Why are large earnings from college sports exempt from gross income tax?

The NCAA’s proposal to allow major university and college sports programs to pay salaries to their athletes makes me wonder what it would take for Congress to require these schools to pay taxes on the revenue produced by their athletic departments. Paying players directly only adds to the long list of practices that make the connection between education and major college sports increasingly distant.

Both tax-exempt and public colleges are technically subject to the Unrelated Business Income Tax (UBIT), which applies to activities that are “not substantially related” to the school’s purpose of being tax-exempt. Which last I checked was education, not content creation for TV.

Recent events make it increasingly difficult to see how the billions of dollars that major college athletic programs earn from the sale of television rights to their events are exempt from UBIT.

Cheers for the old ESPN?

As Duke law professors Richard Schmalbeck and Lawrence Zelenak wrote in 2018, there are several related tax issues surrounding college sports. Should colleges pay tax on ticket sales for intramural sporting events? Should they be taxed on revenue from matches played in their 80,000 seater football stadiums?

Perhaps attending The Big Game promotes school spirit among students and faculty and thus may have a far-reaching relationship with education. But selling your football games to ESPN, where the majority of viewers have no academic connection to the teams they watch, seems more like a business than an educational endeavor. How many viewers of the upcoming Rose Bowl will even know which city the University of Alabama is in?

Duck test failed

You know the old phrase, “If it looks like a duck, quacks like a duck, and walks like a duck, it’s a duck?” Well, major college sports is one massive duck.

Again, this is what the IRS has been doing for years. Its 1980 Revenue Ruling (80-296) concluded that “[T]The educational purposes served by showing a game to an audience that is physically present and showing the game on television or radio to a much larger audience are essentially similar. Therefore, the sale of the broadcast rights and the resulting broadcast of the game contributes significantly to the organization’s exempt purpose.”

This was naive even in 1980 when broadcasting rights were limited to local TV and radio stations. And it’s completely irrelevant in 2023, when TV revenues are orders of magnitude greater and the vast audience has no believable connection to the teams they watch.

From zero to salaries

This brings us to the NCAA’s recent decision. Long before he green-lighted direct player salaries, he encouraged universities to turn sports into huge revenue-generating businesses. By one estimate, the so-called Power Five sports conferences and their member schools receive $25 billion in multi-year television contracts.

“Student athletes” are much more athletes than students. They frequently skip class, have poor graduation rates (depending on whose numbers you believe), and enjoy special housing. Millionaire coaches are paid handsomely to win games, not to promote education.

In 2020, after losing numerous lawsuits and facing new state laws that allowed college athletes to monetize their reputations, the NCAA allowed athletes to supplement their income with name, image and likeness (NIL) payments.

They began as compensation for promoting goods and services, but have become a tool for boosters to direct money to the stars of their favorite college teams through so-called collectives.

The NCAA now says it can allow schools to directly pay salaries to their athletes without having to launder the funds through middlemen.

What should be taxed?

Although the IRS has long exempted sports scholarships from taxes, it seems very likely that athletes will be taxed on these new direct payments that appear indistinguishable from salaries. They should be subject to both income and payroll taxes.

Of course, schools that are taxed on their television revenue should be allowed to deduct their costs of doing business. While this will inevitably create opportunities to game the system, sports programs come with costs. In 2018, Schmalbeck and Zelenak estimated that fewer than 75 schools would pay UBIT on their sports income.

Republicans in Congress, who are fierce critics of “elite” universities, imposed a new tax on very large college endowments in 2017 and may seek to expand that tax. But wouldn’t it make more sense to tax unrelated income?

It’s really simple: Professional sports teams whose products they sell on television owe corporate tax on their earnings. Players who will now receive wages will owe individual income tax on this compensation. And the athletic faculties that pay them must owe a tax on their net television revenue from a product that has no bona fide connection to their university’s tax-exempt purpose. If the IRS doesn’t make them pay fees under current law, Congress needs to change the law.

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