For most Americans, the months of November and December center on reviving old family holiday traditions, reflecting on the events of the past year, and looking forward to the opportunities that lay ahead. This is also the case for professional athletes, though it is also a time of careful decision making and complex financial planning, not only for themselves but also for their team of advisors and specifically their tax accountants. 

The majority of American taxpayers fulfill their tax obligations by filing a relatively straightforward tax return. A W-2 here, a few adjustments and healthy deductions there, with the end result hopefully being a sizeable refund check. For athletes, the notion of a simple tax return filing is wishful thinking. Athletes file some of the most complicated and extensive tax returns that hiring a tax professional is not a luxury but a necessity. 

Athletes are subject to federal income taxes just like any other taxpayer. For the majority of Americans, we are also required to pay income taxes to our state and local governments. 43 out of 50 states have an income tax of their own, with Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming standing as the exceptions. Residents of those seven states do not see an additional income tax bill from their state government. There are other taxes in the form of sales and use taxes on consumption of goods and property taxes on our homes, but for the purposes of this article we will focus solely on income taxes.  

An athlete’s tax filing requirements are usually not fulfilled by filing a return with the IRS and if necessary their resident state tax agency. The main driving factor of the complexity of an athlete’s tax return is not how much they earn but where. The fact that they earn millions of dollars only magnifies the scope of the numbers and is irrelevant when it comes to sheer number of returns and forms an athlete must submit come filing season. 

In the tax sphere, the term nexus, broadly defined as a connection, is the crucial element in determining to which state and how much a business entity will owe taxes for a given year. Most people go to work at a fixed location in one state (usually the state they reside in), so their personal “nexus” is the same as their state of residence, and as a result they will only have to file one state tax return.

In the case of athletes, their nexus or place of business is not fixed as they must travel to other states for away games.  So when Kobe Bryant, a California resident, plays a home game at Staples Center, the income he receives for playing in that game (or rehabbing as currently is the case) is attributable to services provided in his resident state of California, and California therefore has the jurisdiction to impose income taxes on the salary for that game.  When Bryant travels to Madison Square Garden to play the Knicks, however, he is now considered to be providing his services in New York, which therefore has the jurisdiction to impose income taxes for the one game’s worth of salary earned by Bryant. 

In reality, most states do not simply collect taxes on a single or multiple paycheck(s) attributed to one game. Rather, they determine an athlete’s taxable income by calculating the number of days spent in the state during the year. These duty days, or days on which an athlete is required to participate in team activities in fulfillment of his employment, e.g. game, practice and travel days, is then taken in proportion to the total number of duty days in an athlete’s season and then factored against their total annual salary. 

To complicate things further, an important consideration of the American tax system is the principle of “double taxation” which establishes that no taxpayer should be taxed twice on the same income by more than one state tax agency. So the income Bryant earns for playing in New York will be taxed by New York, but not by California, his resident state, and vice versa. California will still require Bryant to report all of his total income on his California return regardless of where it is earned, but will avoid double taxing Bryant’s New York income by allowing a tax credit on his California return for taxes paid to New York. (If you fully understood that last sentence on your first try, you may have a future as a tax professional)

As a case study, let’s take the case of everyone’s favorite supremely physically gifted but mentally vacillating center, Mr. Dwight Howard.  Much was made when Howard passed on the Lakers’ maximum five-year, $118 million contract offer and instead accepted $88 million over four years to play in Houston. To simplify our analysis, we will ignore the extra guaranteed year if Howard stayed in Los Angeles and focus strictly on an annual earnings per year basis. Although we cannot assume that Howard will receive another max contract offer when his current deal expires, we can reasonably expect that he will sign a new contract that matches or even surpasses his current $22 million annual salary.

