Buy a Sports Team, Get a Tax Break
Paying $2.2 billion for a National Basketball Association team with an operating income of $62.7 million a year, as Tilman Fertitta agreed to do earlier this week for the Houston Rockets, is a sign of great wealth, enthusiasm for the sport, and confidence that some future billionaire will eventually take the thing off your hands for a similar or higher price.
It is also, as several readers pointed out after I wrote about the deal, a transaction with some positive tax consequences. Since the passage of the American Jobs Creation Act of 2004, buyers of sports teams have been able to write off a big chunk (sometimes almost all) of the purchase price against the team's taxable income over 15 years. And because sports franchises these days are usually structured as limited liability companies or other pass-through entities whose earnings or losses flow through to owners' personal tax returns, this tax deduction can also be used to offset income from other sources. 1 This benefit is available to buyers of all kinds of businesses, but the remarkably high purchase prices of sports teams relative to the income they generate make it especially valuable to their owners.
Not to pick on Fertitta, who seems nicer than your average billionaire reality-TV star, but let's say his accountants and lawyers can justify treating $2 billion of that $2.2 billion purchase price as intangible assets. (If a team owns its stadium or arena, the intangible percentage would be lower and the write-off rules more complicated, but the Rockets don't.) It is these intangible assets that are subject to the 15-year amortization rule, so let's say they're amortized at a straight-line $133 million a year. That's enough to render exempt from taxation not only the Rockets' $62.7 million in operating earnings (as estimated by Forbes), but also another $70 million or so in earnings from Fertitta's restaurants, casinos and television show.
This adds up, assuming that the income would all have otherwise been taxed at the top marginal rate of 39.6 percent, to almost $800 million in total tax savings. That's an oversimplification, but it's in the ballpark. The Financial Times, using a more complicated approach that didn't entirely make sense to me, estimated in 2014 that Steve Ballmer's $2 billion purchase of the Los Angeles Clippers could generate as much as $1 billion in tax benefits. 2
After 15 years that deduction is up, and getting all those tax benefits means you have to pay commensurately more in taxes when you sell the team -- and that some of the sale gains are taxed as ordinary income, not capital gains. But 15 years is a long time, and tax benefits in hand outweigh potential tax obligations down the road. Also, deducting purchase costs from income makes it easier for owners to plead poverty in negotiations with players and cities. Their tax returns say they're losing money, even when their bank statements say they're not. So clearly, part of what a sports team buyer is paying for is this tax treatment.
How big a part? University of Michigan sports economist Ray Fort estimated in 2006 that tax breaks and a few other ancillary benefits to owners might account for 19 percent or more of the sale value of Major League Baseball teams. The late economist Benjamin Okner argued in 1974, when he was at the Brookings Institution, that
The apparent irrationality of even the worst sports investment is largely explained by the effects of full utilization of the available tax benefits. 3
As is clear from Okner's remark, those tax benefits long predated the 2004 legislation that set the current rules. They are generally traced back to 1946, when Bill Veeck bought the Cleveland Indians and argued to the Internal Revenue Service that most of the value of the team was in its roster of players and that this roster was a quickly depreciating asset (the depreciation of livestock was referenced as a precedent). Veeck, who is still remembered for his promotional stunts, 4 seems to have seen this as yet another why-not-give-it-a-try flyer. As he joked years later:
Look, we play the "Star-Spangled Banner" before every game. You want us to pay income taxes, too?
The IRS, however, took his argument seriously, and determined that the value of this intangible asset should be written down over the useful playing careers of those on the team's roster, usually set at five years. And so what came to be known as the "roster depreciation allowance," or RDA, was born.
