Passive activity losses for sports owners

Owners of sports teams generate losses in several ways. As a partner in a sports partnership, the owner may benefit from depreciation deductions relating to the stadium and other fixed assets, and may also benefit from amortization deductions for media rights and player contracts, among others. Taxpayers are subject to several limitations on their ability to utilize losses, including basis limitations, at-risk rules, excess business losses, and passive activity loss rules.

The passive activity loss rules apply to individuals, trusts, and estates (and limited categories of corporations), including partners of partnerships and shareholders of S corporations. Individuals and trusts owning sports franchise partnerships are subject to these rules.

The passive activity loss rules only allow the taxpayer to use passive activity losses against passive income. To the extent that the taxpayer's passive activity losses exceed passive income, the passive activity loss is carried forward indefinitely. Passive loss carryovers are generally allowed when the owner sells their interest in the team.

In sports and taxes (and comedy), timing is everything. Navigating the passive activity loss rules, and other loss limitations can have a significant impact on the owner's tax position.

What is a passive activity?

A passive activity is a trade or business in which the taxpayer does not "materially participate." There are different tests to determine whether a taxpayer materially participates in a trade or business. Rental activities are generally always passive activities. Passive activities are trade or business activities. Income from portfolio investments is not passive income for this purpose and cannot be offset by passive activity losses.

Material participation

If an owner materially participates in a trade or business, losses from that trade or business are not subject to the passive activity loss limitation. The owner's participation must be regular, continuous, and substantial. Under the regulations, a taxpayer materially participates in an activity if they can meet one of the following tests:

• More than 500 hours of participation during the year.
• The individual's participation is substantially all of the participation in the activity of all individuals (including non-owners) during the year.
• More than 100 hours of participation during the year but that is equal to or more than any other individual's participation.
• The activity is a "significant participation activity" and the taxpayer has more than 500 hours in significant participation activities during the year.
• Material participation for five out of the 10 preceding years.
• Material participation in certain personal service activities for any three prior years.
• The facts and circumstances demonstrate that the individual participates on a regular, continuous, and substantial basis.

Whether a taxpayer materially participates in an activity is determined each year and the results may change from year to year.

Takeaways

Ownership is a significant activity requiring major time and energy commitments. Owners may be regularly meeting the participation thresholds. Documentation and recordkeeping are critical, particularly when defending or preparing in advance of an IRS examination. The IRS' Sports Industry Loss campaign is a further step targeting ultra-high-net-worth individuals and partnerships. Sports partnerships and owners should evaluate loss positions and loss planning opportunities for tax efficiency and mitigating risk. John Wooden also said that "failing to prepare is preparing to fail," and that's as true in tax as it is in basketball.