The NCAA Vs. Taxation: How Colleges Are Caught In The Middle

Professor Richard Schmalbeck of Duke University Law School discusses college sports and taxation, including the potential effect of compensation for coaches and athletes on colleges’ tax-exempt status.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: tax madness.

As the NCAA men’s and women’s basketball tournaments gear up, that makes us think about taxes. Yes, there’s always a tax angle.

The taxation of colleges, student athletes, and their coaches is complex and unsettled. Last year’s Supreme Court decision in NCAA v. Alston granted college athletes the right to compensation, and we’ve covered some of the tax implications of that ruling in another episode.

Recently, Congress has taken an interest in the large salaries paid to many college coaches and whether that fits in with some colleges’ tax-exempt status. So today, we’re exploring the intersection of college sports and taxes with Tax Notes contributing editor Robert Goulder. Bob, welcome back to the podcast.

Robert Goulder: Hello, Dave. Thanks for having me.

David D. Stewart: Now, I understand you recently spoke with a professor about the taxation of colleges and their sports teams. Could you tell us about your guest?

Robert Goulder: Yes, his name was Professor Richard Schmalbeck. He’s with Duke University Law School.

David D. Stewart: Could you give us an overview of what you discussed?

Robert Goulder: Well, the issue that’s at the heart of it, Dave, is that you’ve got all these universities, both public and private, and for various reasons, they’re tax-exempt. That makes a lot of sense, because their business model isn’t to go out and make millions of dollars; it’s to educate the next generation of Americans.

However, when it comes to their athletic department, some of these programs, especially in the Power Five conferences, are earning gobs of money. You can see it in their budgets, as you mentioned, with the salaries they’re paying to some of their coaches.

There’s many different sports that these athletic departments operate, but the two sports that are the center of the focus here are football and men’s basketball, the so-called “revenue sports.” When you think about it, there is a pre-existing doctrine out there in the American tax law, the UBI, unrelated business income tax. It’s a body of law with cases and statutes and regulations and rev procs; all sorts of things.

If you analyze this, it leads you to the conclusion that there’s a very persuasive case to be made that that slice of universities’ universe that’s focused on those two revenue sports should be taxed or produce taxable income through this UBI doctrine.

David D. Stewart: All right, that sounds fascinating. Let’s go to that interview.

Robert Goulder: We’re joined now by Professor Richard Schmalbeck from Duke University School of Law. He’s been doing a lot of thinking about the intersection between big-time collegiate sports and the IRC. He’s written about this with his co-author, Lawrence Zelenak, also a professor at Duke Law School.

I’d like to read to you the first two lines of their article, which is very telling. “Few organizational acronyms are more familiar to Americans than those of the National Collegiate Athletic Association, the NCAA, and the [IRS]. Although neither organization is particularly popular, both loom large in American life and popular culture.”

Well, I could not have said it better myself. This is a huge issue. There’s so much money in big-time collegiate sports, and how it’s taxed or not taxed is just a very relevant issue and becoming more so.

Professor, first of all, welcome to the podcast.

Richard Schmalbeck: Thank you. Happy to be here, Bob.

Robert Goulder: My first question is about this UBI concept that you refer to. It refers to unrelated business income. Can you summarize the basic elements of how those rules work and then outline the prima facie case for applying the UBI doctrine to these big-time college sports.

Richard Schmalbeck: Sure. So, exempt organizations, 501(c)(3) organizations, which would include all private colleges and universities, but also public universities are included under a different section of the code, are exempt from tax generally. But they are not exempt from tax on what’s called UBI.

There are three elements of UBI. The first is, it has to be income produced by a business, obviously. It has to be a business that is not related to the primary functions of the university. The third requirement, that’s not obvious from its name, is that it has to be regularly carried on. Which means that the occasional sporadic activity won’t necessarily fall within UBI, even if it generates income.