Another factor we have to consider that was persistently cited during his free agency was the endorsement deals he gave up by leaving the big market of Los Angeles for the opportunity to win in Houston. Forbes reported Howard will earn $7 million in endorsements for 2013, a significant decrease from the $11 million he earned in 2012. Part of the Lakers sales pitch to Howard was the notion that playing in the Los Angeles market would offer new opportunities not available in smaller media markets to enhance his personal brand and enrich his financial portfolio. While it is practically impossible to know if this would have been the case, the numbers suggest that his time as a Laker had little to no impact, and possibly even a negative one, on his brand’s earning power. 

It’s reasonable to look back and hypothesize that the damage to his image was done over a protracted period, beginning with his final year in Orlando and his strained relationship with Stan Van Gundy, continuing throughout his tumultuous season in Los Angeles, and ending (hopefully for Howard’s sake) with his subsequent departure and fresh start in Houston. It’s worth noting that the top three NBA players in terms of endorsement money for 2013 are LeBron James, Kobe Bryant and Derrick Rose, earning $42 million, $36 million, and $21 million, respectively, and all are MVP-receiving, multiple championship winning (except Rose) superstars playing in major media markets.

Number four on the list? Kevin Durant of the Oklahoma City Thunder, who stands to make $14 million in endorsement money in 2013 despite playing in one of the smallest media markets in the NBA. For all the reasons stated above, we’ll assume that Howard will earn the same amount for 2013 in endorsements regardless of his status as a Laker or Rocket.

An important consideration is that unlike their salaries, an athlete’s business nexus for their endorsement money is not as readily determined. Allocating endorsement income to a specific state jurisdiction is an inexact science, but the general practice is that any income received for a public appearance or filming of a commercial will be allocated to the location of the activity. If a physical location cannot be attributed to an income generating activity then it defaults to their resident state. For the purposes of this analysis we will assume that 50 percent of Howard’s endorsement money is allocated to his resident state and the other half to outside states.

Given Howard’s projected earnings for 2013 and beyond, the main consideration for tax purposes is that California has the highest state income tax rates in the country with a top rate of 13.3 percent on taxable income in excess of $1,000,000. Remember the seven states with no state income tax mentioned earlier? It just so happens Texas is one of them. The IRS does provide some relief for taxpayers residing in states with high income tax rates in the form of an itemized deduction on their federal return for state and local taxes paid. For a high income earner like Howard who pays the highest federal marginal tax rate of 39.6 percent on income over $400k, the deduction is worth a significant amount of tax savings on his federal return, e.g. if Howard paid $1 million in total state and local taxes in 2013 as a California resident, his federal tax liability would be reduced by $396,000 ($1 million x 39.6%). And finally, federal income taxes are the same regardless of Howard’s state of residence, so they are not a factor in this analysis.

A few other details worth considering: As a Laker, Howard would have played 47 regular season games in California (41 home games, plus two road games each against the Clippers, Warriors and Kings) while as a Rocket, Howard will play 45 games in Texas (41 at Houston, plus two road games each against the Mavs and Spurs). We will also assume that other than the intra-state road games, Howard’s away game schedule would have been identical regardless of his status as a Rocket or a Laker. While not 100% accurate, given the fact that both teams are in the Western Conference, it becomes a relatively marginal difference and not enough to warrant any additional analysis. Also, while an NBA season covers two calendar years starting in October and ending in late spring of the following year, a tax year for an individual is from January 1 to December 31, so we will treat Howard’s 2013 season salary as entirely allocated to his 2013 tax year for the sake of simplicity. And finally, Howard’s actual 2013 season salary with the Rockets is $20,513,178, not the $22 million published by most news publications. Howard would have earned the exact same amount in 2013 if he had signed with the Lakers. Enough numbers and assumptions, it’s time to get down to brass tacks. 

As you can see by the numbers, Howard stands to take an additional $1.2 million to the bank in 2013 despite the identical gross income figures. $1.2 million is not chump change by any means but it is not a significant difference given Howard’s total annual earnings. Despite the apparently misinformed claims that Howard left money on the table when he left Los Angeles, money was presumably not the main factor (if at all) in Howard’s decision to sign with Houston compared to other considerations like being surrounded by a younger and more talented nucleus of supporting talent and not having to deal with burden of pleasing/playing alongside Kobe. 

