Death and Taxes... Well, Maybe Not Taxes
Over the past week, the ice cold free agent market started to warm up a bit. I wouldn’t quite call it a hot stove yet, but is it fair to start calling it lukewarm? Tepid maybe? The signings of DJ LaMahieu, Liam Hendriks, Pedro Baez, Archie Bradley, etc. as well as rumored union between the Mets and personal favorite Brad Hand have certainly turned the temperature up a bit. There are a variety of reasons that we’re seeing this trend now: Rob Manfred has told teams to prepare for a full 162-game season, the staring contests between players and teams has to end eventually, and spring training is thankfully just around the corner.
But while we may expect the ongoing staring contests to end in one party blinking first, it seems— at least based on the LaMahieu and Hendriks deals— that both sides have decided to call it a draw and put some eyedrops in. Both parties got something out of these deals and made progress toward building better rosters. And in a world where only a handful of teams are even trying to win, this is a welcome surprise.
The common thread between these two deals though is some slick financial footwork to make the luxury tax implications work with the teams strategies. Before getting into the details of either deal, it’s important to review how the luxury tax works in MLB. Unlike the NFL or NBA which have hard salary caps, MLB has what is referred to as a soft cap: after certain thresholds, teams are taxed at increasingly higher rates on the total payroll overage. The first of these thresholds, and the one that most teams have started to consider a hard-cap is at $210M.
Importantly however, in assessing the luxury tax payrolls, teams are taxed on the average annual value (AAV) of the contract rather than on the amount paid to the player in the period in question. This has been set up to avoid blatant luxury tax circumvention such as offering a player a 2 year, $100M contract with year 1 paid at $99M and year 2 at $1M. Instead of enabling teams to shuffle money and restructure contracts by being taxed $99M in one period and $1M in another, teams are taxed $50M in each period regardless of the annual payment.
Taking a look first at the LaMahieu deal, it’s easy to see how both sides came to terms comfortably on this. LaMahieu was looking for Josh Donaldson money: $90 over 4 years. However, the Yankees, who are aiming to avoid hitting the $210M threshold, would prefer to pay him far less. So, the teams worked out an agreement where LaMahieu gets his $90M, but the period fo the payment is extended to 6 years (garnering him job security as well). Thereby, LaMahieu’s luxury tax burden is decreased from $22.5M to $15M and the Yankees benefit by gaining back $7.5M in cap space.
This is a fairly simple example of reducing the luxury tax burden to create a more effective cost structure. As details on LaMahieu’s deal emerge, options, incentives, or other considerations may change the calculus slightly but as it stands now extending LaMahieu a contract for 6 years rather than 4 strengthens the operating posture for the Yankees.
However, where the Yankees/LaMahieu agreement piques our interest in tax burden reduction, the White Sox/Liam Hendriks pact should command our attention. Here, the White Sox— masters of locking up long term talent in Jimenez, Robert, Bummer, etc.— have struck gold again. On the surface, Hendriks’ contract looks simple enough, 3 years at $13M a piece and then a $15M team option for the fourth year brining the total value to $54M over 4 years. For luxury tax purposes, only guaranteed money is considered in AAV, so under a normal structure, Hendriks’ implication should be 3 years at $13M AAV but $15M AAV for year 4 if the option is exercised. However, the rub lies in the buyout, which in Hendriks’ case is valued at $15M: the exact value of his option year but deferred over multiple years.
Therefore, at the end of 3 years, the White Sox have the option to pay Hendriks $15M to pitch for them in 2024 or pay him $15M to leave Chicago. However, since luxury tax considers all guaranteed money, and Hendriks is at least guaranteed the buyout if denied his option, that $15M is taxed along with the base period’s $39M, bringing Hendrik’s AAV to $18M in years 1 to 3. In 2024, if the White Sox pick up Hendrik’s option they would have already paid the tax on the $15M due to him (through the option tax), and therefore would only be liable for the difference in present value between the deferral and the immediate payment (maybe $2M).
By structuring Hendrik’s contract the way the have, the White Sox have essentially created a way to pre-pay the taxes due to Hendriks and reduce their overall tax burden in 2024. To note, in 2024, the White Sox may not have the financial flexibility they have as their young core begins to hit arbitration and is due larger salaries. With the flexibility they have to retain Hendriks at $15M but with only a $2M luxury tax hit, the White Sox can retain that core while remaining under budget and sustain their success for the long haul.
I’m unable to tell now whether this strategy will be viable years from now. MLB does not look fondly upon luxury tax circumvention and may well place a limit on clubs abilities to do this. However, as baseball contracts become more and more complicated with team options, player options, vesting options, sequenced options, deferrals, etc., a strategy like the one Rick Hahn employed in the South Side definitely has a place in this world. Teams want to sustain their window of contention for as long as possible and the ability to avoid large costs enables this. So while the Hendriks contract and the size of his buyout is certainly weird, Rick Hahn’s braintrust deserves credit for finding this contract structure. Like gases, MLB teams will occupy the space of their container: this past week’s contracts are just the latest example of gases finding a gap.