Well, big-time sports seemed to me to meet all three of these elements. It’s clearly a business. It’s clearly regularly carried on. The issue then, really, is it related to the educational enterprise?

There’s no indication, to be honest, that Congress meant to include it in 1950 when it first added the UBI rules to the IRC. The IRS, notably, specifically addressed the question of broadcast rights to college sports in a revenue ruling in 1980.

But television has changed big-time sports in a major way. By big-time sports, I mean football and men’s basketball at the division I level, especially in the so-called “Power Five” conferences, which are the Pac-12, the Southeastern Conference, the Big 12, the Big Ten, and the Atlantic Coast Conference. We probably should include the Big East in college basketball.

There are other sports like baseball, lacrosse, soccer, women’s basketball that are threatening to become big-time sports, but I don’t think have quite reached a level where they produce much in the way of net revenue to date. But they’re to be watched.

The difference is that in 1980, the Final Four, just as an example, the men’s three-week college basketball championship tournament, raised about $10 million. By 2013 it was up to $1 billion. That is a 100-fold increase. Even after you adjust for inflation, it’s about a 40-fold increase. So, it’s changed a lot and it also changes all sorts of other things.

The viewership is now national, instead of concentrated in the immediate vicinity of the college or university. But, I think the big thing is the television money. Some have said even if college football and basketball were subject to the UBI, it’s income that’s being taxed. You have to look at revenue minus expenses, and most programs don’t actually make any net income. So, there wouldn’t be any business tax to collect, even if it were subject to it.

In that respect, it’s important to recognize that in 1967, the IRS introduced regulations saying that, “Unrelated parts of businesses,” namely some of the profit-making elements, “could be viewed separately from the whole business.” In 1969 Congress endorsed this view by adding section 513c to the code, introducing a concept called “fragmentation.”

To add meat to this fragmentation concept, there’s a unanimous Supreme Court case, United States v. American College of Physicians, in 1986 involving the American College of Physicians. It involved their publication, which is called the “Annals of Internal Medicine.”

It consisted of scholarly articles describing new medical research, but it also included advertising, mostly from pharmaceutical companies. The IRS said, “Under this fragmentation principle, we can and are going to view the ad income separately, and the ad expenses separately.”

The ad income vastly exceeded the ad expenses, of course, so it was designed that way so as to produce funds that would cover the costs of publishing the journal. They made money when viewed, even though the publication overall was not profitable.

The Supreme Court endorsed the IRS view, unanimously as I said. So, this seems to me a pretty clear analogy how that’s set up here. In the “Annals of Internal Medicine,” we have maybe a 15-page scholarly article, followed by 5 pages of ads.

On a college sports broadcast, we have 15 minutes of football, followed by five minutes of commercials, if you’re lucky to achieve that ratio. It seems entirely reasonable to me to fragment the television revenue from most of the expenses, not necessarily all of the expenses.

Some of the expenses would be attributable to the television broadcast itself. But in general, the networks are paying for those. Those are not coming out of the budgets of the colleges and universities. They make a little bit of space in the parking lot available for the ESPN truck, but not much other than that.

Maybe you could allocate the salary of the sports information director or something like that, but you wouldn’t end up with much in the way of expenses to offset the enormous revenues that are coming in from television.

Robert Goulder: Now, there’s a clever line in your article, which relates to this. It points out that the sale of broadcasting rights, regardless of whether it’s directly from a school selling the rights or if it’s done at the conference level, is implicit advertising income. That goes right to your last point, right?

Richard Schmalbeck: That’s right. It’s paid from Budweiser to ESPN and then, ESPN to the NCAA. But that intermediary that represents the NCAA is something that we would generally disregard, I think, in analyzing what’s really going on in financial circles.

Robert Goulder: Now, the IRS, in the past, have tried to do something about this. If you go back, I think it was about 30 years ago, they issued a technical advice memorandum talking about the taxation of sponsorship payments to college bowl games. That came to be known as the “Cotton Bowl ruling.” This set up one rule for sponsorship revenue and a separate rule for ad revenue.

