Donald Sterling Stands to Win Big By Losing the Clippers

Soon-to-be former owner of the Los Angeles Clippers, Donald Sterling has endured his share of bad press in the past several weeks. And now he’s losing his team. Although he had previously sworn to fight any forced sale of the team in court, he recently dropped his opposition to the NBA-ordered sale.

But Sterling may have the last laugh. The team, which he purchased for a mere $12.5 million in 1981 was recently sold to Microsoft’s Steve Ballmer for $2 billion. Not a bad payday at all.

You’re thinking – surely he will be soaked by Uncle Sam and tax-happy California so that his $2 billion payday will shrink to mere few hundred million. Perhaps. But the odds are that Mr. Sterling’s tax bite will turn out to be more like a scratch. Assuming that Mr. Sterling lawyers up, it is safe to say that he will take advantage of any legitimate tax break he can.

“C” Versus “S” Corporations

Thinking too hard about the concept of one man owning a team made up of other men can make you squeamish. But in reality, what Mr. Sterling owned, and what Mr. Ballmer now owns is a corporation that represents the Los Angeles Clippers. In ordinary speech, that means that the Clippers basketball team exists as an entity separate unto itself.

The legal ownership of the Clippers was listed as the Sterling Family Trust, which has all the earmarks of a size-limited “S” Corporation rather than an unrestricted “C” corporation. “S” corporations trade stringent restrictions on size, ownership and other management features for exemption from the dreaded double taxation imposed on “C” corporations. In Mr. Sterling’s case, the potential savings could be $700,000.

Instead, Mr. Sterling and his estranged wife Rochelle would pay federal long-term capital gains tax on the sale, set at a much lower 20% rate. This would result in a tax obligation of merely $397.5 million. If the Sterlings spent at least 500 hours each year on management activities related to the team, which they have, they would also be exempt from the 3.8% net investment tax imposed by the Affordable Care Act.

Death and Taxes

The southern region of California draws visitors and residents from far and near with its glitz and agreeable climate. The atmosphere is so desirable for many people that they are willing to tolerate California’s stiff 13.3 percent state income tax. Mr. Sterling’s sale could potentially net California a tax windfall of more than $264 million, because California taxes capital gains at the same rate as ordinary income.

But don’t look for Mr. Sterling to write that check just yet. Because of the circumstances of the sale, he could make a credible case that the transaction was involuntary. This is important, because an involuntary sale qualifies for special treatment as a Section 1033 conversion that would allow him to defer payment on proceeds from the sale.

Section 1033 and Eminent Domain

Section 1033 is often applied to situations such as eminent domain, not forced sales of professional basketball teams, but the involuntary nature of Mr. Sterling’s sale of the Clippers is clear. Section 1033 requires a reinvestment of the funds from an involuntary sale into similar ventures within 2 years, but the guidelines for what constitutes “similar” are relaxed. Mr. Sterling would also only be required to make an investment of $12.5 million, his purchase price, not the entire price paid by Mr. Ballmer.

If Mr. Sterling opts to pursue the Section 1033 option, his advanced age could result in a bonanza – at least as far a paying taxes on the sale of the Clippers is concerned. That’s because upon death, a step up in basis to market value occurs. And while his estate would be subject to taxation over and above the $5.34 million to which Mr. Sterling and his wife are each entitled to exclude from estate taxation, the step up would prevent his estate from being subjected to income taxation at the same time. And because the Golden State replicates the provisions of Section 1033, those punishing California state taxes could go away as well.

Crime and Punishment?

The forced sale of the Clippers was intended to serve as punishment for Donald Sterling. But he stands to gain millions, the majority of which will likely escape taxation. Many individuals would welcome that type of punishment.

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