Can anyone emulate Ohtani's $700M LA Dodgers tax dodge?

The worldwide news of baseball phenom Shohei Ohtani’s record-shattering $700 million contract is notable from every angle. Even paid out the regular way, it would be big news. But what made the story even bigger was the peculiar nature of the grand slam sized payout. If the California taxes work out as the young star and his advisers likely intend, it might be a very clever slider lobbed at California’s Franchise Tax Board.

Ohtani reportedly deferred most of his salary under his 10-year contract with the Dodgers. Some sources say it cleverly avoids California’s 13.3% state income tax (which will climb to 14.4% in 2024), as long as the start moves out of state before the big money starts rolling in.

But how solid is that tax plan? You might think that $700 million means about $70 million a year for 10 years. But, Ohtani is taking just $2 million per year, with a back-loaded deal that pays $680 million over 10 years starting in 2034. It may not matter exactly why this was done, though some reports say that the deferred payout lets the Dodgers acquire lots of other talent, avoiding baseball’s luxury tax.

Others suggest that state tax rates are a bigger play. Of course, time is money, and in this case, there is evidently no interest that is payable on the very large deferred pay. Therefore, one could say a chunk of that is really interest. In fact, the tax law (both state and federal) routinely recharacterizes some payments as interest, even if deferred payments do not explicitly involve interest payments, as is occurring here.

But the $64,000 question is whether the state tax gambit works under California law. I’m sure the star player has big-time tax lawyers, so I am speculating here. But it looks to me like Ohtani’s tax play has a good chance of working, shorting the Golden State. Well, for now at least.

California taxes just about everything, including athletes who just dip into the state for a game now and then. And as any former California resident is likely to know, if you leave the state, California’s tough tax agency, the Franchise Tax Board, is likely to come after you. In fact, sometimes California taxes nonresidents who never even visited, claiming that a payment is California source income so it’s taxable by the state, no matter where you live.

For example, if you write a movie script in Iowa but send it to a California studio, you might get a Form 1099 from the studio. California may say that what you were paid is California source income so you need to file a California return, even if you never set foot in California. If you are a California resident, of course, the state gets a piece of all your income. Like the IRS, California taxes its residents on worldwide income earned anywhere. If you are a nonresident, only California-sourced income is fair game.

But the Golden State has a tendency to argue about what is sourced here, when you arrived, when you left, and so on. But with some issues, the federal law trumps California, and that is where Ohtani’s tax plan might kick in. There were many disputes about retirement pay for decades. For years, people earned a good living in California, but left for other states to retire only to find that the Franchise Tax Board was chasing them for California taxes.

But after Dec. 31, 1995, federal law prohibits any state – even California – from taxing retirement income received by nonresidents. It covers qualified retirement accounts such as pensions and 401(k) plans, and some nonqualified deferred compensation plans if certain conditions are met. Ohtani’s contract seems designed to deftly satisfy the necessary conditions.

Therefore, if he moves out of California, as many players and other high income people do before big payments start arriving, he might skip California’s 13.3% rate. Again, the top rate climbs to 14.4% in 2024. That’s a lot of tax at stake. It is true that under California law, athletes and performers must report to the FTB their gross pay for performances in the state, and one fair question here is just how much that is in this case. Indeed, given how little Ohtani is being paid now at only $2 million a year, the back end of his contract is huge.

Could the state’s tax man say that the contract does not fairly reflect his pay for services in the state? It is not hard to imagine California making this argument. According to the Athletic, Ohtani’s salary deferral reduces the present value of his contract to $460 million, not the nosebleed figure of $700 million. As a result, they say only $46 million a year will count toward the Dodgers’ luxury tax calculations instead of $70 million. Perhaps the FTB will notice that too.

For one thing, it is common knowledge that California audits people who leave and who collect a big payday shortly after. Moving sounds easy, but if you aren’t careful how you do it, you could end up saying goodbye only temporarily to California taxes and hello to a residency audit from the Franchise Tax Board. So planning carefully to avoid costly mistakes is key. The FTB monitors the line between residents and non-residents and can probe how and when you left.

California also litigates tax cases regularly, and is known to push the envelope, a kind of “show me the money” approach. California sometimes changes the rules, too. In July of 2023, California – retroactively – said that certain trusts to avoid California tax are outlawed as of Jan. 1, 2023. Is that constitutional? Probably, and fighting it would be very expensive, so most people are taking it seriously. That has caused quite a bit of scrambling.

So even if Ohtani’s contract was designed to avoid California taxes, could the state audit and say, “not so fast?” It is too early to say, but California’s Franchise Tax Board is not shy and California tax disputes are difficult. Most people know that the usual IRS statute of limitations is generally three years after you file a tax return. Less well known is the IRS rule that if you omit 25% of your gross income – and that can include overstating your basis in an asset – the IRS gets six years to audit you.

In California, the FTB gets a minimum of four years to audit no matter what. But the really scary audit period in California is if you never file a California return for a particular tax year. Let’s say you leave California and stop filing in the golden state altogether. Suppose that five or 10 years later, the Franchise Tax Board comes along and says you are still a California resident, or that at least you have some California source income that you failed to report. In either case, the FTB can try to collect, with no statute of limitations.

It can make filing a non-resident tax return – just reporting your California-source income as a non-resident – a smart move. Ohtani has plenty of time to plan ahead about his next move.