Is it intuitively correct that those two should be treated differently?

Richard Schmalbeck: I think it’s satisfactory. It’s something you could debate, certainly, but it doesn’t trouble me enormously to draw that distinction. Let me just explain a couple of things as background.

A technical advice memo is something that is written in response to a field inquiry from an auditing agent who wants some guidance from the national office of the IRS. He sends a request for technical advice from the chief counsel’s office of the IRS.

There’s always a particular taxpayer, or in this case, exempt organization that’s involved. It’s redacted so that you can’t tell who it is, but it’s well known in the industry that this was the Cotton Bowl ruling. It was in 1991. So, as you said, almost exactly 30 years ago.

It said that, actually, this was UBI, but there was a big hue and cry about it, and the IRS backed off a little bit. Congress followed up in 1997 and added a provision, section 513j to the code. This is what Congress has said about the sponsorship income.

They say, basically, that it’s not going to be treated as UBI if there is no arrangement or expectation, and, “That such person will receive any substantial return benefit other than the user acknowledgment of the name or logo of such person” —here they mean corporate person— “such person’s trade or business in connection with the activities.”

It does not include, however, “advertising the products or services (including messages containing qualitative or comparative language, price information or other indications of savings or value, and endorsement or inducement to purchase, sell or use such products or services).”

They’re drawing a clear distinction in the sponsorships between having a sign and a logo advertising Mobil Oil, which in fact was the sponsor of the Cotton Bowl at the time. You see these kinds of relatively discreet announcements before PBS broadcasts, for example, as well as at bowl games and others. That doesn’t seem to me terribly disturbing. There’s some goodwill that comes from that, but there’s always some goodwill that comes from corporate charitable contributions.

The questions that are interesting is I’m not sure if anyone has given any thought to how this applies to the two rather different types of genuinely commercial advertisements that you see. You see a lot that are pretty straightforward, advertisements for beer or soft drinks or pickup trucks or things like that, that clearly identify products and promote them. But you also see ads for Nike that say “Just Do It” and don’t identify any particular product, although their logo is all over the place. Or Gatorade, “Is it in you?”

Those might just possibly pass muster as sponsorship payments rather than as advertisements under the rules that Congress has set out. I don’t think that question has been addressed, and I’m not sure how the companies involved are handling that.

Robert Goulder: Separately, there was an occasion, I think in the early 1990s, when the IRS challenged something the NCAA was doing to take just a very small sliver of its commercial empire and say, “That little sliver looks like it’s going to be UBI.”

This had to do with the sale of these magazine-like game programs that they were selling at the basketball tournament. The IRS actually won that case when it was before the Tax Court, but then lost on appeal.

Why didn’t that lead to the IRS becoming a little bit more aggressive and push back against the NCAA?

Richard Schmalbeck: I can’t say why it didn’t. I think it should have. They got a lot of what they needed out of that even at the Tenth Circuit level, because the NCAA conceded that selling the Final Four programs was a business and was unrelated to the educational enterprise. The unrelated part is the part that would be at stake.

The third leg was the one that the NCAA challenged. They said it was not regularly carried on because it was only done for a few weeks. Only $10,000 was at stake. Although that’s a little bit misleading, because sometimes it’s the nose under the tent and lays down some principles that could be valuable to the IRS later. As you mentioned, the IRS won at the Tax Court and then lost at the Tenth Circuit.

When the IRS loses a case, at either the Tax Court level or the Circuit Court level, it usually announces, “This is how I feel about it,” and it does this through announcements about acquiescence or non-acquiescence. It did not acquiesce to this. It actually published a notice that it was not acquiescing to this case, but also wasn’t appealing it.

That’s a little unusual. Usually, when they disagree with a case, they will appeal it, but in this case, it was at the Circuit Court, so the appeal would have been to the Supreme Court.

