How Tax Reform Impacts Baseball

Last week, colleague and attorney extraordinaire Nathaniel Grow sent me an article — specifically, an Accounting Today piece by Michael Cohn — regarding potential changes to major-league baseball trades as a result of the recent tax reform law. I decided, using that piece as a start, to determine what impact the legislation would have on MLB teams generally, if any at all.

As it turns out, the new law does impact them. A lot.

Let’s begin with some background. What we colloquially refer to as the “tax reform law” is actually more properly called by its title, the Tax Cuts and Jobs Act. The law made sweeping changes both to individual and corporate tax rates and regulations. Most of it is outside the scope of our concern here. It’s essential to remember, however, that baseball teams are all businesses. There are, of course, different types of business ownership structures — some are corporations, some are partnerships, some are limited liability companies — but the underlying point is that they are all business entities of some sort or other. And so the changes in the tax code impact how every team operates.

Now, a fair warning: this involves a discussion of tax law, which isn’t famous for producing scintillating content. Also note that what follows represents a gross oversimplification for purposes of brevity. In other words, don’t go doing your taxes based on the information provided here.

Ready? Let’s go.

For businesses, the most recognizable change in the law is the reduction in the corporate tax rate to 21%. On the surface, that sounds good for baseball teams: paying a lower tax rate would appear to mean more money for them. But, as with all things legal, it’s not quite that simple. That’s because available tax deductions have been greatly reduced, as well. A tax deduction is basically a provision that allows one to lower the amount of income exposed to taxation. A tax deduction is not a direct reduction of a tax bill; however, less taxable income earned can mean less taxes owed. And that’s why, at tax time, some people take advantage of what are known as “itemized deductions.”

It used to be that your business could take a client to a Yankees game and deduct the expense. But after passage of the Tax Cuts and Jobs Act, many of those deductions are no longer available. Explains U.S. News and World Report:

Before the tax bill, companies could deduct 50 percent of a variety of business entertainment expenses, such as client meals, event tickets, charitable event tickets and membership fees. Under the new law, no deduction is allowed for any activity generally considered to be entertainment, amusement or recreation. No deduction is permitted related to a facility used in connection with entertainment, amusement or recreation. Deductions are also disallowed for membership dues with respect to any club organized for business, pleasure, recreation or other social purpose.

For companies, that means no more deductions for client entertainment expenses such as that stadium suite or corporate sky box. No more deductions for client outings with tickets to the big game. The Joint Committee on Taxation estimates the change will bring in $23.5 billion in tax revenue over the next decade. But for team and stadium owners, the deduction elimination could lead to a significant revenue loss.

But that’s not the biggest impact. Under old law, you could deduct your individual state income tax from your federal taxes. But the new law caps that deduction at $10,000, which means that, for players signing multi-million dollar contracts, states without income taxes will become heavily favored. That’s because a player is taxed based on the rate of the state in which he plays on a specific day, and a player spends at least half of his time playing at his home park. So, for practical purposes:

the AL West becomes the most attractive for tax status. The World Series champion Houston Astros, along with the Texas Rangers and Seattle Mariners, all have no state income tax. That means a player on one of those teams would play 99 or 100 of 162 games in states with no tax.

But it’s worse yet: that $10,000 cap also must include property and sales taxes that were previously deductible, and aren’t now. As Newsday explains, a player on the Angels with a $10,000,000 annual salary will lose $650,000 by playing half of his games in California.

Now, some teams can balance out this disadvantage by including what’s called a tax equalization clause in their player contracts. That just means the additional tax liability is absorbed by the team, though — a tax hit the team didn’t have before, and a disincentive to sign free agents who demand it. Given the size of the tax bills, it could be a significant one, especially for players like Bryce Harper expected to command mega-contracts next offseason. If Bryce Harper signed with the Dodgers for $40,000,000 annually, he could lose millions of dollars in additional taxes relative to a team like the Astros or Marlins (yes, I know).

Recognizing this, states like New York have proposed potential workarounds by shifting liability to business owners in the form of payroll taxes, which are still deductible. That would mitigate the tax hit somewhat, but nothing’s been enacted yet. And if we’re looking ahead to the 2018-19 offseason, with stars like Harper, Josh Donaldson, Clayton Kershaw, and Manny Machado all up for mega-contracts, these tax issues could very well impact where they go.

Nor is that the end of it. It also used to be that players could deduct their agent’s commission and union dues. Now they can’t do that anymore, either. Those dues are relatively cheap — $17.6 million total last year, and $80 daily per player. But agent commissions are a lot more, sometimes at 4-5% of total contract value. So Bryce Harper can’t deduct the $20 million fee Scott Boras would get on his upcoming $400 million contract. And this creates a powerful incentive for players to seek out the least expensive representation.

This could all lead to pretty significant changes in free agency, assuming teams and players care about these tax issues. And we’ve seen teams move away from free agency already, instead relying on trades for roster construction. Except… the tax law impacts that, too. The reason is how trades are characterized in law. When teams conduct a trade, they’re not actually exchanging people. People aren’t property, and therefore can’t be bought, sold, or traded for each other. Instead, what baseball teams do is trade the rights to employ people, as memorialized in the contracts between the team and player. In other words, teams are swapping contracts.

It used to be that trading players was considered a “like kind exchange.” That’s a technical way of describing a swap for items of the same kind — as opposed to one party using money to acquire an item from another party. You can find like-kind exchanges in Section 1031 of the Internal Revenue Code — or, you could find them there until tax reform made like-kind exchanges of non-real property assets taxable. In other words, teams now have to pay taxes on trades they make, depending on whether or not they realized a “taxable gain” from the trade. And if you’re talking about deals for stars on big contracts, that matters, but potentially not in the way you think.

According to the tax law firm of Seward and Kissell,

[t]he value of a player rests in his or her future performance, which is difficult to predict. Teams may have to adopt or develop a method of valuing player contracts for tax purposes, such as actuarial values based on player age and the average length of a professional sports career. Teams trading players would then recognize gain or loss on a contract when a player is traded equal to the difference between the contract’s actuarial (or other) value and the team’s basis in the contract.

That’s right: the contract value isn’t the thing. The asset value is. So let’s say that the Angels dealt Albert Pujols to the Orioles for Austin Hays, and the O’s assumed all of Pujols’s contract. (Yes, this is a stupid trade that would never happen, but just go with it.) Common sense dictates that the Angels would have to pay taxes for being relieved of Pujols’ salary burden. But that’s not how it would work. Instead, the Angels would be taxed on the difference in projected player surplus value between Pujols and Hays, which is obviously quite sizable. And the Orioles would take on a negative-value asset, which means (in theory) they could get a tax reduction or even a refund (depending, obviously, on many other factors).

Now this is, to a large degree, speculative because we don’t know how the IRS is going to allow teams — and their very creative accountants and attorneys — to value assets. But if they value assets in any way similarly to how FanGraphs does, we could see a massive change in how trades are conducted. All of a sudden, negative-value assets could have positive tax repercussions, which means they have some value to ownership.

That means trades of superstars would be disincentivized because of the massive gain realized by the acquisition. In theory, this could — emphasis could — create a significant incentive to invest in free agency to avoid negative tax repercussions. Unfortunately, remember that this also makes free agency more expensive for teams in states with income taxes. And that means that the net effect of the tax reform law could be to depress spending overall — not good news for the MLBPA after this offseason.