Lin-come Tax: State and Local Income Tax Considerations
In July 2012, NBA star, Jeremy Lin signed a four-year, $28.8 million contract with the Houston Rockets. Based on available information, Houston's contract terms with Lin include a team option in the fourth year, with Lin earning $5 million in year one, $5.2 million in year two and $9.3 million in each of years three and four. The back-loaded offer was potentially designed by Houston as a “poison pill” to create a high salary threshold for Lin’s previous team, the New York Knicks, to consider when deciding whether to match or exceed Houston’s contract offer. Further, the Houston contract would have caused a luxury tax liability for the Knicks that some analysts have estimated at $15 million. These factors seemingly were among the primary reasons the Knicks did not agree to Houston’s contract terms as offered to Lin.
Aside from structuring a favorable contract with Houston, what are the prudent state and city total individual income tax minimization and planning matters Lin should consider, and that other professional athletes should consider in the sports professions of basketball, baseball, football, hockey, soccer, and other sports?
Perhaps the greatest opportunity for total federal and state individual income tax minimization planning is an athlete’s selection of a state and city of permanent residency (“domicile”). Given the disparity in individual income tax rates among state and local jurisdictions, and considering certain factors we will highlight, many athletes attempt to minimize state income taxes by establishing and maintaining permanent residency in a state and city that has a tax rate that is lower than the tax rate in the state and city where the professional sports team is located. Accordingly, it is an important consideration for the athlete to establish permanent residency in a lower tax rate jurisdiction to achieve overall total individual income tax savings.
Establishing temporary residency in a low tax rate state is insufficient to attain the tax benefit of a low tax rate state. The problem is most often triggered by the athlete’s lack of meaningful presence within the lower tax rate state, which most often results in the athlete’s permanent residency position being subject to state audit scrutiny. To illustrate, several years ago New York State scrutinized Derek Jeter’s Florida residency status (Florida does not impose an individual income tax) by arguing that Jeter was a New York State income tax resident, evidenced by the fact that Jeter owned an apartment in New York City. As a result, New York sought to assess a state and city resident income tax on Jeter, at a combined rate of just over 12% (compared to no income tax due to Florida). In addition, the combined New York tax assessed and paid by Jeter may not have been allowed as a federal income tax deduction due to the disallowance of state and local income tax for federal Alternative Minimum Tax (“AMT”) purposes. An upside benefit is available however; athletes in this situation can reduce resident state tax liabilities (subject to limitations, and not applicable to Florida residents as there is no state tax) by the amount of taxes paid to other jurisdictions, as illustrated later in this article.
Athletes Residing in States with No Income Tax and Earning Income in Other States
It is not uncommon for athletes to properly establish and maintain residency in states with low individual income tax rates or with no income tax at all, in order to minimize their overall tax liabilities. Florida and Texas are good examples of states that do not levy individual income taxes, and that have professional sports teams, including the Houston Rockets, Miami Marlins, and others. Beyond Florida and Texas, the states that do not levy an income tax include Alaska, Nevada, South Dakota, Washington, Wyoming, New Hampshire (limited tax on dividends and interest), and Tennessee (limited tax on dividends and interest).
In contrast, New York and California are among the highest taxing jurisdictions in the United States. The 2012 New York state individual income tax rate is 8.82% (for taxable incomes in excess of $2 million). For New York City residents an additional tax rate of up to 3.82% applies, for a combined state and city rate in excess of 12%. New York State and City residents may not even benefit from the payment of federal, state, and city taxes due to the federal AMT, which disallows these payments as deductions against federal taxable income.
While it is often the decision by athletes to maintain a domicile in jurisdictions imposing zero, or low income tax rates, it should not be overlooked that these athletes will be exposed to state and local income taxes in jurisdictions that impose an income tax, and in which games are played or where team practices are held; these factors are most usually out of the athletes’ control and change on a yearly basis.
Typically, an athlete’s earnings are taxed based on duty-days (game days), or an apportionment (or allocation) formula, calculated upon where games are played, where team meetings are held, and where practice sessions occur. Not all states compute the state income allocation on the same basis; certain states exclude practice sessions and allocate state sourcing strictly based on games played. Illinois for example, computes duty-days by including the days starting upon arrival (for Sunday NFL games, typically the preceding Thursday) and through the day of departure (which could be the day after the game).