The Supreme Court generally doesn’t have mandatory jurisdiction. The Supreme Court gets to pick its cases. You petition for certiorari, and the Supreme Court grants certiorari in about 2 percent of the cases that seek it.

So, the IRS, I think, thought they could not get certiorari, unless there was a split in the circuits. If Tenth Circuit decides one way, Fourth Circuit decides some other way, then you can get the Supreme Court to resolve the conflict between or among circuits.

Something I found very curious about this is the NCAA, at the time and now, was located only in a single circuit. These are geographically-based circuits. It was located in Mission, Kansas, which is a suburb of Kansas City. Because it’s done in the Kansas side of the line, it was in the Tenth Circuit.

The IRS wasn’t going to be able to raise another case with respect to the NCAA to get a split in the circuits because it was going to be in the same circuit.

In 1999 the NCAA decided that it would move to Indianapolis, which is in the Seventh Circuit. I don’t know if anybody gave any thought about the implications of walking away from a situation where the IRS was not going to be in a position to further challenge this.

That may be a partial explanation at least of why, for some period of time, and maybe when the issue was hot, and people were thinking about it, they didn’t push it because any pushing of it might have taken place in the Tenth Circuit, which already had some adverse precedent, although it was only on the regularly carried on issue. They still could have gone after the main aspect involved, which is the television revenue that comes not just from the Final Four tournament, but from college sports across the football and basketball seasons.

But the NCAA walked away from its favorable precedent when it moved to Indianapolis.

Robert Goulder: Well, let’s move on now to scholarships. Anyone who’s a fan of college sports or has a favorite team might follow recruiting. You know that your team only has a certain number of scholarships to give, so they are selective about who they give them out to.

Is that taxable income or is that tax-exempt? There’s a statute on that, section 117. There’s a general rule there about the economic value of a college scholarship. Is it taxable to the recipient? What’s the general rule there?

Does it depend if the scholarships are cancelable? If the coach says, “I don’t like the way this guy is playing point guard. We can cancel the scholarship.” How does that relate to whether it’s really a payment for a service?

Richard Schmalbeck: Well, section 117 has a number of requirements, two of which are relevant in the sports case.

The first is that it can’t be payment for services. If the coach can throw a kid off the team and cost him a scholarship, it certainly tends to look like it was payment for services.

The other thing is that in 1986, Congress cut back the scope of the scholarship exclusion, which in particular used to include room and board and now doesn’t anymore. It’s limited to the tuition expense and books and related educational materials, but would not cover room and board.

I understand sports scholarships now include a certain amount of incidental money to pay for trips home, and things like that, that would also not be covered by the section 117 exclusion.

Robert Goulder: Next, I want to talk about what happened just a few years ago in Evanston, Illinois, where Northwestern University is. There were some football players there who applied to the National Labor Relations Board (NLRB) to be recognized as employees of the school’s athletic department.

If I’m not mistaken, the regional director for NLRB actually agreed with them. It wasn’t until later at some national level of appeal that the players’ petition was dismissed.

Mindful of that incident, there was a U.S. senator, Richard Burr, R-N.C, who wrote a letter to the IRS commissioner at the time, John Koskinen, to inquire about the implications of this push for NLRB status on student athletes. That resulted in Commissioner Koskinen producing a letter.

Your article pushes back a little bit against what’s in that letter. I think, at some point in article, you use the term it sort of has a “head-in-the-sand type posture” about how the world works. Can you elaborate on that?

Richard Schmalbeck: Yeah. First, just a word about the NLRB ruling.

When they dismissed that, they dismissed it on grounds that they didn’t have jurisdiction over most college sports teams, because they were governmental units. They actually didn’t get to the merits of what the regional director had found.

So, I would have to say that’s still a live issue. Whether the NLRB is going to be the best medium for getting that notice or not is unclear, but that is, I think, still a potentially live issue.