Just to experiment, let’s assume that if Howard stayed in Los Angeles that he would have earned more than $7 million in endorsements in 2013, and the majority of it could be allocated to California, which is not a stretch since Southern California is still the entertainment capital of the world and potentially most of his publicity and endorsement activities would be based there.  For this hypothetical we’ll assume $10 million in endorsements for 2013, with $8,000,000 allocated to California. 

Again, $1.4 million is not a small number but as you can see by increasing his endorsements by $3 million and allocating 80 percent of it to California the difference swung in the Lakers’ favor, but not by the full additional $3 million he hypothetically would have received if he stayed in Los Angeles. Other factors not taken into consideration include: cost of living, local taxes, property taxes, and sales taxes, which can all further affect this analysis. For what it’s worth, it is widely acknowledged that California has some of the highest costs of living in the country, presumably higher than Texas. Furthermore, the Tax Foundation, a nonpartisan tax research outfit, estimated in 2010 that the average tax burden for California residents was 11.23 percent, well above the national average of 9.9 percent, and high enough for fourth-highest in the nation. Texas residents’ average tax burden was 7.93 percent, a full two percentage points below the national average, and the sixth-lowest in the country. 

For one final comparison, let’s look at Howard’s pre- and post-tax earnings for the entirety of his four year stint with Houston compared to the total earnings he would have earned as a Laker.  As Rocket, Howard stands to make $87,591,270 with Rockets versus $91,753,482 he would have received over four years (assuming Howard doesn’t exercise his player option for the fifth year) from Los Angeles. We’ll maintain the assumption that Howard will receive $7,000,000 each year in endorsements as a Rocket with a 50/50 split between Texas and other states for allocation of the income. And also assuming a 80/20 split between California and outside states for allocation of his endorsement income if he stayed in Los Angeles, let’s see how much additional (if any) endorsement income Howard would have had to generate as a Laker to put himself on equal financial footing for the four-year period.  

As you can see, Howard would have to earn $29,929,740 in total endorsement income for the four years in Los Angeles, which is $1.9 million more than the $28,000,000 in hypothetical endorsements he would earn as a Rocket. Given those figures, it’s highly conceivable and probable that Dwight would have earned an additional $500k in endorsements had he stayed in Los Angeles versus moving to Houston. 

When Phil Mickelson complained earlier this year that 60 percent of his earnings from winning the British and Scottish Opens were going to taxes, he was not wrong, though foolishly misguided in publicly voicing his grievances. He even went so far as to say his tax burden was “not making me want to go out and work harder” and that “it doesn’t work for me right now, so I’m going to have make some changes.” [Note: Mickelson was the seventh highest-paid athlete in 2012, making $47.8 million in total earnings] For decades, lawmakers and the general public have clamored for a simpler(and presumably fairer) tax code but in reality the American tax system has become increasingly complex in recent years, largely in response to the globalization of domestic economies and the labyrinth that is the financial sector.

For athletes, the challenge of choosing a team that gives them the best opportunity to win championships while maximizing their earnings potential continues to be a delicate balance filled with unknowns (Tracy McGrady comes to mind). For Dwight Howard, he chose to leave the bright lights of Los Angeles and high expectations of being the next great Laker center for the chance to win championships with James Harden and one of the most technologically savvy and forward thinking franchises in the Houston Rockets. Basketball reasons aside, his decision to leave Los Angeles was hardly a disastrous one from a financial perspective. What we can all agree on is that given the substantial tax obligations and regulations they face due to their high earnings potential and public presence, athletes are prime targets of federal and state tax agencies. So when a tax agent comes knocking at his door, Howard can forget donning his Superman cape, as all the superhuman strength in the world won’t help him in his fight. The real superhero? His tax accountant.

- Michael Pak is a tax accountant and business manager at Freemark Financial LLP, he can be reached at michael@freemarkcpa.com.