Tax trends: Tax Court determines character, source of golfer's worldwide endorsement income.

• Author: Nitti, Tony

Foreign Income & Taxpayers

The U.S. Tax Court recently decided Goosen, a case with potentially far-reaching implications for foreign athletes who perform within the United States. In Goosen, the court examined the worldwide endorsement income earned by a nonresident professional golfer and held the following:

* The taxpayer's income derived from contracts requiring him to use and wear a sponsor's products during tournament play was properly categorized as 50% personal services income and 50% royalty income;

* The taxpayer understated the amount of U.S.-source royalty income generated from the endorsement contracts; and

* A portion of the U.S.-source royalty income earned from the endorsement contracts was effectively connected with the taxpayer's U.S. trade or business of playing golf.

While this decision leaves some unanswered questions, it instantly becomes the leading authority for determining both the character and the source of the endorsement income earned by international athletes.

The Nature of Endorsement Contracts

In sports such as golf and tennis, endorsement contracts are an industry-wide practice. Many contracts grant the right to market the name and likeness of the athlete to the sponsor while also requiring some level of personal services from the athlete. These agreements are referred to as "on-court" or "on-course" endorsement contracts and typically have the following characteristics:

* The athlete is generally required to exclusively use or wear the sponsor's products during play;

* The athlete is required to make promotional appearances, participate in photo and filming days, and perform product testing;

* The contract mandates that the athlete must play in a minimum number of tournaments;

* The athlete grants the sponsor the right to use his or her name and likeness in promoting its products;

* The contract provides for a flat fee to be paid to the athlete, which will be reduced on a pro-rata basis to the extent the athlete fails to participate in the required number of tournaments;

* The contract provides incentives for success in certain tournaments or for achieving a certain world ranking during the contract term; and

* The sponsor is permitted to terminate the contract if the athlete tests positive for drugs, commits a crime, or otherwise sullies his or her public image.

Some contracts, however, merely permit sponsors to market the athlete's name and likeness in connection with their product, with no requirement that the athlete wear or use the product during play or perform any other personal services. These agreements are referred to as "off-court" or "off-course" endorsement contracts.

Taxation of Nonresident Athletes

In computing U.S. tax liability, a nonresident athlete must determine the character and source of the income generated by both on-court and off-court endorsement contracts.

Character of income: The Code treats personal service income and royalty income differently. As a result, a nonresident athlete must determine whether the income generated from an endorsement contract represents personal service income, royalty income, or a combination of both.

The U.S. generally taxes nonresident aliens only if they engage in a U.S. trade or business or receive U.S.-sourced fixed and determinable annual or periodic income (Sec. 871). When an athlete performs personal services within the United States, such as competing in tournaments or making personal appearances, the athlete is deemed to be engaged in a U.S. trade or business (Sec. 864(b)), and the income is considered effectively connected U.S.-source income (Sec. 864(c)). This income, after allowable deductions, is taxed at the same graduated rates that apply to U.S. citizens and residents (Sec. 871(b)).

Conversely, royalties and other annual or periodic income such as interest, rents, and dividends earned from U.S. sources are not considered to be effectively connected with a U.S. trade or business unless the activities of the taxpayer's U.S. trade or business are a material factor in the realization of the royalty income (Regs. Sec. 1.864-4(c)(3)(i)). This type of income is taxed at a flat 30% withholding tax or lower treaty rate (Sec. 871(a)). In fact, many treaties provide that only a taxpayer's country of residence may tax royalty income, allowing the royalty income to escape U.S. taxation entirely.

In the event royalty income is determined to be effectively connected with a U.S. trade or business, it will be taxed in the same manner as personal services: at graduated rates after applicable deductions.

Generally, off-court endorsement contracts are treated as having generated only royalty income. On-court contracts, however, routinely come under heavy scrutiny because they contain mixed elements of both the provision of services and the licensing of name and likeness...