December is an exciting month for sports fans, particularly New York sports fans. Area soccer teams are vying for playoff spots; Basketball and hockey fans are settling in with mixed feelings about their team’s early performance; and Major League Baseball’s “hot stove” league is buzzing with the potential for free-agent signings.
Baseball’s biggest free agent star this year is pitcher Cliff Lee. And it’s no surprise that the New York Yankees are among the few teams bidding for his affection. The Angels, Rangers and Yankees have reportedly “thrown” Cliff Lee and offered him a king’s ransom to play on their team.
Each of the three teams courting Mr. Lee has something different to offer. California has beautiful weather; Texas has no state income taxes; and New York has the opportunity to make millions of dollars on top of a baseball deal in endorsements and endorsements. There is no doubt that, in addition to his agent, his family, and his friends, Mr. Lee is getting a lot of advice from a variety of marketing, legal, and tax professionals.
Although I haven’t been asked, I thought I’d do my bit for Mr. Lee’s dilemma. Cliff, stay away from New York. It could be financial ruin for him.
Suppose Cliff Lee signs with the Yankees for seven years at $25 million per year and contracts for an additional $5 million per year for marketing. It doesn’t take a forensic accountant to calculate that over the next seven years he will earn $210 million. But suppose Lee, A-Rod and Jeter go out one night to celebrate a big win over their arch-rivals, the Boston Red Sox. We all know that Alex Rodriguez and Derek Jeter are magnets for beautiful women. And suppose Cliff Lee decides soon after that he would be happier living as a bachelor in New York City. Unlike any other state in the union, New York State provides an equitable distribution of increased earning capacity gained during marriage; a concept that the future ex-Mrs. Lee will soon learn.
Improved earning capacity (commonly known as EEC) is calculated as the present value of the improvement in earnings over an expected working life. In Lee’s case, this expectation would extend for the next seven years of his new contract and may continue for many years thereafter, should he be lucky enough to become a coach, commentator or TV analyst after his days are up. As a player.
The approach to calculating enhanced earning capacity in New York State was established in 1985 as a result of the New York Court of Appeals’ decision in O’Brien v. O’Brien. This concept was later reaffirmed in 1995 in the New York Court’s decision in McSparron v. McSparron; as well as many other cases that followed. The methodology used for this specific Cliff Lee calculation can be divided into five steps:
1. Determine Cliff Lee’s earning capacity at the start of the hypothetical divorce action resulting from signing with the NY Yankees. This is known as top line earnings.
2. Determine Cliff Lee’s earning capacity if he had not become a baseball phenomenon and pursued his chosen career at the time of marriage. This is known as baseline earnings.
3. Calculate the after-tax earnings of the top line and base line amounts by applying federal, state, and local income tax rates, as well as social security and health insurance tax.
4. The difference between the net earnings after taxes of each earnings base is the enhanced net earning capacity attributable to your record contract.
5. Calculate the present value of the enhanced net earning capacity on your NY Yankee contract.
For illustrative purposes, let’s assume that Cliff Lee had a bachelor’s degree at the time of the marriage. Let us further assume that a white male with a bachelor’s degree, living in New York City at Mr. Lee’s present age, would earn $125,000 per year. This is the amount that is considered as an indicator of baseline earnings.
The following table illustrates the after-tax earnings of the top line and base line amounts; as well as improved annual net earnings capacity.
Top Line Earnings
Baseline Earnings
Earnings before taxes 30,000,000 125,000
(-) Tax/Medicare -441,622 -8,434
(-) Federal Income Taxes -9,256,731 -24,333
(-) State/City Income Taxes -3,784,335 -12,019
Net earnings after taxes
16,517,312
80,214
Enhanced Net Earning Capacity 16,437,098
A present value discount rate is designed to reflect the value of money in a relatively risk-free investment. Economists, financial analysts and accountants generally agree that the real interest rate is between 2% and 4%. Historically, the courts have accepted 3% as the present value factor applied in this calculation; but in recent cases rates between 5% and 10% have been considered. The present value discount rate is very important. As the present value discount factor increases, the total enhanced earnings calculation decreases.
Based on these calculations, the highest earning capacity attributed to Cliff Lee’s potential seven-year deal with the NY Yankees is $102 million (rounded). The following table illustrates this calculation.
year
Enhanced Net Earning Capacity Present Value Discount Factor at 3% of Net Present Value
1 16,437,098 0.97087 15,958,348
2 16,437,098 0.94260 15,493,541
3 16,437,098 0.91514 15,042,273
4 16,437,098 0.88849 14,604,149
5 16,437,098 0.86261 14,178,785
6 16,437,098 0.83748 13,765,811
7 16,437,098 0.81309 13,364,865
Total
102,407,772
Since New York is an equal distribution state, a portion of this amount would belong to his future ex-wife. In some cases, the courts have granted up to 50% participation and in others as little as 10%.
As you can imagine, there are a variety of things Cliff Lee needs to consider when deciding which mound to call home next year. Will it flourish in the California sun; the familiarity of Texas home cooking; or the concrete jungle of New York City. Only time will tell. But what we do know is this: Divorcing in upstate New York after signing a record free agent contract could be more painful than losing in the World Series to the San Francisco Giants.
For more information on the calculation and application of the Enhanced Earning Capacity calculation, including our Enhanced Earning Capacity Questionnaire, please visit our website at http://www.msgcpa.com.
