Why Do We Sometimes Get Too Obsessed with Taxes?
The recent slew of athletes taking deferred money on their contract to save on taxes proves that even the smartest agents and lawyers in the world still act irrationally when it comes to money
Everyone is familiar with the famous Ben Franklin quote, “In this world nothing can be said to be certain, except death and taxes.” No one likes paying taxes. Regardless of your political opinion or your beliefs as to what programs your taxes should support, every business owner works annually to decrease their tax liability as much as possible. In fact, there are probably a few of you who would possibly consider death as an alternative to paying taxes.1
Every business has its tricks, whether you file on a cash basis or an accrual basis. We all do what we can to keep as much money as possible in our businesses for that much-needed capital. The problem is, sometimes we go too far. Sometimes we get so obsessed with lowering our tax liability that we miss the forest for the trees.2
For months since starting Main Street Mindset, I’ve been looking for an angle to include one of my passions – sports – in one of these columns. I’ve had a lot of trouble comparing multi-billion-dollar sports industries to small businesses. But recently, a light bulb went off as I’ve been following a growing trend in the sports business.
Whether you know anything about sports or not, pretty much everyone understands that professional athletes in the major sports leagues sign contracts with teams. Simplifying it, there are two main parts of a contract: the term and the value. The term is how long you sign for, and the value is the total dollar amount of the contract. So, if someone signs a 10-year, $100-million contract, their average annual salary is $10 million per year.
Now, when you make that much money, your tax liability skyrockets, especially if you live in a high-tax state. Athletes often have a staff of people on their payroll, from agents to business managers to financial advisors, to help them maneuver this type of issue. And in the last few years, there has been a growing boom of athletes utilizing a new trick to try and cut down their tax liability: deferred contracts.
Here’s a great example. Shohei Ohtani, the superstar baseball player, signed the largest contract in baseball history (at the time) back in 2023. It was a whopping $700 million over ten years, for an average of $70 million per year, to play for the Los Angeles Dodgers.3 But here’s the thing: California has one of the highest state tax rates in the nation. And Ohtani decided he wasn’t interested in paying that tax rate. So instead of taking his money over the course of his contract, like most athletes, he deferred $680 million of it until after the contract expires. So for ten years, his actual salary is just $2 million per season. Once the contract ends in 2034, he’ll be 39 years old and likely retired. He can then move to a no-tax state such as Nevada or Texas, where he will make $68 million a year for the next ten years, and be charged no state sales tax on that amount. That change will save him about $8 million per year in California state income tax.
Another recent example, Frank Vatrano of hockey’s Anaheim Ducks, signed a 3-year contract worth $18 million – but half of that value is deferred for 10 years, allowing him the same benefit as Ohtani: he can move out of California and make $900,000 annually for ten years while living in a state with no income tax. Brilliant, right?
Well, not so fast.
If you’ve never heard of compound interest, now’s a great time to learn. Very simply, compound interest is the idea that money invested grows at a faster rate each year because its principal is higher each year. For example, if you have $1 million invested, and you make 10% per year on it, in the first year you’ll make $100,000. But in the second year, you’ll have $1.1 million, so the interest is $110,000. In year three, you’ll have $1.21 million, so the interest is $121,000. That annual interest number continues to increase even if you add absolutely no additional principal to your investments. But if you are so lucky as to be able to continue adding money into the account, that interest number accelerates even faster each year.
Warning: we’ve got some heavy math ahead, so buckle up. If your brain isn’t up to it, just skip ahead a few paragraphs, where I’ll summarize the entire thing.
Let’s take a $10 million annual salary in California over ten years as an example:4
Gross pay: 10M
Federal tax: 3.615M
FICA: 243k
State tax: 1.19M
Net pay: 4.95M
If you spread that net pay over each year and invest all of it (at 410,000 per month) over those 10 years, at the end of the contract you will have these amounts, depending on the compound rate:
3% = $57.847M
5% = $64.341M
7% = $71.789M
10% = $85.096M
Let’s call this our control group, as this is what it would look like under a typical contract.
Now let’s say you defer 90% of the value, so that you only make $1 million per year, and the other $90 million gets paid out after the contract.
Gross: 1M
Fed: 285k
FICA: 31.7k
State: 88.9k
Net: 594k (40.6% effective tax rate)
Investing the entire amount at 10%, you’ll have $10,273,825 at the end of the contract.
If you get the remaining 90% over the ten years after the contract, then during that period you receive annually:
Gross: 9M
Fed: 3.245M
FICA: 220kM
State: 0
Net: 5.535M
Invested over ten years, and also adding the 10.273 million that you got from the first ten years of the contract after compound interest, that becomes:
3% = 65.019M + 10.273 = $75.292M
5% = 72.318M + 10.273 = $82.591M
7% = 80.689M + 10.273 = $90.962M
10% = 95.647M + 10.273 = $105.920M
And the 57.847M from our control group contract, after those same ten years (years 11 through 20), becomes:
3% = 78.056M
5% = 95.275M
7% = 116.253M
10% = 156.594M
The math shows very clearly that, even at the highest state tax rate, you come out behind by as much as 33% if you defer most of your contract money out because of the loss of compound interest. Even in the most conservative return rates, you still come out slightly ahead if you don’t defer the money. But if I can do this math from the comfort of my desk, why are these brilliant-minded agents and lawyers utilizing this strategy? I’m certainly no smarter than any of them.
