Sports Franchise Acquisitions: Purchase Price Allocation Procedures. PART 1 OF 2
By Robert F. Reilly
The sale and purchase of professional sports franchises generally receives a lot of welcome publicity and media attention—as well as some unwanted attention from the IRS and other taxing authorities. A professional sports franchise purchase price allocation is a challenging valuation analysis, particularly with regard to the valuation of acquired intangible assets. Economic justification of the prices paid for professional sports franchises—based on traditional pricing metrics, such as price/earnings multiples—is often difficult because many sports franchises do not generate positive accounting earnings.
Part One of this two-part article considers why both fans and taxing authorities seem to be obsessed with sports franchise transactions. It then summarizes both the financial accounting and income tax accounting rules with regard to sports franchise purchase price allocations, and describes many of the relevant intangible assets.
Part Two will explore the most common procedures analysts use to identify, value, and “life” these transferred, intangible assets, then illustrate a purchase price allocation of a hypothetical sports franchise transaction. It will describe how the national franchise agreement is sometimes valued by the capitalization of “residual income” over the current franchise term and any expected franchise renewals. This residual income is the franchisee’s expected income after the discrete intangible asset income has been allocated to those intangibles. Part Two will also illustrate a typical sports franchise purchase price allocation.
Sports franchise transactions and owners. Professional sports franchise sales receive so much attention for several reasons. A transaction typically involves the purchase of a sports team and its player contracts. Franchise and team purchases sometimes result in team roster changes, player contract terminations, player trades, coach reassignments, and other organizational disturbances that interest fans. Furthermore, both the success and the ownership of a professional sports franchise are matters of citywide and regional pride.
Outspoken and opinionated franchise owners are often as newsworthy as the team’s star players, and sports franchise transactions can involve multi-hundred-million-dollar price tags. These transactions are usually reported in both the general business news media and the sports news media.
Taxing Authority Interest
The IRS pays particular attention to franchise purchase transactions. Compared to the typical closely held business sale, professional sports franchise sales involve fairly large prices and taxable gains or losses. In addition, sports franchise buyers are typically wealthy individuals with substantial business interests and a high public profile.
With regard to transaction purchase price allocations, sports franchises are generally subject to different basis/amortization tax rules than most other businesses. Sports franchises also have relatively unique intangible assets, which often require a very special application of valuation approaches and methods. Accordingly, sports franchise purchase price allocations often attract the attention of the IRS.
State and local taxing authorities are also interested in sports franchise sales. These transactions may provide the justification for a revaluation of the franchise’s stadium for ad valorem property tax purposes. While the IRS often concludes that the franchise purchase price is principally related to nonamortizable franchise value, local taxing officials often conclude that the same purchase price relates principally to the stadium’s leased fee interest or leasehold interest.
Virtually all professional sports franchises are closely held businesses and do not publicly report their financial statements. Accordingly, buyers and owners are not concerned with purchase price allocation for financial reporting purposes. Many franchises, however, have minority owners that receive periodic financial statements, and even single-owner franchises typically prepare financial statements in compliance with GAAP.
SFAS 141 and 142 provide GAAP guidance with regard to purchase price allocation accounting. SFAS 141, Business Combinations, provides that all business combinations be accounted for using the purchase method of accounting. SFAS 142, Goodwill and Other Intangible Assets, provides guidance related to the capitalization and amortization of acquired intangible assets in business combinations. For goodwill and other intangibles recorded prior to SFAS 141, SFAS 142 allows the impairment loss related to previously purchased goodwill and intangibles to be recognized as the effect of a change in accounting principle. The first Sidebar excerpts details of the relevant provisions.
Income Tax Reporting
Like other taxpayers, sports franchise acquirers allocate the acquisition purchase price under either IRC section 338 (for deals structured as qualified stock purchases) or section 1060 (for deals structured as qualified asset purchases). The regulations under both IRC sections 338 and 1060 require the taxpayer to determine the total purchase price paid for the acquisition. Specific rules determine which acquisition-related expenses should be capitalized and also what tax liabilities (assumed or created by the transaction) should be included in the total purchase price. Due to capitalized acquisition expenses and income tax liabilities, the income tax purchase price is typically much greater than the financial accounting purchase price for the same franchise.
