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King’s Ransom

Potential tax reform takes a substantial bite out of not only Lebron James contract extension but all professional athlete’s contracts.

Introduction

December 2nd, 2020 – The Los Angeles Lakers agreed to a two-year contract extension with LeBron James, reported to be worth $85,655,532. The extension pushes James’ original four-year contract into a fifth year, in which he will now earn $44,474,988 for the 2021-22 NBA season. By the time James enters the final year of his new contract, he may have a new tax policy in place that targets the wealthy and could cost him an additional $6 million more in income and payroll taxes. Although this is a substantial hit to James’ net contract earnings, he is not the only athlete who will be impacted, as all professional athletes who earn above $400,000 will also feel the effects of the potential change in the tax code.

Background

With President-elect Joseph Biden scheduled to take office in January, there has been speculation in what changes to the tax code may take place once the new administration takes over. The previous administration of Donald Trump, which held a Republican majority in both the Senate and the House of Representatives were able to enact sweeping reform in their first year in office in the form of the Tax Cuts and Job Act (TCJA) of 2017.

The expediency of the tax reform in 2017 was unprecedented. The likelihood that this type of reform being enacted without the support from both the Senate and the House of Representatives would be highly unlikely. Considering that the new administration will have to deal with a national pandemic once they take office, tax reform may not be as high of a priority. Therefore, sweeping changes to the tax code should not be expected immediately.

If there is to be tax reform, it would have to be items backed by every Democratic Senator or have mutual support from both sides of the aisle (Democrats and Republicans) and would not cause complicated legislative actions (creating new or changing current tax law). However, the possibility of some type of tax legislation from the new administration could be at least proposed. Kari Smoker, Assistant Professor, Accounting and Business Law at Ithaca College, points out that in midst of a pandemic in which billions of dollars are going out in relief, the government will need to generate revenue for itself and this is generally done though taxes.

Tax reform can come in the form of either changes to the corporate or individual tax code. Under individual income tax, revisions to the tax code can be made by raising or lowering the tax rate on either active (wages) or passive (endorsements, financial or rental) income and/or adjusting available (or eligible) deductions or tax credits. Biden’s promises during the campaign touched on many of these categories, however, this article focuses only on those items that have the potential to pass legislation in the present political climate while also potentially impacting the landscape in which professional athletes currently reside.

Before we look at potential changes that have been proposed, it should be noted that the expediency of the TCJA, which was passed in the first year of the Trump administration, still did not take effect until the following tax year. With that taken into consideration it can be reasonably assumed that if any tax reform is to take place, the earliest we would see such reform would not be until the 2022 tax year.

Active Income (Wages)

The TCJA lowered tax rates for all tax brackets. Most notably lowering the tax rate in the highest bracket from 39.6% down to 37% for those earning over $518,401 ($622,051 for married). Biden has proposed having that bracket revert back to a rate of 39.6% for those earning over $400,000.

Another proposed change that impacts those earning over the $400,000 threshold is to re-impose the Social Security payroll tax on those earners. Currently, Social Security is funded by imposing a 12.6% tax on employee wages up to $137,000, which is split and paid evenly by the employee and employer. Once the tax has been paid on earnings up to the cap, it is no longer imposed on any wages. Biden’s plan would create a so-called “donut hole” as it seeks to impose the tax up to the cap and then again on all earnings over $400,000.

Below, is a chart which shows the additional tax earners (y-axis) over $400,000 could expect to pay under Biden’s proposal. This takes into consideration the change in the federal income tax rates and the additional Social Security tax while also considering the additional deductions allowed under the proposed Biden tax plan. These deductions will be discussed in further detail in a section below.

As indicated, an athlete earning $2,500,000 will expect to pay $147,651 (5.9%) more in tax while one earning $30,000,000 can expect to pay $2,162,108 (7.2%) more, of which 85% ($1,837,792) would be caused by the additional Social Security Tax!

The result is that athletes who earn over $1,000,000 will pay more in tax in nearly all situations, however, there are some notes of interest when you look inside the numbers that should be pointed out and will be addressed when we discuss deductions.

Passive Income (Long-Term Capital Gains)

Biden’s tax proposal would increase the current tax rate on long-term capital gains from 20% for those earning over $1,000,000 to their ordinary tax rate, which under Biden’s proposed plan would be 39.6%. The chart below shows the additional tax an individual earning $7,500,000 would expect to pay depending on the amount of gains (y-axis).

Therefore, it can be expected that should the long-term capital gains tax rate increase to the taxpayer’s ordinary tax rate, the result would be a 79% increase in tax.

Deductions (SALT Deductions)

One popular aspect of Biden’s tax proposal calls for increasing the limits on state and local taxes (SALT) deductions; Biden’s plan also indicates that these itemized deductions would be capped at 28% of the value of an individual’s earnings. Currently, the TCJA caps property and state taxes to $10,000. To counteract the loss in itemized deductions, the TCJA doubled the standard deduction. There is no indication that Biden would adjust the standard deduction rates.

By increasing the state and local tax deductions, how much more athletes can expect to pay depends on not only their income level but the state in which they are residents. The result will lessen the gap between the tax paid between high income state athletes and those who play in low-income states by 11%. Although all athletes pay more at the federal level, the ability to deduct state taxes helps alleviate some of the heavy state tax burden on those athletes who play in states like California, Minnesota and New York, and New Jersey.

As the chart above indicates, at the highest salary level a player earning $30,000,000 will still have to pay $3,521,156 more in total tax in playing and residing in California as opposed to Florida, however it will be $443,607 less than under the current tax law.

Case Study: LeBron James

Finally, we will take a practical look at the proposed tax changes using LeBron James’ recently signed two-year extension with the Los Angeles Lakers worth $85 million. In comparing the amount of tax James will be subject to under the proposed changes, the chart below breaks down the difference between the proposed new tax law and the current tax law.

As the chart above indicates, although he will only pay slightly more at the federal level and his state taxes remain the same, where James will feel the bite of the new proposed tax increase is in his payroll taxes, specifically his Social Security taxes which will increase by over $5.2 million.

Conclusion

The idea behind any tax change is to generate revenue by increasing the taxes on the wealthy and athletes fall under that category. As this article and the case study of LeBron James’ new contract indicates, the new administrations tax proposal would create a larger tax liability for both active and passive income. Although the increase in allowable deductions will limit some of the pain – especially for those athletes who play in high income tax states – the increased social security tax for all who earn over $400,000 will cause a greater amount of financial pain and it will impact everyone.

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