First Northwest Industries of America, Inc. v. Commissioner of Internal Revenue

Court of Appeals for the First Circuit
1981 U.S. App. LEXIS 11925, 649 F.2d 707, 48 A.F.T.R.2d (RIA) 5416 (1981)

ELI5:

Rule of Law:

In a sports league expansion, existing team owners may subtract their cost basis from expansion proceeds only for those specific rights that are actually transferred or diluted to the new owners, provided the cost of those specific rights can be accurately ascertained.

Facts:

In 1967, the Taxpayer purchased the Seattle Supersonics NBA team for $1,750,000.
The purchase included 13 specific rights, such as the right to draft players, participate in revenue sharing, and exclusive rights to exhibit games within 75 miles of Seattle.
In 1970, the NBA expanded by adding new teams in Portland, Buffalo, and Cleveland.
The league collected proceeds from the sale of these new franchises and distributed them equally among the existing team owners, including the Taxpayer.
As a result of the expansion, the Taxpayer's share of national broadcasting revenues and league promotional income was diluted from 1/14th to 1/17th.
However, the Taxpayer retained its exclusive rights to local broadcasting and home-game gate receipts, which were not shared with the new teams.
The Taxpayer sought to offset the gain realized from the expansion proceeds by subtracting a portion of its original cost basis.

Procedural Posture:

The Commissioner of Internal Revenue assessed a tax deficiency against the Taxpayer regarding the expansion proceeds.
The Taxpayer petitioned the Tax Court for a redetermination of the deficiency.
The Tax Court ruled in favor of the Taxpayer, holding that they could subtract a proportion of their total cost basis from the expansion proceeds.
The Commissioner appealed the Tax Court's decision to the United States Court of Appeals.

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Issue:

Does an existing professional sports team owner transfer a portion of its original franchise rights to new teams during a league expansion, thereby permitting the owner to offset the expansion proceeds with a portion of their original cost basis?

Opinions:

Majority - Judge Wright

Yes, but strictly limited to those specific rights that were actually diluted or transferred. The court reasoned that a professional sports franchise consists of a bundle of rights, some of which are held in common with the league and others that are held independently. While the Taxpayer argued that the expansion was a sale of a portion of a partnership interest, the court rejected this because team owners retain independent business controls (like gate receipts). Conversely, the court rejected the Commissioner's argument that no transfer occurred. The court found that rights to shared revenue (like national broadcasting) were indeed transferred because the Taxpayer's share decreased from 1/14 to 1/17. However, rights such as local broadcasting and gate receipts remained intact and were not transferred. Therefore, the Tax Court erred by allowing the Taxpayer to allocate cost basis from the entire bundle of rights; basis can only be subtracted if the specific cost of the transferred rights can be ascertained.

Analysis:

This case is significant because it rejects the 'all-or-nothing' approach to the taxation of franchise rights. It treats a professional sports franchise not as a monolithic asset, but as a divisible 'bundle of rights,' requiring distinct tax treatment for each stick in the bundle. The decision places a heavy evidentiary burden on taxpayers to accurately allocate the original purchase price among these specific rights. If a taxpayer cannot prove the specific cost of the rights transferred (e.g., the specific value of the national TV rights at the time of purchase vs. local rights), they may lose the ability to claim a basis deduction, even if a transfer legally occurred.

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