Proper Drafting of Signing Bonus Agreement Can Minimize State Taxes
Professional athletes are often paid signing bonuses to execute a contract with a team. These bonuses are in addition to the athlete’s salary, performance bonuses, and other incentives that may be integrated into the contract. While signing bonuses are common in all professional sports, large signing bonuses are most prevalent in professional football as player contracts in the NFL are not fully guaranteed. For example, in 2016, Andrew Luck signed a 5-year contract with a $32 million signing bonus. These large bonuses will create a substantial federal and state income tax liability for the player, and although federal taxes will be difficult to avoid, state income taxes can potentially be minimized by paying close attention to the player’s state of residency and by properly drafting the signing bonus agreement.
How States Apportion Income for Professional Athletes
The primary rule of state taxation is that income is taxable in the jurisdiction in which it is earned (where the services are performed). For most taxpayers, this is a relatively simple concept as they live and work in the same jurisdiction. However, for professional athletes, taxation becomes extremely complex because an athlete’s services are provided in a large number of states, cities, and counties, each of which may impose a tax on that player. In addition to games played in various states, a player may also have off-season workouts, exhibition games, training camp, practices, and other mandatory appearances in other states. This may lead to over a dozen states and/or cities seeking to tax a portion of the player’s income.
Most states allocate income on a “duty day” basis. In essence, every day in which the player is performing services for a team, whether it is a game or practice or mandatory appearance, is considered to be a duty day. Each state will tax a percentage of income based on the number of duty days in that state as a proportion of total duty days. For example, at year end, Andrew Luck may have amassed 200 duty days over the course of the season. If four of those duty days were related to games played in California, then Mr. Luck must allocate 2 percent (4 divided by 200) of his salary to California. These rules apply to a player’s salary as well as to bonuses that are directly connected to the player’s services (such as performance bonuses and roster bonuses). However, separate rules apply to signing bonuses.
Allocation of a Signing Bonus
The allocation of signing bonus income is quite different than allocation of salary and performance bonuses. Unlike salary (which is in exchange for specific services rendered), a true signing bonus does not relate to a player’s performance. Instead, a true signing bonus is considered compensation for entering into a contract and the implicit promise that the player will not play for any other team during the term of the contract. Thus, a signing bonus is not subject to allocation among the various states in which an athlete performs and is taxed solely in the athlete’s state of residence.
For players who reside in a non-taxing jurisdiction (Florida, Texas, New Hampshire, Tennessee, Nevada, and Washington among others) or a state with a low individual income tax rate, the allocation of signing bonuses solely to the state of residence provide a significant tax savings opportunity. To illustrate the opportunity, let’s consider two players. Player A and Player B both reside in Florida, and both athletes play professional sports for California teams. Player A enters into a contract with a $20 million signing bonus and a $5 million salary for 2017. Player B enters into a contract for a $25 million salary in 2017, but no signing bonus. Both players spend 80 percent of their duty days in California. Although both players receive the same gross payments ($25 million) in 2017, Player A incurs dramatically lower California income taxes than Player B because the bulk of his income is allocated to Florida whereas the majority of Player B’s income is allocated to California. More specifically, Player A would incur a California income tax of $532,000 and Player B would incur a California income tax of $2,660,000 – for a net difference of $2,128,000!
In reality, determination of whether a payment is considered as a signing bonus or as payment for services is a bit more complex than the label on the contract. Most states follow similar rules which provide that a signing bonus is not considered to be paid in exchange for services if a three-part test is satisfied:
- The payment of the bonus is not conditional on the athlete playing any games for the team, or even making the team;
- The bonus is paid separately from the athlete’s salary; and
- The signing bonus is nonrefundable.
