue (the revenue procedure is a good place to start) and what alternative approaches there might have been.