Tax Avoidance

Baseball has two programs in place to force its richest teams to share a bit of their wealth.  One program is revenue sharing – teams that earn the highest gross revenues have to share some of those revenues with their poorer brethren.  Every team in baseball either pays or receives revenue sharing money.  The second program is the Competitive Balance Tax, sometimes called the “luxury tax”.  The luxury tax forces teams with large year-end payrolls to pay a “tax” on the amount by which the payroll exceeds an amount specified in baseball’s Collective Bargaining Agreement (CBA).  Luxury tax moneys go to player pensions and Bud Selig’s “Industry Growth Fund” – none of this money goes to small-payroll baseball teams.  Most years, it’s only the Yankees that pay luxury taxes.

Here’s an example of how the luxury tax works.  Last year the Yankees had a year-end payroll of a bit more than $215 million, which exceeded the 2010 luxury tax limit by about $45 million. The Yankees were subject to a 40% luxury tax on this excess, forcing the team to pay $18 million in luxury taxes.  The Red Sox also had to pay a luxury tax last year, but at a lower rate (the Yanks pay at a high rate because they’re repeat luxury tax offenders) and on a smaller payroll excess: the Red Sox luxury tax liability last year was only $1.5 million.

But as we know, rich people don’t like to pay taxes, even a little bit of taxes, and the Red Sox are run by rich people.  Under his contract with the Padres, Gonzalez is owed a tad more than $6 million this year.  For luxury tax purposes, the Red Sox would like Gonzalez’s 2011 salary to stay at $6 million.  But if we factor in the Red Sox commitment to pay Gonzalez $22 million a year from 2012-2018, then Gonzalez’s average annual salary for the next 8 years is $20 million.  For the Red Sox, the 2011 luxury tax difference between $6 million and $20 million is around $4 million, and the Red Sox would like to avoid having to pay out that $4 million.

But how to legally avoid that tax?  If the Red Sox inked their extension with Gonzalez prior to Opening Day, the increased salary under the extension would count against the Red Sox this year. But if the Red Sox could delay signing that extension until after Opening Day, then the extension would not count against the luxury tax until 2012 … if indeed there is a luxury tax in 2012.  (Under the terms of the current CBA the luxury tax is supposed to expire this year, though the CBA itself also expires this year, and all expect that the luxury tax will be continued in some form in the next CBA.) And if there is a luxury tax in 2012, then the Red Sox will have at least delayed having to pay luxury tax on the Gonzalez contract. For rich people, delaying the payment of tax is nearly as attractive as avoiding tax altogether.

The Red Sox have used other tactics in the past to delay the impact of the luxury tax.  For example: in 2010 the BoSox signed Adrian Beltre to a one year $9 million contract that gave Beltre the option to play for the Red Sox in 2011 at a reduced $5 million salary. Did anyone think that Beltre might exercise that option?  No.  But the option effectively lowered the luxury tax hit for signing Beltre — his $9 million salary was averaged along with the $5 million option, so for luxury tax purposes Beltre’s 2010 salary was computed at $7 million.  The $2 million savings lowered the Red Sox 2010 luxury tax by $450,000.  But since Beltre (as expected) passed on that $5 million option and signed as a free agent with the Texas Rangers, that $2 million will be added back to the Red Sox luxury tax payroll this year, potentially costing the Red Sox an extra $600,000 in luxury tax (the 2011 tax increase is larger than the 2010 tax savings, because the Red Sox will be a repeat luxury tax offender in 2011 — assuming of course that the Red Sox cannot find a way to avoid paying luxury taxes in 2011).

Save $450,000 one year, just to pay $600,000 the next? The Red Sox are OK with that: their strategy is to avoid tax this year any way they can, and worry about next year once it arrives.

The Red Sox strategy with Gonzalez works this same way: it lowers the Red Sox luxury tax payroll by about $14 million in 2011, but increases the size of this payroll by about $2 million a year between 2012 and 2018. The Red Sox are familiar with this strategy, as they’ve used it before, delaying their contract extensions with Coco Crisp (2006), David Ortiz (2006) and Josh Beckett (2010) to minimize the then-current year calculation of the team’s luxury tax payroll.

Let’s return our focus to the contract extension with Gonzalez. If Bob Nightengale and others are right and the Red Sox reached their current deal with Gonzalez last December, was it kosher for Boston to delay signing the extension until now?  Not exactly.  Under Article XXIII (G)(1) of the CBA, teams are prohibited from entering into any transaction designed to defeat or circumvent the luxury tax.  More specifically, Article XXIII(G)(2) of the CBA prohibits “unreported understandings or agreements of any kind” between teams and players. If the Red Sox truly agreed to a contract extension with Gonzalez last December and failed to document it until now in an effort to avoid the luxury tax, this scheme violates the express terms of the CBA.

However, this violation is mostly technical – the Red Sox will face no consequences for its violation of the CBA.  The two parties with the most at stake here are the parties that would receive this extra luxury tax – namely, the player’s union and the Commissioner’s Office.  The player’s union has (to my knowledge) not said a word about the Red Sox’s efforts at tax avoidance, and MLB Executive Vice President Rob Manfred said last December that the Commissioner’s Office does not view this tax avoidance as “a real area of abuse.”

Manfred probably has the right understanding here: the best reading of Article XXIII(G)(2) is that there was no enforceable understanding between Gonzalez and the Red Sox last December.  No matter what the two sides might have believed last winter, either side was entitled to change its mind right up until the formal extension was signed this spring.

This is where the story really gets interesting.  Some top baseball writers, including SweetSpot Czar David Schoenfield, think that Gonzalez is a bargain at $22 million per year.  What would have happened if Gonzalez had reached this same conclusion prior to Opening Day, and had decided to demand a Ryan Howard-like salary of $25 million a year?  Then the Red Sox effort to save $4 million in luxury tax might have cost them $21 million in extra salary.

From this perspective, the Red Sox took a big risk in delaying Gonzalez’s contract extension until April. But as we said above, rich people don’t like to pay taxes.

So in the end, the Red Sox scheming comes down to plain old garden-variety tax avoidance … and possible not the world’s most intelligent tax avoidance at that, given the risks involved.  However, the Red Sox have weathered the risk.  They’ve signed the guy they want to be their first baseman through 2018, in a way that will save them luxury tax this year, and for the most part the Red Sox have been praised both for their baseball acumen and their tax planning.  Some days it must be nice to be the guys who run the Red Sox.

And if you’re wondering about the reaction if it had been the Yankees and not the Red Sox who had jobbed the system out of $4 million in luxury taxes …  my advice is to shrug your shoulders, take a deep breath and forget about it.

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