R&G Dugout: The House v. NCAA Settlement—Tax Implications for Colleges and Universities

On this episode of the R&G Dugout podcast, Ropes & Gray intellectual property transactions partner and a leader of the firm’s sports industry initiative Erica Han is joined by tax attorneys Gil Ghatan, Kendi Ozmon and Franziska Hertel, who lead the firm’s tax-exempt organizations practice. Together, they discuss the tax implications of the House v. NCAA settlement, including the rules that permit colleges and universities to pay student athletes for their name, image, and likeness (NIL). Tune in to understand the compliance challenges for schools seeking to create opportunities for their student athletes and athletics programs through NIL deals.

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Transcript:

Erica Han: Welcome back to the R&G Dugout, a podcast series brought to you by Ropes & Gray focused on analyzing the landscape of sports, entertainment, and media investments. My name is Erica Han. I’m a partner in the Boston office of Ropes & Gray, and I am a leader of our sports industry initiative. Today, I’m joined by my colleagues Kendi Ozmon and Franziska Hertel, tax partners at Ropes & Gray, and Gil Ghatan, tax counsel at Ropes & Gray, who lead the firm’s tax-exempt organizations practice group.

In our last episode, we talked about the evolving name, image, and likeness (NIL) landscape, including the influx of investments from NIL collectives or “boosters”; the House v. NCAA litigation and what the proposed settlement would mean for colleges and universities; and the future of college athletics. Today, we’re building on that conversation by diving into tax implications for colleges and universities, especially now that the House settlement has finally been approved. Thanks so much for joining me, Kendi, Franziska, and Gil.

Kendi Ozmon: Thanks for inviting us.

Erica Han: To start, let’s recap our previous discussion and talk about the update in the House litigation. Last time, we talked about the NCAA policy change in July 2021 that first opened the door to student athletes receiving payments in connection with their name, image, and likeness property rights, as well as how this change led to the House litigation and the proposed settlement among the class action plaintiffs, the NCAA, and the formerly known as “Power Five” conferences.

Since our previous conversation, the major development to have hit the press is that the House settlement was finally approved on June 6. The approved version of the settlement agreement includes some revisions related to the rights of future athletes, including with respect to roster limits and the administration of claims, but the headline terms we discussed last time were unchanged.

I want to revisit one of the central terms of the settlement that we discussed last time, which is also the most relevant to our discussion today. The settlement agreement allows Division I schools who opt in to directly pay their student athletes for things other than scholarships and educational benefits on a going-forward basis. Each school covered by the settlement has the discretion to make additional payments to student athletes up to a certain cap (referred to in the settlement as the “Pool”), which is expected to be about $20-22 million per school in the first year of the settlement’s 10-year term.

The “Pool” and this going-forward payment model has been widely referred to as a “revenue sharing model” in the news. The first question I wanted to ask is what are the tax implications for colleges and universities under this so-called revenue sharing model?

Gil Ghatan: Thanks, Erica. I’m glad you raised this point, as the references to revenue sharing in the news did have us concerned. But a careful look at the settlement agreement indicates that the so-called revenue share component is not really a revenue share in the traditional sense—at least not for tax purposes. As you noted, what the settlement allows is for colleges and universities to make discretionary payments up to a certain cap. The amount of the cap or the “Pool” is calculated as a function of average revenue amongst schools covered by the settlement, but the agreement itself does not provide for sharing profits or revenue or any other elements that you would expect of a true revenue sharing model.

As a result, we do not expect the settlement to raise the types of tax concerns that can typically be raised by revenue share arrangements, such as whether the arrangement is deemed a partnership for tax purposes or whether there has been impermissible private inurement.

Erica Han: Thanks, Gil. That’s helpful clarification. In that case, what kinds of tax issues are raised by these newly permitted discretionary payments to student athletes? How should colleges and universities be thinking about these payments from a tax perspective?

Kendi Ozmon: You’re right, Erica, that the payments permitted under the House settlement will require additional tax planning and forethought. But before answering your specific question, I’ll share two preliminary observations.

First, we want to emphasize that the recent developments in NIL and college athletics are uncharted territory tax-wise. There has been some IRS guidance related to the tax-exempt status of NIL collectives, which are separately incorporated entities from the colleges and universities they support—we’ll get to that in a bit—but besides that, there’s really very little legal authority that deals specifically with NIL deals. That’s all to say—we’re working with our understanding of general tax principles and the laws governing the tax exemptions of colleges and universities as section 501(c)(3) organizations, and we’re using our best judgment as to how these principles would apply to the facts before us, but the facts we’re working with have never been specifically considered by the IRS.

The second observation relates to a point you highlighted in your previous podcast, which is that the settlement is silent on what form these discretionary payments to student athletes can take. Colleges and universities could enter into NIL deals directly with student athletes or they could opt to provide additional scholarships or benefits. So long as schools don’t exceed the yearly cap, there’s really not a lot of restriction in the settlement on how they can pay their student athletes. Of course, as you previously noted the discretionary payments would be subject to other rules, including existing NCAA rules about recruiting and extra benefits, as well as laws such as Title IX. That said, the settlement itself doesn’t provide much in the way of guidelines for colleges and universities considering additional payments to student athletes. We understand that a lot of schools are planning to start paying student athletes for their NIL or to enter into arrangements with third parties that include payments for student-athlete NIL, so we’re focusing today on those types of payments. Other types of payments, of course, might raise other tax issues.

