CENTER FOR CONTINUING EDUCATION
Self Study Article and Self Assessment Test
Sports Law
presented by Walter T. Champion, Jr. Houston, Texas.
Chapter 3: Financial Considerations
The astute agent of a professional athlete, through tax and financial planning, should maximize the athlete's income and minimize the tax bite on his earnings. Success is measured by the athlete's financial security at the time of his retirement from the work force rather than at the end of his playing career. One must strive to preserve capital and lessen any adverse tax consequences during the peak income period.
A. Taxation
Taxation is the application of tax rates to taxable income during a given tax year. To determine an athlete's tax liability one must calculate the gross amount of all income attributed to the athlete-taxpayer during the taxable year. After that, subtract from this gross amount, all deductions; that amount is the taxable income figure which will be used to determine the athlete's tax liability by the application of rates.
Income is a gain derived from any source whatsoever. It includes not only salary, but also bonuses, prize money, the value placed on interest-free loans, endorsement revenues, sportswear companies' gift products, gifts for radio or TV appearances, employer-provided insurance benefits in excess of $50,000.00, "free use of an automobile," etc.
1. Gross Income
An athlete's gross income is where many of the athlete's expenses can be deducted. Gross income can be reduced by deductions for business-related expenses. Business-related expenses are all the ordinary and necessary expenses that are incurred by reason of an athlete's performance in an athletic event including the cost of tools of his trade, expenses related to maintaining a good physical condition, travel, professional services, business entertainment and necessary gratuities. In order to prove the deductibility of an expense, the athlete must maintain a system of record-keeping of expenditures so that the business expense deduction can be maximized and all expenses can be monitored to determine if they are excessive.
2. Planning
The crux of the "problem" is that, typically, athletes receive a large amount of income in a very short amount of time. Therefore, tax planning is imperative. The purpose of this planning is to maximize the benefit from those years in which a high income is realized by spreading the tax liability to those years of lower income. There are many different ways that one can arrange a tax plan. These arrangements can include deferred compensation plans, tax sheltered investments, and other contractual arrangements that spread out income over a period longer than the playing period of the athlete.
B. Assignment of Income
The idea behind income assignment is to avoid realization of income from professional services as an athlete by assigning a portion of that income to a third person. This assignment would reduce overall tax liability by spreading the income to another person who is in a lower marginal tax bracket than the athlete.
It is a good strategy; however, an attempted assignment will be nullified unless it avoids the assignment of income doctrine which stipulates that he who is entitled to income cannot circumvent tax liability by causing it to be paid to another through an anticipatory assignment. There must be a legitimate basis for the other person to receive the assigned income from the athlete. The way to establish this basis is to show that the recipient performed valuable services which aided in the production of the income so as to be entitled to the assignment. Because the highest tax rate is now just 31 percent, any technique that required the assignment of $1.00 to save 31 cents will be of dubious value. This technique is advisable only if tax rates increase.
C. Deferrals
The principle behind deferring income is to lessen tax liability by prolonging the incident of taxation from the years in which the athlete earns income to a time in the future. An employee can arrange income through his employer by way of the contract or it can be arranged separately by either the athlete or the athlete's agent. Income can be deferred through pension plans, by contract or by the receipt of restricted property. The latter technique can be accomplished through "substantially nonvested property." That is, property that is not required to be included as income until the first time that the beneficial percentage in the property becomes substantially vested.
1. By Contract
Deferral of the receipt of income can be arranged by way of contract through the SPK. The contract can stipulate that the payment of income will be extended over a period of years and paid in equal sums during each year of that period.
2. By Pension Plans
An extremely popular deferral plan is one arranged by a pension plan that can be created by or for the benefit of a professional athlete. These plans can be individually negotiated or they can be the result of a collective bargaining agreement. A qualified pension plan will provide several benefits including deferring the income to later years to the extent of the employer's contributions; making the employer's contribution deductible; and tax-deferring the pension income.
