Going, Going…Gone: Will Medicare Tax Liability Strike Out Shohei Ohtani’s Annual Salary?

Sports fans across the world turned their heads when Shohei Ohtani’s record breaking $700 million contract with the Dodgers was announced. Many people, myself included, were enamored with the figure alone. Ohtani is a generational talent, and it was thought that he would be receiving a contract in the $500-$600 million range. The $700 million contract was even higher than the top baseball analysts had expected.

During contract negotiations both parties work together to achieve an optimal situation for each other. Ohtani and the Dodgers want to win a World Series, Ohtani wants to be paid at the highest market value for his talent and the Dodgers would like to retain as much payroll flexibility as possible, so the team can be competitive in the future. As these goals coincide with one another, a unique contract would need to be designed for both parties to be satisfied in pursuit of their goals.

If Ohtani were to have signed a “standard” contract, Ohtani would be receiving $70 million for each of the 10 years of the contract. While, baseball does not have a salary cap, this payment would have counted towards 30% of Major League Baseball’s (“MLB”) Competitive Balance Tax (CBT) threshold. The CBT, often called a luxury tax, was designed by baseball to discourage teams from accumulating player salaries more than the luxury tax thresholds. Once a team reaches the luxury threshold, they pay this tax penalty which is then pooled and split up amongst the teams with the lowest payrolls in baseball. A standard contract with Ohtani would cause the Dodgers to exceed the annual payroll threshold and subject the Dodgers to an annual luxury tax for the foreseeable future. The solution that Ohtani and the Dodgers agreed to, was to design a deferred contract arrangement.

The “deferred contract” results in a deferred compensation payment structure. Ohtani, his agents, and the Dodgers structured the contract so that $20 million will be paid to Ohtani from 2023-2033 ($2 million per year), with the remaining $680 million deferred amount to be paid from 2034-2043.

The benefit to the Dodgers under this agreement is that under the MLB’s collective bargaining agreement, the calculation of the luxury tax under a deferred agreement is based on the present value of the contract and therefore the Dodgers would save annually $24 million of his annual $70 million salary towards the luxury tax threshold. The Dodgers will also benefit from earning interest income on the money they are required to put aside in escrow each year starting in 2026 to fund the deferred payments starting in 2034.

Even though both parties identified the benefits of the deferred contract arrangement, there are a few financial challenges for both of them.

One financial effect for Ohtani is the time value of money. In Ohtani’s deferred contract, no interest will be due on the $680 million deferred portion of the contract. Therefore, the present value of the contract will be less than advertised. Financial analysts all agree that “a dollar today is worth more than a dollar tomorrow.” Using the present value calculation that baseball used to calculate the yearly salary cap, the present value of the contract is approximately $460 million.

Of course, our focus for this article is to analyze the Federal and State(s) tax effect to Ohtani over the life of his deferred contract including the deferred payments he is to receive over the 10 years after the contract has expired.

Let’s start with his federal payroll tax liability. Like most employees, Ohtani’s gross salary is subject to social security tax and Medicare tax withholding. The Social Security tax withholding is 6.2% on a maximum gross salary of $168,600 for 2024 (the maximum is subject to annual increases).

However, unlike Social Security tax, the annual Medicare tax withholding is based on 100% of the employee’s annual gross salary (with limited exceptions such as employee’s contributions to employers’ medical plans). Certainly, Ohtani is not expecting and will not owe, Federal or State income taxes on the deferred compensation until the later years when he receives the cash, so one would suspect that his annual Medicare tax withholding would also be deferred and be subject to withholding when paid. However, that might not be the case in this situation.

Internal Revenue Code Section 3121 defines when both Social Security tax and Medicare tax are assessed and subject to withholding under a deferred compensation arrangement. Specifically, the law states that these taxes are due in the year that the services have been performed to earn the fixed right to receive the compensation. There are a few limited exceptions to this rule most notably if there is an account balance plan.

Although we do not know the details of the Dodgers deferred compensation plan as it relates to Ohtani, it would appear under the general tax rules mentioned above that Ohtani’s annual Medicare tax withholding would be assessed on a base annual salary of $70,000,000. The employee’s Medicare tax rate is 1.45% on gross salary plus a surtax .09% on gross salary in excess of $200,000. Therefore, Ohtani’s annual Medicare tax withheld from his negotiated $2,000,000 annual cash paid gross salary is $1,643,200 leaving just $356,800 left BEFORE federal and state income tax withholding.

The good news for Ohtani is that federal and state income taxes will be assessed only when the deferred compensation is actually paid.

Next, let’s review his State tax liability.

Ohtani’s deferred compensation arrangement provides him an interesting State income tax planning opportunity that would not have been available had he signed a “standard” contract.

The Los Angeles Dodgers play their home games in California, which has the highest state income tax rate. The highest 2024 individual income tax bracket rate in California is 14.4%. However, Ohtani’s deferred compensation arrangement provides him the ability to save a significant amount of California income taxes on the deferred payments received after his 10-year contract has expired.

Under the deferred compensation arrangement, Ohtani will receive $680,000,000 over ten years or $68,000,000 annually from 2034-2043. Assuming that Ohtani’s 2034-2043 annual deferred payments are classified as an eligible nonqualified deferred compensation plan then under the provisions of Internal Revenue Code 114, these payments would be classified as income earned in his resident State of the year of each annual payment. IRC 114 specifically applies because it requires that there are at least 10 years of equal payments. That condition is satisfied in Ohtani’s contract. Furthermore, Internal Revenue Code section 3405 states that nonqualified deferred compensation plans are to be treated as wages when received and are subject to personal income tax withholding. Under these two sections, states cannot impose an income tax on deferred payments to nonresidents of their State. Therefore, the state taxability on Ohtani’s deferred payments will depend on his state residency in the year of the deferred payment. Alternatively, Ohtani could choose to move back to his home country of Japan and pay no state income taxes in the U.S.

With that being said, regardless of where Ohtani plans to live after he is done playing in 2033, he will still owe federal and possible state income taxes on the deferred payments. However, he will not owe any more Social Security or Medicare taxes.

At Withum, we have a dedicated team that specializes in tax planning and the unique accounting requirements for professional athletes and sports organizations. Our Professional Sports Services Team is expecting to see more creative contracts like this in the future as teams and players start to approach negotiations with a like-minded outlook on how to best achieve their on-field objectives first and financial objectives second.

Author: Matthew Frei | [email protected]