In most cases, the first two requirements are easily satisfied. However, the question of whether a signing bonus is “nonrefundable” has been subject to litigation in many instances. For example, in the Matter of the Appeals of Garrison Hearst and Antonio Langham, 2002-SBE-007;142388; 141888 (Nov. 13, 2002), two San Francisco Forty Niners players, Antonio Langham and Garrison Heart, argued that their signing bonuses were not subject to California tax even though they had apportioned 95 percent of their salaries to California under the duty days method. The signing bonus riders contained the following relevant language:
“As additional consideration for the execution of NFL Player Contract … and for the Player’s adherence to all provisions of said contract, Club agrees to pay Player [the signing bonus amount].
“It is expressly understood that no part of the bonus herein provided is part of any salary in the contract specified above ….
“In the event Player, in any of the years specified above or an option year, fails or refuses to report to Club, fails or refuses to practice or play with Club, or leaves Club without its consent, then, upon demand by Club, Player will return to Club the proportionate amount of the total bonus not having been earned at the time of Player’s default.”
The critical issue in the litigation was whether the signing bonuses were nonrefundable. Ultimately, the California Board of Equalization ruled against the players and held the bonuses were refundable and subject to California taxation. The BOE stated “It is clear from the language of the signing bonus riders that appellants were obligated to repay a proportionate share of the bonuses for any period of time in which they failed or refused to practice or play with the Forty Niners. The fact that the bonuses were refundable demonstrates that they actually represented compensation for services, rather than mere consideration for signing the contracts.”
Similarly, in Dishman v. Wisconsin Department of Revenue, WTAC, 04-I-24 (May 24, 2005), the issue was whether Cris Dishman’s signing bonus was allocable to Wisconsin. In this instance, Mr. Dishman entered into a contract with a rider entitled “Signing, Reporting and Playing Bonus,” which provided for an additional payment of $1,250,000 to Mr. Dishman for the execution of the contract, his passing the team’s physical examination, and his adherence to all provisions of the contract. The rider included language stating:
IN THE EVENT PLAYER FAILS OR REFUSES TO REPORT TO CLUB, TO PRACTICE OR PLAY WITH CLUB, OR LEAVES CLUB IN ANY YEAR WITHOUT ITS CONSENT, DURING THE DURATION OF THE ABOVE CONTRACT YEARS, THEN, UPON DEMAND BY CLUB, PLAYER SHALL RETURN TO CLUB THE UNEARNED PRORATED AMOUNT OF THE SIGNING BONUS.
Again, the determination as to the proper allocation of the income was dependent on whether the signing bonus was refundable or nonrefundable. The Wisconsin Tax Appeals Commission ruled against Mr. Dishman and held that the signing bonus was refundable and subject to Wisconsin taxes. They reasoned that “If Mr. Dishman merely signed the contract and passed the physical examination without performing the other services specified in the contract, he would not have been entitled to the bonus. In fact, if Mr. Dishman had failed to perform the services as required in the signing bonus, the Kansas City Chiefs football club was allowed to demand back the unearned prorated amount of the signing bonus. If this bonus was paid strictly for signing the contract and passing the physical examination, Mr. Dishman’s right to retain any part of the bonus would not depend upon whether he performed other services for the Kansas City Chiefs.”
Drafting a Bonus Agreement to Minimize State Taxation
As the aforementioned cases indicate, states are very aggressive in attempting to tax signing bonuses and the specific language included in an athlete’s contracts will determine whether these bonuses are subject to tax or not. In particular, athletes should avoid language in the signing bonus agreement specifying that the bonus is contingent on practicing and playing with the team as well as provisions specifying the athlete’s obligation to forfeit or repay a portion of the signing bonus in these events.
For an athlete wishing to minimize state income taxes, careful attention should be paid to the language included in the contract. Even though most professional sports contracts are standardized, there is room for modification in the contracts and, more importantly, the signing bonus riders (referred to as the “Signing, Reporting, and Playing Bonus Agreement” in most NFL contracts). By considering the income tax consequences during the contract negotiation and drafting process, an athlete potentially stands to avoid millions of dollars in income taxes.