The proposed regulations for the new pass-through deduction under Section 199A generally categorize the ownership of sports franchises as a disqualified activity, but the rules may allow owners to qualify related business activities.
The IRS decision to interpret “athletics” to include sports team ownership as a disqualified activity is a blow to owners, who will be denied the pass-through deduction on core franchise income if the rules are finalized without change. However, the proposed regulations potentially offer the deduction for related activities in a separate trade or business, such as broadcasting or operating arenas and other facilities. A series of anti-abuse rules for entities with common ownership complicate the potential opportunity.
Deduction for owners of sports teams
Section 199A was enacted as part of H.R. 1, commonly known as the Tax Cuts and Jobs Act, to allow pass-through owners a deduction of up to 20% against qualifying income. If allowed in full, the deduction creates an effective rate of 29.6% for income subject to the top rate of 37%. Taxpayers with taxable income above a certain threshold are not allowed the deduction for a list of specified service trades or businesses (SSTBs), which includes “athletics.” (For more information on the general rules, read our full Tax Flash
on the proposed regulations.)
The proposed regulations define athletics to include services performed “by individuals who participate in athletic competition such as athletes, coaches, and team managers,” and provide an expansive but non-exclusive list of covered sports as examples. The regulations then clarify that the income owners receive from an SSTB is considered to be nonqualified regardless of whether the owners participate in running the business, specifically using owners of sports franchises as an example of who would be denied a deduction.
The regulations are only proposed, though taxpayers can generally rely on them until final regulations are issued. Extensive comments are expected, and the IRS has scheduled a regulatory hearing on Oct. 16, 2018.
Grant Thornton Insight: The IRS and Treasury will be pushed hard on many aspects of these proposed rules, both by taxpayers and members of Congress. Comments are due Sept. 30, 2018, and sports franchises could use the comment period to advocate for a more favorable interpretation. It is unclear how receptive the government will be to such efforts. The IRS and Treasury received comments asking for a different interpretation before the proposed regulations were issued. The inclusion of sports franchise owners as an example seems to indicate the government specifically considered this issue and chose to make its determination explicit.
Deduction for ancillary activities
The proposed regulations clarify that the term athletics does not include services that do not require skills unique to athletic competition. The regulations specifically cite broadcasting and operating or maintaining facilities for athletic events as examples of businesses that are not SSTBs. Team owners who have broadcast, arena, real estate, or other activities operating in truly separate trade or businesses may have the potential to receive deduction on income from these activities. But the IRS was concerned about businesses dividing SSTB activities into qualifying parts and proposed several anti-abuse rules that could make planning difficult.
The anti-abuse rules apply to otherwise qualifying businesses that share at least 50% ownership with an SSTB. These businesses can be re-characterized as non-qualifying if they provide at least 80% of their goods and services to a related SSTB or if they share expenses with the SSTB and their gross receipts represent 5% or less of combined gross receipts. Even if an otherwise qualifying business does not exceed these thresholds, the deduction is not available for any income for providing goods and services to the related SSTB.
Sports teams should consider the potential for related activities to qualify when structuring activities and investments. The determination will hinge not only on the proportion of total income arising from the other activities and how much income derives from providing services and goods to the disqualified athletic activity, but also on whether the other activities are conducted as separate trades or business. The trade and business determination can depend on a variety of factors, including whether the activity is conducted in a separate entity respected for tax purposes. In addition, team owners should remember that the rules are proposed and could change when finalized.
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