Business Structures, Bankruptcy, and Taxation in Sport

1. Chapter 5 C H A P T E R 5 Business Structures, Bankruptcy, and Taxation

2. Chapter Objectives • Understand why a business structure can affect a company financially. • Define the requirements for each type of business structure utilized in sport. • Compare the advantages and disadvantages of sole proprietorships, partnerships, corporations, and limited liability corporations or limited liability partnerships. • Understand some of the tax concerns affecting the sport industry. • Describe the importance of tax planning in sport. (continued)

3. Chapter Objectives (continued) • Understand how tax law is applied to athletes. • Understand the basics of financial risk management. • Describe the techniques that can help spot financial trouble. • Understand how to reorganize a troubled business. • Compare the types of bankruptcies available.

4. Government Structures • The text does not focus on government structures. • However, it is important to note the following: • Government entities can run numerous sport entities (e.g., park and recreation departments, high school athletic departments, community centers, public college athletic programs, and numerous other programs sponsored in whole or in part by the public). • Most sports organizations throughout the world are owned or operated by government entities. • Olympic programs in most countries are run by the government.

5. Nonprofit Organizations • A large number of sport organizations are established and managed under a nonprofit business structure. • A nonprofit status is given if the organization has a cultural, artistic, educational, or other public benefit.

6. Types of Business Structures • Sole proprietorship • General and limited partnerships • Subchapter S corporation • C corporation • Limited liability corporation or partnership

7. Sole Proprietorship • A business owned by a single person. • Most businesses in the world are sole proprietorships (Cheeseman, 1998). • For example, Big Ted’s Hometown Buffet, Slick Kitty’s Piercing Palace • Also independent contractors such as professional bowlers, skaters, and race car drivers (continued)

8. Sole Proprietorship (continued) • Advantages of Sole Proprietorships • Total control over decision making • Revenues taxed only once • Great flexibility • Easy to form • All profits retained by owner • Less concern about confidentiality • Easy to sell • Fewer government restrictions • Disadvantages of Sole Proprietorships • Limited managerial experience • Unlimited personal liability • Lasts only as long as the owner lives • Limited access to capital funds

9. Partnerships General and Limited Partnerships • A division of ownership. • If two individuals decide to run a sport business equally, and if each owns 50% (or any other division of ownership) of the business, they are considered partners. General partnerships: Individuals or groups combine resources to share in operating, managing, and controlling as well as profits and liabilities. Limited partnerships: One partner manages; others are financial partners only (limited partners). (continued)

10. Partnerships (continued) • Advantages of Partnerships • Some control over decision making • Revenues taxed only once • Great flexibility • Easy to form • All profits retained by owners • Easy to sell • Fewer government restrictions • Disadvantages of Partnerships • Limited managerial experience • Joint personal liability • Limited access to capital funds • Lasts only as long as partnership survives

11. C Corporations • Fictitious legal entities whose formulation complies with specific state laws. Also known as corporations. • Need to develop bylaws and articles of incorporation that specify how they will conduct business. • Can be formed in any state; Delaware is the “friendliest.” Articles of Incorporation (Cheeseman, 2010) • Corporate name • Number of shares the corporation will issue • Corporation’s initial address • Name and address of each of the initial incorporators (continued)

12. C Corporations (continued) Advantages of C Corporations • Unlimited life of the corporation • Liability limited to extent of corporation assets • Creditors not permitted to come after individual investors for payment over and beyond their equity investment • Ownership interest easily transferable (shares) • Ability to hire a broad base of talented managers • Tax benefit: dividends paid to corporations are 70% tax free • Greater bargaining position with vendors who are more willing to provide credit to a corporation versus a sole proprietor (single owner) • Ability to issue publicly traded debt and equity (continued)

13. C Corporations (continued) Disadvantages of C Corporations • Complex formation process • Need to answer to shareholders who might have ulterior motives • Sometimes onerous government regulations • Double taxation (corporation is taxed; dividend income to shareholders is also taxed)

14. Subchapter S Corporations Subchapter S Corporations • May have up to 35 shareholders • Must be based in the United States • Can own subsidiaries Tax-Exempt S Corporations • For example, charities • Can own shares • Advantages of S Corporations • Income flows directly to shareholders (SH pay taxes as personal income) • Not subject to double taxation • Can own subsidiaries (helps insulate them further from liability) • Disadvantages of S Corporations • Cannot be owned by another corporation or partnership • Can issue only one form of stock

15. Limited Liability Corporations and Partnerships • These business structures have some of the benefits of corporations and partnerships without some of the drawbacks of typical corporation creation. • Advantages • Classification as a partnership for federal income tax purposes • Liability protection afforded to corporations • Can be owned by another corporation or partnership • Easy and inexpensive to form • Disadvantages • Newness, no national standard • Each state thus has unique rules and regulations

16. Taxes and Cash Flow Tax Basics • No matter what organizational structure is chosen for a business, every manager needs to know some tax basics. Cash Flow • Cash flow is subject to taxation when disbursed and when received. • The value of any financial asset or instrument is contingent on the cash flow produced by the investment. (continued)

17. Taxes and Cash Flow (continued) Tax Rate Affects Investing Decisions • If the tax rate on a given investment cash stream is too high, the investor will opt for a different investment that may have a lower return but also lower taxes.

