Trade Deadline: Will The New Tax Law Affect It?

The 2019 MLB trade deadline rapidly approaches. The interwebz are full of fans posting the latest (mostly incorrect or made up) “rumors” about their favorite players. Writers and bloggers try to increase page views try to provide insight into a team’s moves. Typically these trades seem to us like just a simple bit of negotiation, with a series of back and forth discussions on different players and pieces until they reach an agreement. Sometimes, trades involve things other than just players, such as draft picks or cash, to offset a high-salary player involved in the trade. But behind the scenes, many other factors that affect how teams approach trading players. This year, the Internal Revenue Service could be one of those factors.

Normally when teams reach a trade agreement, they simply swap the contracts and rights of players involved. Each team takes on the arriving player’s obligations as if they had made the deal themselves. Oftentimes, these contracts have wildly differing salaries, particularly when teams trade prospects for veterans. In the past, this has never really amounted to anything more than a minor bookkeeping issue for teams. But what happens when a huge overhaul to the tax code changes the potential tax implications of those contracts and accompanying money?

The Background

Before the 2017 Tax Cuts and Jobs Act, player contracts and draft picks were considered property used in a business. Businesses could trade or exchange property free of capital gains tax, provided that they received a ‘like’ item in exchange. These ‘like-kind exchanges,’ or swapping a business asset or property for another substantially similar asset or property, have long been a tool of tax planners (and real estate investors). Section 1031 of the Internal Revenue Code (link provided for the lulz or those with insomnia) allowed that as long as teams were trading a contract/player for another contract/player, they could avoid realizing any income from the different values between the contracts.

The Problem

In January 2019, the TCJA went into effect. One aspect of this massive change in tax law was that like-kind exchanges became limited to real property only (essentially land and buildings). Effectively, this meant that teams would have to realize a gain or loss (taxable income) based on the difference between the fair market value of the contract and/or draft pick and their basis in the contract. Basis is a non-fancy but complicated tax term that essentially means what it cost a team to acquire the contract (or pick). So, a team’s basis could include things like signing bonuses or other certain payments for future services, and then they would subtract depreciation. Yes…young, healthy, athletic people can be depreciated like an aging, broken down home.

Observant tax planners recognized that this would require assigning a value to contracts that went beyond simply the value of payments made to the player. Teams would have to account for things like how that player’s presence affected ticket sales and concession sales and marketing deals and a whole host of other things that had actual little (on the surface) to do with trading Anthony Swarzak for Jesse Biddle and Arodys Vizcaino. In addition to being highly subjective, the market value of a contract could fluctuate wildly, depending on things like a team’s winning, or even what team held the contract. The contract of a star player on a team with many star players could have a value far different than if that same star player was on the only prominent player on a smaller market team. Like Bryce Harper‘s contributions to the Philadelphia Phillies this year, the market value of a player contract at any specific time is a hard thing to measure (I kid. A little. But not really).

The Fix

In April, the IRS issued Revenue Procedure 2019-18. Revenue Procedures are official statements that the IRS issues to clarify previously unclear aspects of tax law, or to dictate the duties of a taxpayer or tax professional in certain situations. Revenue Procedure 2019-18 provided a ‘safe harbor’ for professional sports teams that allowed them to set a value of zero for player contracts and draft picks (for tax purposes). This effectively meant that teams could simply treat player contracts (and draft picks) the same as they did before to the 2017 TCJA.

However, teams must meet certain conditions to take advantage of the safe harbor method:

• First, all parties to the trade that are subject to U.S. federal income tax must use the safe harbor.
• Second, each party to the trade must transfer and receive a personnel contract or draft pick. In addition, no team may transfer any other property (other than cash) as part of the trade.
• Third, no personnel contract or draft pick on any side of the trade may be an amortizable Section 197 intangible.
• Fourth, the financial statements of all teams that are party to the trade may not reflect assets or liabilities resulting from the trade other than cash.

All parties to the trade must agree to the safe harbor rules, the trade can not involve property other than cash, and, the trade can not involve an amortized intangible asset (often a contract on a recently sold team). This Revenue Procedure also only applies to sports teams; no other business can take advantage of this safe harbor.

There are potentially two problematic issues, though. First, teams receiving cash in a trade could potentially realize a gain and have positive taxable income from the transaction. Second is the Section 197 intangibles clause. This section dictates that teams must amortize certain costs over 15 years when acquiring a business. One of those costs is ‘workforce in place’ acquisition. Given the number of teams that have been sold in recent years (and as such have had some of those costs amortized under Section 197), this limitation poses a problem and seems to raise all of the issues the IRS sought to avoid in the first place.

The Consequences

There are several potential tax consequences resulting from the IRS Revenue Procedure ruling in April.

• Because the value of each contract or draft pick can be set at zero, no gain or loss will be recognized by a team if it does not receive cash and does not have a tax basis in the personnel contract or draft pick given up.
• Any cash received by a team as a part of a trade is included in the team’s amount realized and will be recognized as gain to the extent it exceeds the team’s tax basis in the contract or draft pick transferred in the trade.
• A team will generally recognize a loss if it has a tax basis in the contract or draft pick it transferred (e.g., if the traded player was paid a signing bonus that the team had not yet fully depreciated) that exceeds the amount of any cash the team received in the trade.
• A team that provides cash as part of a trade will acquire a tax basis in the personnel contract or draft pick it receives equal to the amount of such cash.  This tax basis may be depreciated over the life of the asset acquired.  If more than one personnel contract or draft pick is received, the basis must be allocated to each personnel contract or draft pick equally, regardless of the subjective value the team may place on each.
• A team that does not provide cash as part of a trade will have a tax basis of zero in all contracts or picks received.

Isn’t accounting interesting and fun? Yeah, I didn’t think so.

The Deadline

So, how does all of this tie into the trade deadline? It potentially makes trading for someone like Zack Greinke a whole lot more convoluted than simply agreeing to players. Money that the Arizona Diamondbacks might send in the deal to offset a portion of Greinke’s contract might become taxable income to the receiving team. A team like the Miami Marlins, who were recently sold, may not be as active as before because of the Section 197 limitation on trading items that have been amortized. Had Giancarlo Stanton been involved in a Marlins trade this year, the safe harbor rules might not apply (since his contract may have been part of the costs amortized when Derek Jeter and company bought the team), meaning his contract would have to be assigned a Fair Market Value and then a potential gain calculated.

It’s hard to say at this point if the new tax law will definitely have any measurable impact on the trade deadline. Teams employ large financial departments, and billionaires have platoons of accountant nerds like me to minimize their tax hits. This will be the first trade deadline in which the Tax Cuts and Jobs Act is in play, but one has to think teams have planned for this, and will factor it into their plans accordingly.