To illustrate, assume that Jeremy Lin establishes domicile in Texas, which does not impose an individual income tax; as a result, Lin will pay no Texas income tax attributable to games played, and team meetings and practice sessions held in Texas. However, based on the Houston Rocket’s 2012/2103 regular season schedule, Lin will be required to pay state income tax attributable to games played in states that impose an individual income tax. Accordingly, as approximately 37% of the Rockets’ regular season games will be played in states that impose an income tax, and assuming Lin’s first year salary is $5 million, $1.850 million of his salary will be allocated to and taxable in states that impose an individual income tax. In addition, Cleveland will impose a local city tax on Lin when he plays the Cavaliers in Cleveland, for a combined state and city Ohio tax rate of 8%.
Tax Credits: Athletes Residing and Playing in States with an Income Tax
Athletes residing in states that impose an income tax generally will obtain an income tax credit (subject to certain limitations) for taxes paid to other states. For example, if Lin remained a New York State resident and had decided to return to his former team, the Golden State Warriors, Lin would be subject to a 2012 top individual New York State tax rate of 8.82%. However, Lin would also be subject to California individual income tax (California has a 2012 top individual state rate of 10.553%) attributable to games played and team meetings practice sessions in California. In this example, Lin would be paying a significant amount of income tax to the State of California (in addition to taxes paid to New York state as a resident) because 57% of his salary would be allocated to California based on games played in California for the 2012/2013 regular season. Considering practice sessions and team meetings held in the state, an even higher California allocation percentage could result. However, Lin generally should be entitled to claim a tax credit (subject to certain adjustments and possible limitations) against his New York tax liability for the California income tax paid, but limited to the New York tax paid on the California sourced compensation (i.e. the New York tax rate of 8.82%). Since California imposes one of the highest income tax rates in the United States, it would make sense that if Lin’s compensation structure and amounts and other facts were the same, to attain total income tax minimization it could be more beneficial for Lin to be a Knicks player than a Warriors player, since New York has a lower tax rate compared to California.
Athletes Must Also Consider the Tax Bite from Other Sources of Income
There are additional factors that athletes consider when selecting to play for a certain team, in order to circumvent a potentially enormous tax bite associated with “Jock Taxes” – so named for the tax on income levied by certain states against non-resident athletes who play a professional sport in a city or state, and earn compensation in that jurisdiction.
There are numerous compensation income streams that athletes receive that are subject to state taxation; therefore proper tax planning should be considered to minimize the related state income tax. These streams include players’ current salary and signing bonuses, compensation contract deferrals from current or prior years and payable at a later date or upon an event, licensing and branding and endorsements fees, personal appearance fees, awards or prizes paid in cash or property constructively received, non-cash benefits received and not excludable from income, taxable reimbursements received such as certain moving and housing allowances, royalties, rental income (may not apply to all athletes), and other income streams.
Income and Estate Tax Minimization Strategies Athletes Should Consider
Following are additional planning ideas to consider and analyze to properly minimize state and local income tax on behalf of an athlete:
- Defining and maintaining or changing “tax home” and “tax domicile” – these definitions strive to resolve the identification of where an athlete resides for state income tax purposes.
- State income sourcing (or/and) apportionment based on duty days or games played (pre-season, regular season, post-season, and practice sessions). Every state has its own unique rules regarding the sourcing computation of a player’s income.
- Players will receive a benefit for playing home games in a tax-free state (assuming the athlete has taken the proper steps to establish domicile in such state), but will pay taxes to other jurisdictions (that impose an income tax) for all away games with no offsetting tax credit from their home state.
- The state of domicile could be different than the state where the home games are played.
- De minimis filing exceptions (i.e. Minnesota has a minimum income filing threshold).
- Tax treaties between states that address the taxation of athletes (the athlete is resident in one state and is playing games or rendering other services in the other state).
- States that assess “Jock Fees” instead of income taxes; whereby an athlete is prevented from obtaining a resident credit on their resident state return (i.e. Tennessee).
- State credits and limitations on the amount of credit to be applied resulting in double taxation (i.e. Illinois does not honor the credit for taxes paid by athletes to other jurisdictions).
Further, proper preparation of a typical athlete’s income tax return will include some, or all, of the following considerations:
- Analyzing an athlete’s contract terms and all applicable provisions to determine the proper federal, state, local and international income tax treatment.
- Assisting the athlete in establishing state residency in the desired jurisdiction (state and city).