After that fiasco, as you say, Senator Burr, a former college athlete himself, undoubtedly on scholarship who went to Wake Forest, wrote a letter asking about that. The Koskinen response basically just cites revenue ruling 77-263. Which, as I just mentioned, wasn’t probably an accurate description of what the NCAA was doing, even in 1977, and certainly wasn’t in 2014, when Commissioner Koskinen wrote the letter.

Of course, he probably didn’t personally write it, but I hope he read it before he signed it, and he probably didn’t investigate the facts. His fingerprints may not be on this in any significant degree, but the IRS officially is on notice. I guess I shouldn’t say that they’re on notice. There’s no formal obligation of the NCAA to send its rules every time it revises them to the IRS, but it wouldn’t take a lot of investigation to find those rules. We found them quite readily.

They could have taken a look at that and should have known. I don’t know if anybody intentionally ignored those rules or if, as we describe it in the article, it was just a head-in-the-sand kind of thing of they really didn’t want to know.

Koskinen’s letter is based on assumptions about the facts that simply aren’t true as to NCAA scholarship practices in the present day.

Robert Goulder: I want to talk about the Tax Cuts and Jobs Act here. We’re constantly talking about TCJA, still, years after its enactment. But one maybe overlooked provision of it is that it added this new excise tax, section 4960, a 21 percent excise tax on the excessive compensation of certain employees of tax-exempt organizations.

Well, my goodness, I’m thinking about Jim Harbaugh at the University of Michigan, the head coach of my favorite college football team. He just signed a new contract, and it probably makes him one of the highest-paid employees of the state.

It might not be expressly targeted at football and basketball coaches, but the practical effect is that that’s exactly who they’re targeting.

In your opinion, did TCJA get that correct?

Richard Schmalbeck: I’m not a big fan of this kind of special excise tax in general. This was meant to mirror to some degree a provision that affects for-profit businesses. Corporations are not allowed to deduct salaries in excess of $1 million. That’s been true for several years under section 162m.

That has a huge loophole in it, however, which is that incentive pay doesn’t count. Businesses that want to pay their executives more than $1 million just restructure their pay so that it’s packaged into the incentive structure.

So, 162m doesn’t work, but it’s also probably ill-conceived. I mean, the market is the market, and if Jamie Dimon, CEO of JPMorgan Chase, can command whatever it is he commands, I’ll leave that to the shareholders of the bank to decide whether that’s appropriate or not.

Now, nonprofit organizations don’t have shareholders. You have football fans, though. Football fans, by and large, think Nick Saban’s worth every penny that they pay him. So again, don’t see really the reason for this.

Obviously, it had to take the form of an excise tax in the nonprofit area. It’s like the bandits in the Sierra Madre telling people that they don’t need no stinking badges. The NCAA is in a situation of saying that they don’t need no stinking deductions if you’re not going to be taxed on your income at all. An alternative to that is to oppose the excise tax, and then the rate of the excise tax is precisely what the corporate tax rate is now of 21 percent.

That’s the idea. Only applies to a handful of people and it only applies to the excess over $1 million. There are presidents of universities and colleges, not by any means a majority of them actually, probably a few dozen or so, that are over $1 million. There will be more of course, as the years go by, that has been increasing at a rate well above inflation.

But still, it’s only the excess. You might be taxing $200,000 here and there or $500,000 here or there. That’s not going to add up to very much.

Medical service personnel have been exempted from this requirement, curiously, so you can still pay your orthopedic surgeon as much as it takes to recruit him or her.

It’s primarily going to touch a little bit the executive tier of the university, but probably mostly, the head football and basketball coaches. Something that shocked me when I first learned it is that there are now offensive coordinators and defensive coordinators who are making $2 million a year. So, they might be hit a little bit by these, but it’s basically aimed at, I would think, the Mike Krzyzewskis and the Nick Sabans and the others.