For relatively high-paid athletes, the most important fact of a qualified pension plan is the extent of the tax reduction on current income. Usually, the athlete will receive monthly payments on retirement or disability. These payments are a part of the athlete's income. The athlete, however, can exclude an amount equal to a portion of the higher payment into the plan. This portion is determined by the exclusion ratio which is determined by dividing the athlete's investment by its expected return. The amount to be excluded will equal the figure that is produced by multiplying payment by the percentage. Since most athletes do not personally contribute to the pension plan, then all of the payments will be included as income.
Another option is that the athlete can receive his benefits in a lump-sum which will qualify for special averaging. One other option is a pension plan that is available to the athlete who does not participate in team or league plans. These plans usually cover non-team sports, such as tennis or golf, and allows the athlete as a self-employed person to be treated as both employer and employee for pension plan purposes.
The final option concerns individual retirement accounts. These accounts are for those people who are not active in a qualified plan and could be established by the athlete for a non-working spouse. The athlete then can contribute and deduct a maximum of $2,000 of the compensation included in the gross income for the taxable year. However, for the typical athlete, no deduction will be permitted because the deduction is available for persons who earn $50,000 or less. The nondeductible contribution is still advisable because the income earned on the contribution is tax-deferred until final withdrawal. Withdrawals are not permitted prior to age 59(sfr)1/29(efr) and do not qualify for the five year forward averaging rule for lump sums under qualified plans.
3. Substantially Non-Vested Property
Another deferral technique concerns substantially non-vested property which is property that is transferred in connection with the performance of services. The value of this property does not have to be included in the athlete's income until the first time its beneficial interest becomes substantially vested; that is, until it is transferable or no longer possesses a substantial risk of forfeiture. This mechanism can provide the athlete with a means of deferring income recognition while providing some security.
The athlete can acquire possession of property at the time services are rendered while allowing taxation deferral until the time when there is a lapsing of a substantial risk of forfeiture. For this to work, the athlete must have the party to whom the services are to be rendered take the deferred amount and purchase the type of property that is preferred by the athlete, e.g., corporate stock or real property. This property then must be transferred to the athlete with a restriction that would qualify as a substantial forfeiture risk such as a provision that would require the athlete to transfer the property to the other party in the event that the athlete ends his athletic services during a particular period of time.
D. Tax-Sheltered Investments
Another method to lessen taxes is through tax-sheltered investments. These investments are those that through appropriate deductions shelter the athlete's income from tax liability. Although such investments vary in kind and activity, they often possess the following tax-minimizing characteristics: leveraging, tax-deferral and tax-free cash flow.
Leveraging: Some tax-shelters offer the investor the use of someone else's money to finance an investment. This is called leveraging.
Tax-deferral: When an investment permits deductions to be accelerated in the early years of the investment and applied to the investor's other income, such an investment offers tax-deferral.
Tax-free cash flow: When a tax-sheltered investment combines deductions with investment income and generates both simultaneously; the investor receives the cash without having to recognize it as income.
Two programs that remain viable are real estate investments especially in low income housing, and oil and gas. However, as with any investment, these programs involve a degree of risk. Thus, a professional athlete must carefully evaluate each program prior to making the investment.
E. Incorporation
Another form of temporary tax planning is to create a personal services corporation based on the athlete's athletic participation, commercial endorsements, etc. This type of corporation is organized for the purpose of using the athlete's abilities. The athlete will form the corporation and then become its major shareholder. He is obliged to perform specialized services with the corporation which would then contract with the sports team. This type of corporate structure allows a deferral of income by the adoption of a corporate pension and profit sharing plan along with a corporate fiscal year.
The corporation can adopt corporate fringe benefits programs and can also allow the creation of various estate planning advantages that are offered by the corporate form of organization. The corporation, though, must have some other purpose than merely avoiding tax.
F. Financial Planning
The aims of planning should be capital preservation, tax minimization, protection against risk and an orderly estate plan. The primary objective of financial planning is to increase long-term capital at the expense of current income.
The four basic ways of managing an athlete's assets are to let him decide his own choices, invest in mutual funds, turn the account over to a broker or retain an investment manager. The latter is the most preferred since the investment manager acts as a personal agent and is not a broker.