If schools start to enter into NIL deals with student athletes, that would generally raise two sets of potential major tax issues for schools that we want to flag today. One is compliance with what’s called the private benefit doctrine, which generally prohibits 501(c)(3) organizations, like most colleges and universities, from conferring more than incidental benefit on private parties. And the other is the tax on unrelated business taxable income (often referred to as “UBTI”), which requires tax-exempt organizations to pay income tax on certain income that is not substantially related to the organization’s tax-exempt purposes. Then, there are, of course, a host of ancillary issues that would have to be worked through, such as what reporting obligations may be triggered by these payments and whether tax withholding might be required.

Erica Han: I see—lots to think about. But for now, let’s focus on the major issues of private benefit and UBTI. Could you tell us a bit more about each issue and how it might apply to NIL deals between schools and student athletes?

Franziska Hertel: Certainly. Let’s start with the private benefit doctrine, which is generally meant to prevent 501(c)(3) organizations from operating to primarily benefit private rather than public interests. Generally speaking, a 501(c)(3) organization must be operated for specific, charitable purposes that benefit the public interest. This general rule does not mean that tax-exempt organizations are not allowed to make payments that incidentally benefit private parties—for example, a tax-exempt organization is permitted to make payments to third parties in exchange for goods and services at fair market value. But if the benefit to private parties is disproportionate in relation to the benefit to the public interest, an organization’s exempt status may come under scrutiny under the private benefit doctrine, and could, in the most extreme situation, be revoked.

We know the IRS views the private benefit doctrine as particularly relevant in the NIL context. The IRS recently cited the private benefit doctrine to deny tax exemption to NIL collectives that applied for tax-exempt status. In a 2023 generic legal advice memorandum, as well as in numerous private letter rulings issued to NIL collectives over the past few years, the IRS ruled that payments to student athletes for their NIL impermissibly conveyed private benefit, and when such payments represented a large portion of the collective’s activities, the organization itself was not operated for charitable purposes. This guidance has made it difficult for NIL collectives to obtain tax exemption and suggests that the IRS does not consider payments to student athletes for their NIL rights, in and of themselves, as conveying a public benefit.

Obviously, colleges and universities stand in a different position than NIL collectives, given all of the other educational activities they engage in. Whether an NIL deal entered into by a college or university raises a private benefit issue would depend on the facts and how the relevant contracts are drafted. Understanding whether the private benefit doctrine applies would require analyzing whether any NIL deal is expected to primarily benefit the college or university (as opposed to a student athlete or any third party) and whether any anticipated payments to student athletes or third parties under the arrangement would be reasonable in light of the benefit provided to the school.

Erica Han: Got it. What about the second issue, taxes on UBTI?

Kendi Ozmon: UBTI is generally meant to ensure that tax-exempt organizations are taxed on income that is unrelated to their exempt purposes at the same rate as if they were a taxable entity. The question will be whether colleges and universities expect to receive any payments from NIL transactions that are not in furtherance of their tax-exempt purposes, and, if so, whether any of those payments would fall within the scope of certain UBTI exceptions. Two exceptions that schools tend to rely on in the conduct of their athletic programs are royalties and qualified sponsorship payments. Both exceptions, much like the broader UBTI framework, involve fairly complex sets of rules that will be important for schools to consider when assessing the tax implications of NIL deals with student athletes and third parties.

Again, like the private benefit issue, whether any specific NIL deal raises UBTI issues would depend on the facts and how the relevant contracts are drafted. Understanding whether UBTI is expected would require analyzing the overall terms of an NIL deal, whether the arrangement contemplates payments to a college or university, and whether those payments, given the overall terms of the arrangement, would be treated as taxable income under the UBTI rules.

Erica Han: Thanks, Kendi. That’s all very helpful, and it sounds like payments to student athletes from the “Pool” are not the only kinds of activities that could trigger the tax issues you mention. We began this discussion by talking about the additional payments permitted by the House settlement, but I’m hearing that colleges and universities should be thinking about tax issues that could be raised by NIL deals more broadly.

Gil Ghatan: Yes, that’s exactly right. Given that many of the NIL deals we’ve seen so far involve not only schools and their students, but also third parties such as brands and sponsors, we think it’ll be important to understand the tax issues that could be raised both by payments received by schools and payments made by schools to students and third parties.

You made a great point in your previous episode that we wanted to amplify here again. Despite the compliance challenges, there is a lot of opportunity right now for colleges and universities, especially given the recent interest by investment firms in sports investments. The schools that will be best poised to take advantage of those opportunities will be those that can both develop creative NIL deals and also successfully plan for the tax implications of the NIL deals they want to engage in. For colleges and universities, the potential tax issues not only affect the economics of a deal and what kind of arrangements are broadly feasible, but also could impact their tax-exempt status.

Erica Han: And I think Kendi mentioned it earlier that the exact terms of an agreement matter a lot, even if a deal appears to be generally of a form or kind that would be permissible under the private benefit doctrine and UBTI rules. Is that right?

Franziska Hertel: That’s right, Erica. It’s very important to analyze the specific documentation from a tax perspective, since two contracts that purport to describe the same economic deal could have very different tax consequences depending on how the arrangement is documented. It is easy to make foot-faults in both areas, so we would urge colleges and universities to not only think generally about the tax considerations we discussed earlier but also to make sure that the documentation of NIL deals is carefully reviewed and analyzed from a tax perspective. And as mentioned, the issues we’ve focused on here are just two of the major issues we anticipate seeing—there are many other tax details schools will want to think through for their particular arrangements.

Erica Han: Thank you all again for the insight. And thank you, listeners, for joining us in the R&G Dugout today. You can listen and subscribe to this and other Ropes & Gray podcasts wherever you regularly listen to your podcasts—that includes Apple and Spotify. Look forward to discussing more on the next episode.