Certainly Harbaugh’s a nice example as is Krzyzewski. Krzyzewski was actively recruited by the Los Angeles Lakers some years ago, and Harbaugh was most recently recruited again to go back and has had experience as a pro coach.

Undoubtedly, you can show he was better paid as a professional coach and would be better paid as a professional coach. The general standard for compensation for nonprofit organizations is that you are permitted to pay the market salary for whatever skill set you’re hiring when you hire an employee. There’s no reason to believe that these highly paid coaches are being paid more than the market value of their services.

It’s a public relations thing on the part of Congress of just responding to perceived citizen unrest, although I’m not sure there’s even that much of that.

Robert Goulder: While we’re on that topic, last question, does it apply to public and private universities the same? There’s a bit of a technical issue.

Does it have to do with what is the basis for the institution being tax-exempt? Is it through section 115 or is it the Doctrine of Implied Statutory Immunity?

Look at Duke University and the University of North Carolina. One’s public and one’s private. You could have one basketball coach or the school paying the excise tax and their rival, a few miles away, not paying it.

Richard Schmalbeck: Yeah. It’s clear from the committee reports from the 2017 Act that Congress meant to apply it to all colleges and universities, but they may have bollixed up the statutory language.

Professor Ellen Aprill at Loyola, Los Angeles has been kind of the main spear carrier on this. I’m convinced by her analysis of this, which is that at least if you are a public college and university that has not been recognized under 501(c)(3) and you can be, you can apply for 501(c)(3) status just to satisfy your donors that they get the deductions and many have. You can ask for that to be annulled, and go back to not being a 501(c)(3) institution.

Then there’s the 115 question. Aprill’s analysis of that suggests that, although it’s there, they don’t need it, don’t necessarily apply for it, and could again renounce it if they didn’t want it.

So, public universities, it would appear, can get out from under this. Many would not be automatically out from under, they’d have to do something to revoke some prior registration that they’ve done, but that they probably could do that.

The IRS issued regulations on this last year that don’t directly engage this issue, even though it’s one of the big ones that’s out there. They really just elide over what organizations are subject to this.

But the Joint Committee on Taxation has made some pronouncements about this. They used the word “may.” They say, “It may be that public institutions are not actually subject to this tax, and it may require technical corrections.”

I think that’s the mild weaseling on their part. I think they think it probably doesn’t apply or need apply anyway, if a public university wants to take steps to get out from under it, and that will need a technical correction.

The problem, of course, is the 2017 Act needs lots of technical corrections. It was rather hastily drafted. I’m sure you’re familiar with 50 or 60 mistakes off the top of your head that you can suggest for technical correction.

But it was a bill passed by a Republican House, a Republican Senate with no Democratic votes in either House and then signed by a Republican president. The Republicans are the ones who really should be pushing for the technical corrections to make the bill do what they wanted it to do.

But now, it’s a Democratic House and a Democratic Senate and a Democratic White House. I don’t think there’s a huge amount of enthusiasm among Democrats for that. If the Republicans were to push it, the Democrats would probably say, “Well, OK, but how about some substantive changes to that obnoxious bill, while we’re at it?”

I think the prospects, in the short run, at least, for a technical corrections bill may not be very good. You may be able to slip in little parts of it here and there that the Democrats could easily agree to into some other tax bill short of a general TCJA technical corrections bill. But unless they do that, I think this may take some time before it actually resolves. We’ll just have to see.

Robert Goulder: Well, sadly, that’s all the time we have for today. I want to refer any interested people to this article. It’s titled, “The NCAA and the IRS: Life at the Intersection of College Sports and the Federal Income Tax.” The authors are Professors Richard Schmalbeck and Lawrence Zelenak from Duke University School of Law.

Professor, thank you so much for taking the time to talk to us today.

Richard Schmalbeck: Thank you, Bob. I enjoyed it.