An investment manager makes decisions on an investor's behalf based upon research of the investment's potential. Rather than receiving payment for each stock transaction, the manager is paid an annual fee for structuring an investment portfolio. As part of this structure, the manager will invariably attempt to achieve financial security for the athlete's investments.
1. Preservation of Capital
The number of years the average professional athlete can compete is extremely short: for example, three years in football and four and a half in baseball. Since the athlete will probably have 40 or so years until retirement age it is imperative that a strategy be adopted to maximize his investment portfolio. There are many products that can assist in achieving the goal of capital preservation such as certificates of deposit, common stock and annuities. An annuity is a contract between the athlete and an insurance company for fixed payments at regular intervals over some period of time. An example would be a 30 year old athlete who purchases an annuity for $100,000 with payments of money per month beginning at age 45.
2. Tax Minimization
The planner also should consider the following tax measures to minimize the income tax burden of the athlete:
1. Making a contribution to an IRA for a non-working spouse. Although no deduction is allowed for the couple making in excess of $50,000 per year, all income earned on the IRA is tax-deferred until final distribution.
2. Making Keogh contributions: for athletes with substantial endorsement income, contributions of up to the lesser of $30,000 or 25% of this self-employment income are allowable.
3. Converting taxable income into tax-exempt income.
4. Making family gifts so that earnings can be removed from income.
5. Making contributions to a college fund for the athlete's children.
6. Converting personal non-deductible interest into qualified residence income.
3. Protection Against Risk
There is an ongoing struggle between investing in assets that appreciate rapidly and investing in assets that protect against risk. Since the money that the athlete can earn from his skills is finite, it is imperative that he does not lose money. Therefore, investment plans should be balanced against his risk. Conservative instruments such as certificates of deposit and money market funds are available but the skilled investment professional should be capable of structuring a more profitable conservative plan while retaining emphasis on preservation of capital. This approach can achieve a higher return at little risk to the athlete/investor.
4. Estate Planning
Estate planning is important for athletes since they risk accidental death with every tackle or misplaced fast ball. An athlete should have a will to pass title to property on death. A will can be used to place funds in a trust for the benefit of others unable to manage property. For example, a trust can be used to educate and care for the deceased athlete's children and when they reach maturity, provide for the principle to be paid out as specified in the will.
Another aspect of estate planning is the creation of a revocable trust. A trust takes effect at the time of its creation. A trust is an agreement between grantor and trustee which contains instructions to the trustees so as to assist in the disposition of the property that is transferred to the trustee. Revocable trusts can establish a workable asset management arrangement during the athlete's life; allow the owner to evaluate the performance of the trustee; provide for support for the owner upon incompetence; and for athletes who enjoy their privacy, there is an opportunity for the athlete's affairs to be relatively anonymous since the trust property is not subject to probate upon the owner's death. The trust can be freely revoked or amended during the owner's life and the cost and delays are less than those in an administration of a will.
Estate tax is the government's tax on the value of property that passes from a person who has died to his beneficiaries. The tax is assessed against the fair market value of all property that was owned by the decedent upon death. Estate tax is calculated on the taxable estate which is the gross estate less deductions and exclusions. There is a marital deduction which allows an unlimited deduction for property passing from the decedent to the surviving spouse. There is also a charitable deduction which can benefit the athlete in his estate plan by providing a deduction from estate taxes. Like property that passes to a spouse, property that passes to a qualified charity is also deductible from the gross estate. While spousal and charitable deductions are deducted from the athlete's gross estate, the "unified credit" is applied to reduce the tax itself. This credit can currently eliminate estate taxes on $600,000 worth of property.
There is also a generation skipping tax which is a separate tax designed to prevent avoiding estate or gift taxes which would have been applicable if the property in question had first been given to the intervening generation and then transferred to the grandchildren. However, there's a significant exemption from generation-skipping taxes which allows each individual to transfer up to $1,000,000 of property, free from this tax.
Life insurance is yet another aspect of many financial plans. Because of their age and robust physical condition life insurance is readily obtainable at a reasonable price by professional athletes. Insurance proceeds can be important to his family if the athlete does die young. These proceeds can be used to pay debts, taxes, bequests, and/or provide funds for trusts for family members of the athlete.