The answer likely lies in a famous psychological theory known as “loss aversion.” Coined by Nobel Laureates Amos Tversky and Daniel Kahneman in the 1970s,5 the theory is that humans are so irrational as to fear a loss more than they desire a gain. Basically, someone’s happiness at winning $10 is exponentially lower than someone’s sadness at losing $10. Another example is that a $5 discount or a $5 surcharge avoided are viewed quite differently by our brains, even though the net benefit is identical.
In one of the duo’s landmark studies, they offered people to flip a coin, with the chance to either win $40 or lose $20, depending on the outcome. Most people chose not to take that risk, despite the fact that the math shows you’re more likely to come out ahead by taking this chance (it’s an expected value of +$10). We put a greater value on the money we have as opposed to the money we could have, even to our financial detriment.6
Loss aversion explains quite easily why athletes are becoming more willing to take deferred money at the risk of their overall financial health: they can tangibly see how much they will lose in tax liability by earning that money now. But it is extremely difficult to see how much more they will earn by taking the hit now to earn compound interest on it over the coming decades. Research continues to show that humans behave irrationally, especially when it comes to finances, even when faced with irrefutable evidence to the contrary.
In fact, even the teams are seeing how irrational this move is – if the Dodgers put the entirety of that deferred $680 million into escrow, they could potentially be earning the interest that Ohtani is missing out on by deferring the money in the first place! Ohtani’s loss is the Dodgers’ gain. Isn’t this exactly why lottery winners take the lower lump sum now, rather than the higher-valued annuity? You want the money in your pocket now so you can utilize it for future earnings.
Which brings me to perhaps the smartest use of the deferral strategy: Seth Jarvis of the Carolina Hurricanes. A star defenseman, Jarvis signed an eight-year contract that deferred $15.67 million until after the deal expires. But instead of an annual payment starting in the ninth year, he gets that entire deferred amount in one lump sum. How does that change the complex math we just did? It changes it heavily in his favor. Let’s take our sample contract from earlier:
If, instead of getting the remaining 90% over ten more years, you get that 90% in a lump sum at the end of the contract, after moving to a no-tax state, then:
Gross: 90M
Fed: 32.453M
FICA: 2.197M
State: 0
Net: 55.350M
Invested over 10 years, that becomes:
3% = 88.550M + 10.273 = $98.823M
5% = 108.083 + 10.273 = $118.356M
7% = 131.882M + 10.273 = $142.155M
10% = 177.646M + 10.273 = $187.919M
In this example, you come out with the highest net value of all three contractual methods. You only have the chance to come out ahead if the remainder is given as a lump sum, not over a period of years.
Now, there are also some potential risks of any deferred salary gambit. For one, the legality of it is quite dubious. At the moment, California does not appear to be able to fight the issue, but all it takes is an act of Congress (or even a lengthy lawsuit) for them to claim that Ohtani’s or Vatrano’s salaries, even the deferred portions, were earned while they worked in California, making that portion of their paychecks subject to state income tax. In fact, there’s a superstar NHL player going through a major tax lawsuit with Canada as we speak based on a financial maneuver he made that Canada has deemed illegal. Talk about loss aversion: would you really take the risk that you might owe millions of dollars of back taxes just to take a contract that will net you less than it would if you just took your pay normally? The layers of irrationality are heavy.
There are a variety of other factors that come into play in complex situations such as these that I’m obviously not taking into account for simplicity. In fairness to the player, it’s possible that the team wouldn’t offer as much money if the contract was paid only during the term of the contract. Maybe Ohtani would only have been offered $650 million if the money was taken over the first ten years. In that scenario, he certainly comes out ahead by deferring it. A player may also take a gamble that the federal tax rate ten years from now will be lower than what it is today – that also could make them come out ahead.
The bottom line is this: while we all want to lower our companies’ tax liabilities as much as possible throughout our lives, be sure that you’re not sacrificing your financial health by doing so. In a business scenario, perhaps you’re deferring some revenue in order to push it into a future tax year. Take into account what you could be doing with that extra revenue to better your business now, even if you have to pay a bit more to Uncle Sam. Ten years down the line, your business may thank you.
Joke’s on you! Even in death the government’s still got you.
Notice my use of language, that we work to decrease our tax liability, not “how much we pay in taxes.”
That sounds nice, but I wouldn’t want to take a pay cut from my current rate.
I’m making a bunch of assumptions here that are not always correct, for the purpose of simplicity. For example, I’m assuming athletes get paid over 12 months (which they do not, they only get paid during their league’s season); that they do not use a single penny of their earnings for living (unlikely unless they have many endorsement deals); and that the entirety of their earnings get put directly into an investment account (also unlikely). Just go with me here.
Technically, Tversky did not win the Nobel, but that’s only because he died in 1996 and Nobel Prizes are not awarded posthumously. Kahneman was awarded the prize for the work the two of them did together decades earlier. For all intents and purposes, I’m considering both of them to be Laureates.
As an aside, there’s a running joke in the science world that Tversky is involved in the world’s fastest IQ test. You let someone begin talking to Amos Tversky and see how long it takes them to realize that Amos Tversky is smarter than them. The quicker they realize it, the higher their IQ.