Athletes consider alternatives as California’s latest tax increase is implemented
In January, California increased its income tax rate by 2%—to 12.3%—for resident and non-resident individuals earning over $500,000. With California’s Mental Health Service Act imposing an additional 1% on individuals earning over $1,000,000, the state’s 13.3% income tax rate represents the highest of any state in the U.S.
Prior to California’s tax increase, golfer Phil Mickelson created quite a stir when he stated that federal and state tax increases had made him contemplate moving his residence out of California. Although his statement was controversial, it’s based on sound financial principles. Mickelson finished third on the PGA money list this year and earned $5,295,793. With this amount of income, Mickelson will incur a hefty tax burden. He will face a cumulative federal and state income tax rate of 48% and a total potential tax liability of $2,544,796, of which 26.76%—or $680,942—could be owed in state taxes.
Both individual and team athletes alike are affected by resident and nonresident state income tax. According to a 2010 report from the California Franchise Tax Board, the state collected over $171 million alone from both resident and nonresident athletes. A 2% rate increase in California’s state tax means that revenue from athletes could grow another $34 million.
For a resident athlete earning the league average in the National Basketball Association (NBA) who earns the league average, California’s 2% tax rate increase will mean an additional $100,000 liability in California state tax, while a Major League Baseball (MLB) player earning the league average will incur an additional $64,000 liability and a member of National Hockey League (NHL) in the same scenario will have to pay an additional $38,000. With this increased tax burden, it is not surprising that both individual and team athletes are reconsidering their options when it comes to establishing and maintaining residency in the state of California or elsewhere.
The question that many athletes like Mickelson need to ask themselves, then, is whether or not the cost of being a California state resident—a hefty tax burden—is worth what the state has to offer them in return.
What determines residency in the state of California?
Residency is important because it determines how income is taxed in the state of California. California residents are taxed on income from all sources, both inside and outside the state. Therefore, a resident athlete who earns income outside the state of California will still be accountable to pay California state tax on that income. A part-year or non-resident athlete, on the other hand, will only need to pay California state tax on income earned inside the state of California.
Athletes and their advisors need to be aware of what determines residency in the state of California. An athlete will be considered a resident of the state of California if he or she is present in California for other than a temporary or transitory purpose or if he or she has established domicile in the state.
While many states consider domicile and residence to be the same, California makes a distinction and views them as two separate concepts even though, in practice, they often overlap. For instance, you may be domiciled in California and therefore be deemed a California resident or you may be domiciled in another state but still be deemed a California resident for income tax purposes. As outlined in the State of California Tax Publication 1031, domicile is defined for tax purposes as the place where, whenever you are absent, you intend to return. Residency, on the other hand, is determined to be the place where you have the closest connections.
Factors that the state of California will consider to determine residency and/or domicile include:
the amount of time you spend in California versus the amount of time you spend outside California;
the location of your principal residence;
the state that has issued your driver’s license; and
the state in which your vehicles are registered.
Professional athletes have challenged California’s domicile policy. Joe Morgan, a second baseman with the Cincinnati Reds during the 1977, ‘78 and ‘79 seasons, had a home in both Houston and California. He was found by the State Board of Equalization to be a resident of California based on its determination that he was domiciled in California.
The deciding factor was that both Joe Morgan and his wife were domiciled in California prior to the years in question. Mr. Morgan, although born in Texas, was raised in California; and in the state of California, domicile, once acquired, is presumed to continue until it is shown to have been changed. The state determined that Morgan’s domicile had not changed.
Several items tied the Morgan’s to the State of California, including the fact that the couple had a home in the state; used the home address on their federal income tax return and for purposes of the homeowner’s property tax exemption; had their daughters enrolled in California schools; maintained their California state driver’s licenses; and returned to California during the off-season.
What is the cost of living in California?
There are two issues to address when considering the California state income tax burden on a professional athlete: first, the additional tax burden on a resident athlete who maintains residency in California while performing services with a team outside the state; and second, the additional tax burden for a non-resident who performs services for one of the state’s professional teams and thereby establishes residency in the state.
Residents of California playing in another state
The case of Joe Morgan illustrates that domicile in the state of California comes at a price. Although California offers a tax credit for taxes paid to other states, the fact that California’s tax rate is greater than all other states creates an increased tax burden on residents earning income outside the state.
To illustrate this point, consider Troy Tulowitzki, who grew up in Sunnyvale California but is currently playing for the Colorado Rockies. Based on Tulowitzki’s 2014 salary of $16 million, filing as a resident of California as opposed to Colorado would increase his state tax burden by an estimated $1.3 million.
Residents of other states playing in California
Residents of other states who play for a team based in California—thereby establishing residency in California—also increase their tax burden. Using the 2013 average league salary for both Major League Baseball (MLB) ($3.2 million) and the National Football League (NFL) ($1.9 million), we can better illustrate the actual monetary burden for non-resident athletes performing services in California.
Consider first the NFL player. A football player who plays for one of the three California based NFL teams will, on average, take home $130,083 (or 11.33%) less in net income than he would if he were playing for one of the league’s seven teams based in no-income-tax states.
Net Income (Average after state and federal income tax)
% of Total Income
(Average)
Difference
Playing for California based NFL Team: $1,018,364
53.60%
Playing for NFL Team in State with No Income Tax: $1,148,447
60.44%
$130,083.00
Consider next the Major League Baseball player, and we see how different leagues and salary levels also play a role in the additional tax burden athletes performing services in the state bear. A baseball player earning the league average can expect to take home an average of 52.4% of his income—should he play for one of the five California based teams. In contrast, an athlete playing for one of the five teams based in a no-income-tax state will take home, on average, 12.25%—or $206,323—more than his net income for a California based team.
Net Income (Average after state and federal income tax)
% of Total Income
(Average)
Difference
Playing for California based Baseball Team:$1,683,898
52.40%
Playing for MLB Team in State with No Income Tax: $1,890,221
58.82%
$206,323.00
Conclusion
Whether or not he/she is an individual or team athlete—and whether or not he/she is a resident or nonresident, athletes and their advisors need to consider the tax consequences of living and playing in the state of California. As illustrated in this article, the cost can be quite substantial and should be considered carefully when weighing contract proposals from different teams based out of different tax jurisdictions.