Tax Considerations for the Sports Card Market
Of all the non-tech industries that were able to benefit from the COVID-19 pandemic, perhaps none experienced a more surprising surge in both revenue and interest than sports cards. In truth, the pandemic only accelerated what was already a steady resurgence from the overproduction-based market crash the industry experienced in the 1990s. While the “sports card renaissance” can be enjoyed by collectors and hobbyists of all ages and income levels, it has also attracted the attention of ultra-high net worth investors and Silicon Valley. These parties view sports cards as an alternative asset that can not only diversify their portfolio but can, in terms of appreciation, far outperform traditional assets such as stocks. However, a major difference between these asset classes is the way the IRS treats the long-term capital gains that investors realize upon selling.
Under the Internal Revenue Code, “collectibles” are subject to a special, and uniquely high, long-term capital gains tax rate of 28%. While the underlying policy rationale can be logically applied to sports cards, nothing in the law specifically identifies or defines sports cards as “collectibles.” The relevant statute, IRC §408(m)(2), contains a catchall provision defining a collectible as “any other tangible personal property specified by the Secretary.” Because of the large gaps created by this statutory ambiguity, the application of this discretion is often determined by the taxpayer’s particular use of the asset.
In Associated Obstetricians & Gynecologists, P.C. v. Commissioner, the Sixth Circuit affirmed the Tax Court’s treatment of various artworks as business property rather than collectibles, though the artworks may have reasonably been classified as the latter, thus saving the taxpayer from the onerous long-term capital gains tax rate of 28%. The reason the artworks were treated differently for tax purposes was due to the way they were used by the owners. The Sixth Circuit accepted this because none of the artworks, which were on display in a medical office, were “purchased for investment or used for any personal or non-business purpose.” This case stands for the proposition that the tax treatment of tangible personal property such as sports cards depends on how its owner uses it.
The Tax Court came to a conclusion that also supports this proposition in Mayhew v. Commissioner, TC Memo. 1994-310. Here, the Tax Court provided some limited clarity in the classic car context, which can be a complicated tax issue considering their wide variance in uses. However, the categorization of sports cards as “collectibles” remains an open question, and neither the courts nor the IRS has ever weighed in on how the tax code should apply to the extreme variety of stakeholders in the exploding sports card market. Sports cards, along with other types of trading cards and memorabilia, can have legitimate uses that are recreational, financial, sentimental, or some blend of all three. This makes their tax treatment an especially tricky, and as yet unanswered, question.
Answering the Open Questions
Like classic cars or office artworks, sports cards are not expressly enumerated in IRC §408(m). So how is this hobby – or, depending on who you speak to, this alternative asset – taxed? How does the use-dependent treatment manifest in the context of the robust sports card market? Consider the deep roster of players in this space:
What if the taxpayer is one of the many immensely popular “breakers” on YouTube or Twitch? These individuals typically purchase unopened packs of cards and record or livestream themselves unveiling their contents. Viewers can obtain the most valuable cards, or “hits”, in various ways, often through buying into predetermined spots in the order the cards are revealed. Depending on the value of the unopened cards, the breakers and viewers stand to realize significant gains. Livestreaming these breaks has become especially lucrative during the pandemic and allowed a select few to devote full time attention to the activity, reaping additional financial benefits from high viewer counts. In this context, it becomes hard to argue that the cards are not a business expense incurred by the breakers. Under Associated Obstetricians, this would change the tax treatment of the cards away from “collectibles” and toward the lower rates associated with business expenses.
Breakers should be aware, however, that this activity very likely makes them “dealers” for purposes of the IRC. In this context, the tax code defines a dealer as an individual engaged in the trade or business of selling personal property. To meet this definition, the activity must be continuous and consume a large amount of the individual’s time and effort, much like a full-time job. Sports card breakers, particularly the ones who have become popular enough to sustain themselves off breaking alone, certainly fit this mold. The implications of the “dealer” label are higher tax rates. The cards become property held for sale to customers in the ordinary course of a trade or business, and the profits made by the breakers are not taxed as investment gains, but rather as ordinary income.