As "NBA salary cap enthusiast" Albert Nahman writes on his Heat Hoops blog in the most comprehensible history of the RDA that I've found, the IRS began after a couple of decades to reconsider this permissive approach. Things came to a head in 1970 when a group led by Bud Selig, later the commissioner of Major League Baseball, bought the Seattle Pilots for $10.8 million and moved them to Milwaukee (where they were renamed the Brewers). The purchasers allocated $10.2 million of that price to player contracts, and began amortizing that over five years. The IRS balked, saying that most of the franchise's value resided in intangibles other than player contracts that didn't lose value over time. A U.S. District Court judge overruled the agency (and a U.S. Court of Appeals panel later upheld the ruling.) Writes Nahman:
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.
It could, however, be corrected by Congress, which passed legislation in 1976 that among other things limited the RDA to 50 percent of the purchase price, with some exceptions, and kept five-year amortization as standard. That's pretty much how things worked till 2004, although by then IRS agents and team owners were getting into increasingly complex and contentious debates over exceptions to the 50 percent limit, especially whether the value of team media rights deals could be amortized or not.
What the debates came down to, as in 1970, was the question of whether the intangible assets of sports franchises really do depreciate -- that is, lose value over time. In economic terms, it seems like the opposite is true. In the 2006 study that I've mentioned already, economist Fort found that Major League Baseball team purchase prices rose at an average inflation-adjusted rate of 4.8 a year from the early 1900s through the early 2000s, compared with a 3 percent real growth rate for the economy as a whole.
But the politics of intangible-asset depreciation have shifted over the decades. In the 1940s, sports teams were pretty unique in their high ratio of intangible assets to real ones. Over time, as manufacturing's share of economic activity declined, services boomed and brands gained in value, that began to change. By the late 1980s, lots of business purchasers were paying mostly for intangible assets -- and wrangling endlessly with the IRS over whether and how to write down these assets' value over time. To simplify things, Congress decreed in 1993 that businesses were entitled to tax deductions for almost all intangibles purchases, amortized over 15 years. Sports franchises were excepted, however, and required to keep following the rules that had applied to them since 1976.
In 2004, then, Congress finally decided to treat these pioneers of aggressive intangibles tax accounting in the same (perhaps overly magnanimous, but at least consistent) way that it treated other businesses. Murray Solomon, a tax partner with the accounting firm EisnerAmper in New York who helped me understand some of the details here but is in no way responsible for anything I've gotten wrong, remembers estimating at the time that, despite the longer amortization period, this would generate significantly more tax benefits for team buyers than the old approach. He was right. In a 2010 paper, Fort and N. Edward Coulson of the University of California at Irvine concluded that the tax change had increased team values by 11.6 percent.
Pretending that all of teams' intangible assets decline in value, then, has resulted in yet another increase in the value of those intangible assets. It's a sporting miracle!
This can only be done if you're actively involved in the management of the team, which can be a modest hurdle for some minority owners (in general you're supposed to spend at least 500 hours a year on team business) but shouldn't be a problem at all for Fertitta.
The FT appears to have gotten to $1 billion ($995 million, by my calculation) by assuming that Ballmer's $594 million in raw tax savings would be reinvested every year and earn an annual return of 7 percent. But it seems like if you're going to get fancy like that, you should also be discounting the value of tax savings years in the future, which brings the amount back down. Also, we're not factoring in state income tax here, but that's OK because neither Texas nor the state of Washington, where Ballmer lives, has a state income tax.
This is from a volume edited by Roger G. Noll and titled "Government and the Sports Business," but that wasn't readily available so I got the quote from a 2015 article by Lance Taubin in the Cardozo Public Law, Policy and Ethics Journal.
Among the most famous were hiring a clown (albeit one with baseball experience) as a coach for the Indians, bringing in 3-foot-7-inch Eddie Gaedel to pinch-hit for the St. Louis Browns, and persuading tone-deaf Chicago White Sox announcer Harry Caray to sing "Take Me Out to the Ball Game" at home games, a tradition Caray later brought to the Cubs' Wrigley Field, where it has continued, via video recording and famous guest singers, since his death in 1998. Also significant, and not really a stunt: At Cleveland, Veeck signed Larry Doby, the first black player in the American League, and soon added a second, the legendary Satchel Paige.
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