18. Formulas for Investments and Taxes Two formulas to help determine which of two investment options would return the most after taxes are as follows: • Tax-equivalent yield • Minimum municipal bond yield

19. Tax-Equivalent Yield • A formula measures the yield of a tax-free municipal bond against other investments that might require tax payments. • The yield a taxable investment would have to produce to match a tax-free investment Tax-equivalent yield = (tax-exempt yield) / (1 – tax rate) • If a business has a 28% tax rate and a tax-exempt municipal bond pays 5% interest, the necessary return on a taxable investment would be 5% / (1 – 0.28) = 6.94%. • Thus, to maximize your investment return, you should invest in the tax-exempt municipal bond unless you can find another investment that has a return greater than 6.94%.

20. Minimum Municipal Bond Yield • This formula determines the yield on a municipal bond (YM) when one knows the taxable bond yield (TBY). YM = (TBY)(1 − marginal tax rate) • (14.5%)(1 − 0.31) = 10.0% • For example, a person taxed at 31% considering a TBY bond with a 14.5% return • In other words, such a person would want to find a municipal bond with a rate of at least 10.0% in order to match the yield of the TBY.

21. Tax Planning • If businesses fail to plan for all potential tax liabilities, they could lose significant revenue Value-added tax: A tax that is applied to the value added at every stage of the manufacturing process. • The two key concepts for analyzing taxing structures are marginal and average tax rates: • Marginal tax rate: The percentage of tax liability imposed on the next dollar of income earned by the company or individual (Spiro, 1996). • Average tax rate: The total tax liability imposed on all taxable income.

22. Tax Issues in the Sport Industry • Lease values (and amortization) • Public tax dollars helping owners • Issuing of tax-exempt bonds to sports franchises (private owners) • The private-activity test (related to determining if a bond is tax exempt) • Bowl games and the taxation of educational (not-for-profit) institutions • Forcing nonprofit educational institutions such as schools involved in bowl games and some athletic departments to pay taxes if they are in fact engaged in a business enterprise • $1 million received by a title sponsor may be taxable

23. Tax Issues for Athletes • Athletes must know how to categorize their income. • Revenue Ruling, 1958 • Business expenses for athletes are highly diverse. • Careful planning by an athlete can reduce potential tax obligations. • Tax issues associated with bonuses and business expenses also affect other monetary matters. • Failure to properly plan can “destroy” an athlete.

24. Depreciation of Assets Current expenses can be written off the year they are incurred Capital assets are expensive assets with a longer life (e.g., machinery). • For example, if a machine costs $1 million and has a life of five years, the company can depreciate it by $200,000 a year for five years. • An athlete’s salary in professional sport is the only type of salary that is depreciable (Euchner, 1993). (continued)

25. Depreciation of Assets (continued) These are other capital assets that can be depreciated (Euchner, 1993): • The franchise itself • Lease contracts • Concession contracts • Broadcast contracts • Customer lists

26. Financial Risk Management Risk management is the process designed to identify problems and produce solutions for various risks that can range from tax concerns to litigation-based issues. • Risk management is designed for loss prevention. Insurance protection represents an attempt to shift the risks associated with a financial loss. (continued)

27. Financial Risk Management (continued) Risk financing is designed to help settle a financial dispute after a loss has occurred. • Risk financing establishes who will pay. • Risk financing is a passive activity compared with risk management.

28. Bankruptcy • Bankruptcy is the primary technique used by sport business owners when they are facing mounting obligations and do not have the resources to finance continued operations. • Three primary bankruptcy options are available to debtors to obtain court protection from creditors: Chapters 7, 11, and 13. • Chapter 11 bankruptcy provides an outline for a formal business reorganization supervised by the court. • Most sports team bankruptcies (e.g., Phoenix Coyotes, Texas Rangers, Chicago Cubs, Los Angeles Dodgers, and Buffalo Sabres) are Chapter 11 bankruptcies. • Specific protections are afforded a debtor in Chapter 11 proceedings, including an automatic stay that prohibits the commencement or continuation of any legal action against the business (Cheeseman, 2010).

29. Questions for Class Discussion • If you were going to operate a small sport business such as a fitness center or sporting goods store, what type of business structure would you try to establish and why? • The NFL currently does not allow any team other than the Green Bay Packers to have any shareholders. Should the NFL change this rule? • Give the pros and cons of public ownership of a sports franchise. Should more teams be publicly owned so that fans can be owners? • With all the money that the NCAA generates, should it still be considered a nonprofit organization? (continued)

30. Questions for Class Discussion (continued) • Would you ever want to start your own business? If so, what do you think you would need to be financially successful? • Do you think that the LLC structure gives too much flexibility to business owners, who can hide their assets and avoid financial judgments by claiming that the LLC has no money and is just a shell? • Should a business be able to choose what business structure it wants to adopt, or should the government decide? • Should professional team owners be allowed to depreciate players’ salaries? Take the pro or con side of this question. (continued)

31. Questions for Class Discussion (continued) • Should athletes have to pay tax in states that they play in but do not live in? • Should the heirs of team owners have to pay taxes if they inherit a team? If so, should they pay taxes on the value of the team when originally purchased or at the appreciated value? • What is financial risk management, and how can it be used by a sport business? • What risk management strategies do you take on a daily basis to protect your finances (everything from insurance to preventing identity theft)?