Portfolio Management Services
Perhaps the taxpayer owns a number of ultra-high-end sports cards. This individual may be tempted to engage with a service such as Alt, a company that specializes in portfolio management for “alternative assets” such as sports cards. The Alt website purposefully mimics the charts and data displays typically found on stock-market-based financial services, allowing the owner to track the value of their cards in real time. Alt even offers vault security to hold and protect the cards. On this extreme end of the spectrum, the taxpayer’s use of the cards is very likely for “investment purposes.” Here, the IRS would consider the cards collectibles held as investments, which will be taxed at the higher 28% rate.
The implications of this classification would be surprisingly far-reaching. For one, the owner whose cards are held by Alt or similar services may be able to invest their gains into a Qualified Opportunity Fund and elect to defer paying tax on those gains. The same owner would also be able to avoid paying self-employment tax on the gains made by the increase in the value of their card collection, a potentially lucrative option for individuals with extensive collections who frequently buy and trade.
Expenses reasonably related to the “management, conservation, or maintenance” of investment property are generally deductible. These terms may remind sports card aficionados of the ubiquitous presence of the major card grading companies; Professional Sports Authenticator (PSA) and Beckett Grading Services (“Beckett”). While these services, explained in further detail below, may satisfy the everyday meaning of “management, conservation, and maintenance” of sports cards, owners should understand precisely how deducting the cost of these services would work. To qualify for deduction under IRC §212(2), the taxpayer bears the burden of showing that these expenses are “ordinary and necessary,” a determination based on an individual factual analysis. In general, in order for these expenses to be deductible, the taxpayer must show that the expenses bear a reasonable and proximate relation to the production of income.
The high-end sports card market is dominated by PSA and Beckett. These companies offer services by which owners submit their cards for “grading”, an exhaustive microscopic inspection of the card’s quality that results in the assignment of a numerical value and/or description such as “gem” or “mint”. The graded card is encased in a hard plastic shell which protects it from wear and tear. The card’s “grade” is signified by an individually identifying slab affixed to the shell. These graded cards, particularly the well-graded ones, are highly coveted by collectors and are almost always worth more than their ungraded or “raw” counterparts. PSA and Beckett themselves tout the value-adding aspect of their services; a claim strongly backed by significantly higher market prices of graded cards. Are these services not to be considered “management, conservation, or maintenance” of the cards? High-end cards are always encased and graded as a matter of course, a practice likely to satisfy the “ordinary and necessary” inquiry. Even if the cards themselves will be taxed at a higher capital gains rate, taxpayers may still reap benefits from their card collections by being able to deduct the cost of grading services.
The Three Categories
Sports card stakeholders are likely to be categorized by the IRS as either investors, dealers, or personal collectors. As explained above, each has specific benefits and drawbacks that fit every individual differently. For example, while dealers will have their gains taxed at higher rates than investors, a dealer is able to deduct certain losses that an investor cannot. Depending on a few key factors to be weighed by the courts, the imposition of taxes as laid out in 26 U.S.C. §1411 can apply in drastically different ways. These factors include the individual’s intent, the duration of their card ownership, and the frequency with which they buy, sell, or trade cards. No single factor is dispositive and courts use a totality-of-circumstances approach in their analysis.
Tax law can be a notoriously complex field. Despite its remarkable breadth, the entire body of law is seemingly in a state of complete silence in regard to an industry experiencing explosive growth unlike any other. Until the courts directly address these issues, owners of sports cards are without guidance on the treatment of their investments, which in some cases, can exceed millions of dollars in value. If anything is clear, it is that the sole stakeholder in this market who may not have to worry about the tax implications of sports cards is the young and/or casual fan; someone who simply enjoys collecting cards as an expression of his or her fandom, and not as an alternative investment or business expense at all.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.