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How tax changes, presidential election results could impact MLB free agency

Existing state tax laws, Donald Trump's proposed changes to the federal tax rate and the changing CBA could all combine to have an impact on which players sign where, and for how much money.

Baseball's hot stove season officially began shortly after the Cubs' historic World Series triumph earlier this month, but it has been lukewarm at best, especially when it comes to free agency. There are two factors that could help explain the delay in big-money contracts being handed out. One is the collective bargaining agreement, which expires on Dec. 1 and could lead to a work stoppage that would freeze the free-agent market until a new CBA is in place. The other is the proposed tax plan of President-elect Donald Trump, which would reduce the maximum federal income tax rates. That, along with the existing variances of state income tax levels, could substantially advantage certain teams and incentivize free agents to consider deferring some money to 2018 and beyond.

State tax implications

As we have explained in several articles on NBA free agency, the impact of state income tax variations on free agency is most evident in leagues that have collectively bargained maximum salaries and salary caps. MLB, however, has no salary cap and no maximum salaries. That’s not to say there aren’t restraints on pay. Teams with high payrolls are subject to a “luxury tax," a penalty imposed on teams that exceed a payroll threshold. In 2016, the threshold was $189 million, and the accompanying penalty for exceeding it ranged from 22.5% to 40% depending on whether a team had exceeded the threshold several years in a row. The mechanics of the luxury tax could change in the next collective bargaining agreement. Regardless, the luxury tax is not a fixed cap; teams can accept it as merely a cost of doing business.

Baseball also features compensation for signing other teams’ free agents: the signing team loses its first round draft pick the next year, and the team that loses that player gains a pick in the compensation part at the end of the first round. Draft pick compensation—which is expected to undergo changes in the next CBA—is only a deterrent to signing a free agent, however, rather than a bar.

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This landscape means that MLB teams can offer top free agents like Yoenis Céspedes and Edwin Encarnación any amount of money they deem appropriate. As a consequence, teams that play in states with higher income taxes might offer more money to offset the financial advantage those players would obtain by signing with teams that play in states with low or no income taxes.

For instance, the tax rate for the highest earners in California—home of the Angels, Dodgers, Athletics, Padres and Giants—is 13.3%. After the state's voters passed Proposition 55 in this past November’s election, the 13.3% rate will remain in place until at least 2030. By comparison, three states with MLB teams—Florida (Marlins, Rays), Texas (Astros, Rangers) and Washington (Mariners)—do not have state income taxes. That means that a player who signs a contract worth $100 million with the Rangers or Marlins would “take home” millions of dollars more in income than if he signs an identical contract with the Dodgers or the Angels. This point is especially relevant for the Blue Jays, whose players are subject to Canada's national and provincial taxes that collectively impose a rate as high as 53.53%.

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Trump tax cut implications

The minimum salary for MLB players is currently set at $507,500, meaning they will pay some tax at the highest federal income tax rate: 39.6%. President-elect Trump, however, plans to seek a reduction of that rate to 33%, and with Republicans controlling both the House of Representatives and the Senate, the current top tax rate could be lowered in 2017. The degree and timing of that drop remain to be seen: Any reduction might not be implemented until a future year and could be phased in gradually, as the Bush Tax cuts were throughout the early to mid 2000s.

It is also worth noting that Trump’s tax plan calls for a cap on itemized deductions ($200,000 for married taxpayers and $100,000 for single). This is important for players on teams in high-tax states. Currently, those players can offset some of their federal tax burden by the amount they pay in state income taxes. Under Trump’s plan, however, they would potentially lose some of the benefit of paying higher state taxes on their federal returns.

Taken together, the likely reduction in the top marginal rate means players might want to defer their highest salary years to 2018 or '19. This is particularly true if players and their representatives are skeptical of Trump being re-elected in 2020 or if they believe that the Democratic Party will retake majority control of Congress in the next election cycle or two. Political developments could lead to significant changes in income tax rates in the 2020s. These points translate to a basic strategy for top free agents: Try to negotiate the highest annual salaries for between 2017 and '20.

Jock Tax

In assessing state income tax variations in how teams pursue free agents, players’ representatives should consider the impact of “jock taxes.” As we have explained in other articles, a “jock tax” is a tax imposed by a state and municipality on the proportion of income attributed to athletes on visiting teams when they play games in that state or municipality. Put in its most basic form, a jock tax is an income tax levied on a visiting team’s player because he or she is playing a game there.

The jock tax is controversial because no similar mechanism is strictly enforced to tax other types of professionals in similar ventures, such as a physician or attorney who travels to another state or municipality for a business purpose. Jock taxes are also subject to change based on a host of factors, including political ones.

Bottom line: State tax lax variations matter, and it probably makes sense to defer income to 2018–20.

Michael McCann, SI's legal analyst, is a Massachusetts attorney and the founding director of the Sports and Entertainment Law Institute at the University of New Hampshire School of Law.

Robert Raiola is the Director of the Sports and Entertainment Group at the accounting & advisory Firm PKF O’Connor Davies. He has more than 20 years of experience in the public and private sector providing business management services, tax planning and business consulting to high net worth individuals and their families in the sports and entertainment industries.