An Income Tax Play for Professional Athletes
This April in America brought a confluence of two monoliths of popular culture: sports and effective income tax planning. In the "big four" professional leagues, the MLB was in full swing, the NHL and NBA playoff races were heating up, and the NFL draft followed the standard free agency shuffle. On the tax side, the federal income tax deadline arrived once again like clockwork, reminding us that those envelopes marked "IMPORTANT TAX RETURN DOCUMENT ENCLOSED" may have deserved a second look. It was a lively time, and it provided a natural moment to review the state of taxation in sports. In particular, this article focuses on the tax implications for professional athletes when changing teams via trade or free agency, and provides a suggestion for mitigating potentially adverse income tax consequences.
Professional athletes who compete in team sports are generally considered employees of the team that holds the player's contract. As such, the salaries paid by teams to the players are considered "W-2 wages" subject to standard federal payroll taxes, like FICA and FUTA, and also state-level income taxes based on the location of the services provided by the player. Famously, in 1991, the state of California demanded payment from the members of the Chicago Bulls for California income taxes owed on the proportional amount of the Bulls' players' salaries earned while playing games in California. This was the first meaningful attempt by a state to impose a "jock tax" on professional athletes who play for out-of-state teams, and its success opened the floodgates for other states to do the same. While most states have general non-resident income tax provisions imposing income taxes on income earned within the state by a non-resident, many states have enacted explicit jock tax rules applying specifically to professional athletes who may only be present in the state for a short period of time, i.e., imposing taxes based on "duty days." Other states have carved professional athletes out of the general non-resident filing thresholds, creating a functional but not explicit jock tax. The most recent example of this type of regime is in the state of Washington, which has enacted a "millionaires tax" imposing a 9.9% tax on income earned in excess of $1 million within the state, with a general non-resident filing threshold of five days but an explicit jock tax carveout applying the tax on athletes who make in excess of $1 million even if only performing duties within the state for a single day (for example, NFL Sunday).
The proliferation of the jock tax has led some commentators to wonder whether certain non-income tax states like Texas or Florida could have an inside track on signing free agents due to the relative benefit to players who perform most of their services in those states. This may be true in certain cases, as a player's effective salary could be worth hundreds of thousands of dollars more or less depending on the effective income tax rates applied to salary payments. Not only would this fluctuate based on the home-state of the player's team, but also the home-states of the most common opponents that a player would compete against. For example, a team in a West Coast division might play more games in California and Washington versus a team in the Midwest, and its players would likely owe higher state taxes as a result. In the case of a free agent signing with a new team, the player has the opportunity to make an informed decision about the team for which he or she will play, and the relative tax cost could be taken into account in contract negotiations in the form of a salary gross up.
But what if a player is traded (and the player's contract assigned) to a new team without the player having any say in the matter? In this case, a player could be relocated from a no-income tax state to a high-income tax state overnight, or if traded to a Canada-based team potentially subject to federal income tax in both the U.S. and Canada. What can the players do, if anything, to mitigate these potentially adverse tax implications? Using MLB players as an example, the standard Uniform Player Contract (UPC) under the current collective bargaining agreement, both of which are publicly available on the MLBPA website, says little about taxes. It does, however, provide that teams and players may mutually agree upon any special covenant regarding the method of payment of a player's salary (including deferred compensation), and provides that teams and players may agree to limit or eliminate the right of the team to assign the player's contract (a "no trade clause").
This freedom of contract is most typically utilized by a player to avoid being traded to teams with poor records of on-field performance. It seems unlikely that a player would include a high-tax state team like the LA Dodgers in a no-trade clause purely to avoid higher taxes, forgoing the opportunity to play for a contender. What if, instead, the player includes a special covenant limiting the team's ability to assign the player's contract to another team if that assignment would result in the player being subjected to higher income taxes and a lower effective salary? The covenant could also require the assigning team to make a gross-up payment (as a special bonus or deferred compensation amount) to the player of an amount that covers the player's increased tax liability. Nothing in the standard UPC appears to limit that freedom of contract or restrict the ability to require a variable payment based on the occurrence of a particular event (in fact, those payments are contemplated in the form of "performance bonuses" or "award bonuses").
However unlikely it is that tax considerations win the day in negotiations, we'll be rooting for it.