- Preparation of a “duty day” schedule, properly allocating “duty days” to each state and local jurisdiction in which the athlete performs services.
- Determination of all jurisdictions in which an athlete’s tax return is required to be filed, taking into account reciprocal agreements, de minimis filing requirements, and non-taxing jurisdictions (states and cities).
- Proper treatment of bonus income and income deferrals to determine if specific allocation is applicable. In New Jersey, an athlete’s signing bonus is not included in compensation of a non-resident if the bonus is not conditional on the athlete playing any games for the team, performing subsequent services for the team, or even making the team.
- Proper reporting of other income such as from endorsements and appearances, royalties, and other activities.
- Determination of applicable business deductions (i.e. agent fees, equipment, etc.), including the consideration of employing a “skip-year” strategy, where income and deductions are accelerated or deferred. Scheduling state and local income and real estate tax payments to avoid AMT should be considered.
- Properly avoiding potential double taxation through calculation of state tax credits and reverse tax credits (double taxation is not unconstitutional).
- Calculation of all federal and state estimated tax payments, properly deferring federal and state estimated payments while avoiding tax underpayment penalties and making certain employee withholding is correctly computed for each jurisdiction, if applicable.
- Proper taxation and minimizing state and local taxation attributable to retirement income and deferred compensation income.
- 2012 federal income tax estimated tax payments due and safe harbors (amounts due are generally the lesser of 110% of 2011 tax liability, or 90% of 2012 tax liability).
- The top 35% 2012 ordinary income tax rate expires at December 31, 2012, as does the current 15% tax rate on qualified dividends and long-term capital gain income. Without U.S. tax legislative action these rate are increasing, effective January 1, 2013, to a top rate of 39.6% for ordinary income and qualified and non-qualified dividend and short term gains, and 20% for long term capital gain income.
- Starting in 2013, athletes will pay an additional .9 % percent in Medicare tax on earned income over $200,000 ($250,000 if married).
- Additionally, in 2013 there will be a 3.8% Medicare Contribution Tax liability on unearned income (above certain income thresholds).
- For international athletes (non-U.S. citizens or green card holders); consider home and host country taxation and special treaty provisions specific to athletes and entertainers.
- Federal and state estate tax planning considerations based on domicile of choice should be considered, especially if the athlete is considering relocating to Florida, a jurisdiction with no estate or inheritance tax. Note the $5.120 million (per individual) unified estate and gift and generation-skipping transfer tax exemption is scheduled to expire at December 31, 2012.
- Review additional estate planning opportunities and 2012 tax-free gifts using the $13,000 gift tax exclusion (per donee/recipient) or $26,000 for married donors; planning considering non-U.S. citizen spouses; wills in place and beneficiary designations, and separate beneficiary designations for retirement plans and life insurance; trustee(s) for trusts created by wills or for trusts established during lifetime.
Financial Planning Matters Athletes Should Consider
Other areas that require an athlete’s attention include the following:
- Review of investment portfolio performance (pre- and post-tax), the appropriateness of asset allocation models attendant to investment policy statements considering investment goals and objectives, a desired rate of return (appreciation and yield), risk tolerance, and investment horizon.
- Review of risk management exposures and insurance coverages that can mitigate risk, such as life insurance, property and casualty coverages, and other coverages. Additional considerations pertaining to life insurance contemplates the amount needed to fund family needs in the event of a premature death, types of life insurance (term, whole, universal, variable, other), premium payment modes and options, modeling premium payment modes (permanent and term models), and ownership and titling of life insurance, for example, the use of a family trust.
- Charitable giving and the appropriate use of tax-exempt foundations and charitable trusts and other vehicles as well as related record keeping, documentation and tax filings.
This article represents one in a series EisnerAmper LLP will release regarding income tax planning and considerations related to professional athletes, models and entertainers. EisnerAmper LLP practices contributing to these articles include members of the firm’s Personal Wealth Advisors Practice (Evan R. Waxman and Tim Speiss), the State and Local Tax Practice (John Genz and Stephen Bercovitch), and the Sports and Entertainment Practice (Michael Breit).
The information contained in this article should not be relied upon as, nor intends to provide, investment or tax or economic advice unless specifically stated herein. This article does not provide investment or tax or other advisory services unless specifically stated herein. EisnerAmper LLP is a certified public accounting firm and is an independent member of Allinial Global