Under both IRC sections 338 and 1060, the calculated purchase price is allocated among specifically identified categories, or classes, of acquired assets. Under both sections, the semifinal category relates to acquired identified intangible assets, while the final category relates to acquired goodwill. The purchase price amount allocated to goodwill is based on the residual method. The remaining purchase price, after allocations are made to acquired financial assets, personal property, real estate, and identified intangibles, is assigned to goodwill.
In terms of determining the total purchase price paid and allocating it to individual acquired assets, the process for sports franchise owners is basically the same as for any other taxpayer. The process of amortization deductions for acquired intangible assets is distinctly different for sports franchise owners, however, because most taxpayers claim amortization deductions for acquired intangible assets (including acquired goodwill) over a 15-year period, under IRC section 197. IRC section 197(d) defines intangibles, including franchises; section 197(e) expressly excludes sports franchises and items connected with them from the section 197(d) list. The second Sidebar lists the specifics of sections 197(d) and (e).
Because of the 197(e) exception, a sports franchise purchase price allocation is different from most acquisitions in two ways:
Sports Franchise Intangible Assets
Professional sports franchises have numerous intangible assets that immediately match up to the IRC section 197(d) list of intangibles, as well as others not included on that list. A unique intangible asset is the franchise agreement (and any associated contract) between the national league/association franchisor and the team owner/franchisee. While this franchise is not necessarily the most valuable intangible asset, it is important to the franchise owner.
As with all franchise agreements, sports franchises provide some elements of limited monopolistic economic benefits to the franchise holder. In numerous instances, buyers have paid substantial amounts for “naked” franchises, as in the case of expansion teams; however, a buyer is unlikely to pay a substantial amount for player contracts and stadium rights without the expectation that the franchise will be transferred as well.
Several sports franchise intangibles are related to employees. First, there is a trained and assembled administrative workforce, which includes management, marketing, public relations, customer relations, accounting, and other personnel. Other than a few senior executives, these employees are unlikely to be under contract. Second, there are the coaching and player development staffs, which include scouts, recruiting agents, assistant coaches, physical therapy and medical personnel, and senior coaches. Many but not all of these employees are likely to be under contract. Third are the team players, all of whom are typically under some type of contract.
There are four categories of intellectual property: patents, copyrights, trademarks, and trade secrets. The franchise workforce’s value generally encompasses that of the organization’s trade secrets; for instance, they may have developed specialized systems and procedures related to accounting, administration, player therapeutic procedures, and even player development. These trade secrets may be documented in written standards and manuals. Any such manuals are also intangible assets. Most trade secrets of a sports franchise are encompassed in its employees’ collective knowledge and experience.
A franchise may hold copyrights on team songs, brochures, slogans, and related material. Any such copyrights are also acquired intangible assets. Most franchises also have trademarks and trade names (e.g., the team nickname), service marks, associated trade dress, and similar items. The team name and logo may be the source of national or local product licenses, which are a secondary but important income source for the franchise.
In addition to product licenses, many sports franchises have numerous contract-related intangible assets, such as:
Most franchises either own or lease stadiums. In addition, many franchises either own or lease training facilities and other specialized real estate properties.
Obviously, these properties are substantial components of the overall franchise value. Real estate–related contracts are also important intangible assets to franchise holders. These intangibles may include:
An important intangible asset for many franchises is the customer-related intangible, which typically includes recurring customer relationships with season ticket holders.
Arguably, the most important intangible is the franchise agreement with the national sports league or association. The national franchise agreement may not be the most valuable intangible asset of the franchise owner, but is necessary for realizing the full economic value of all other assets. The operation of all of these assets contributes, at least in part, to the franchise agreement’s value. The franchise agreement (and any associated contracts and covenants) may include the following component intangibles:
Franchise buyers sometimes pay for goodwill. With regard to sports franchises, goodwill is often considered to be the portion of the franchise purchase price that cannot be associated with identified tangible or intangible assets. Under this definition, goodwill is the residual (i.e., remaining) purchase price premium not allocated to any other asset.
Martin J. Lieberman, ASA, CPA/ABV
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