Understanding payroll and luxury tax

Matt Gelb

The Phillies Zone

Posted: Thursday, March 1, 2012, 9:33 AM

CLEARWATER, Fla. — They will play Grapefruit League baseball this weekend, the latest sign that meaningful Phillies games are closer. If last season's camp was defined by the hype surrounding Four Aces, much of this early spring has been about money.

How much can Cole Hamels make? Will the Phillies pay him? Can the Phillies fit Shane Victorino and Hunter Pence in the future payroll? How much could a new TV contract in 2016 net the franchise? Is the payroll too top-heavy? Will there be funds for a trade deadline move, if necessary?

This winter, the Phillies said many of their decisions are made under the limitations of the competitive balance tax — a.k.a. luxury tax. The Boston Red Sox and New York Yankees, two teams perennially paying luxury tax, spent less this offseason with the goal of someday squeezing under the cap with the rest of baseball.

A month ago, we attempted to explain how the Phillies were closer to the tax threshold than it appeared. And, unfortunately, it only confused everyone even further. (Apologies are long overdue.)

Our goal is to educate because this is a topic rarely explored and certainly a relevant one. If the Phillies publicly say the luxury tax threshold is a limit, it's best to know as much as we can about the subject.

Hopefully this guide can be used as a reference throughout the season.

I. How is it calculated?

The definition for "payroll" under the newest collective bargaining agreement is as follows: "Payrolls are for 40-man rosters and include averages of multiyear contracts; health and pension benefits; clubs medical costs; insurance; workman's compensation, payroll, unemployment and Social Security taxes; spring training allowances; meal and tip money; All-Star game expenses; travel and moving expenses; postseason pay; and college scholarships."

Some of that, we cannot account for. But we can gain an idea of the biggest expenses, which total probably around 98 percent of the payroll.

The majority of payroll comes from the average annual value (AAV) of every contract on the 40-man roster plus medical benefits and performance bonuses. That is a different definition than the typical way of computing payroll by how much the team is actually paying a player in a given season.

For example, Ryan Howard will earn a $20 million salary in 2012. But he counts for $25 million against the luxury tax because the AAV of his deal includes the $10 million buyout for a 2017 option. AAV accounts for all guaranteed money in a contract; Howard is guaranteed that $10 million whether the option is exercised or not. Thus, the $25 million figure.

The final numbers are not computed until the end of the season. Thus, whatever the figures are now, it can all change come October. Last season, according to a baseball source, the Phillies were less than $1 million shy of the luxury tax limit. (Two payments from the Houston Astros 1 totaling in approximately $8 million as conditions of the Roy Oswalt and Hunter Pence trades allowed the Phillies to stay under.)

What's important

to note are expenses beyond the 25-man roster salaries, all of which count toward that $178 million cap.

A baseball source said the annual expense for medical benefits typically runs between $10 and $11 million per season. We'll split it down the middle for our purposes and say $10.5 million.

All players on the 40-man roster must be accounted for. We'll use Joe Savery as an example. He's on the 40-man roster for the first time and signed to a split contract. So his major-league salary is the minimum of $480,000 and his minor-league salary is $78,250. If he spends the entire year on the Phillies (or the major-league disabled list), he will count $480,000 toward the final payroll. So however many days he spends in the majors, he'll earn a prorated portion of the $480,000, and when he's in the minors, he'll earn a prorated portion of $78,250. Whatever the total is, it counts toward the final figure because Savery is on the 40-man roster.

That's where the "40-man roster" figure comes from on the forthcoming worksheet. It's a rough estimate of the combined salary earned by all of the 40-man roster players not on the 25-man roster when the season ends. 2

The bonuses figure is also an estimate. Performance bonuses can take many forms. Some players, like Kyle Kendrick, have incentives for games started and appearances made. Most of the core star players have award bonuses and All-Star bonuses. To name just a few from last season: Cole Hamels earned $50,000 for making the All-Star team. Placido Polanco made $50,000 for winning a Gold Glove. Roy Halladay added $75,000 for finishing second in Cy Young Award voting.

II. What are the penalties?

Under the new collective bargaining agreement, the luxury tax threshold will remain at $178 million for 2012 and 2013. In 2014, it will climb to $189 million.

One notable change to the system in the CBA was the addition of punitive penalties. Repeat offenders will pay a higher tax each time. Teams are taxed for the dollars over the threshold. So if a team is $5 million over, the tax rate is applied to that figure, not the entire payroll.

The tax rates for 2012 are such:

First-time offenders: 20 percent

Second-time offenders: 30 percent

Third-time or more offenders: 42.5 percent

Those rates change beginning in 2013:

First-time offenders: 17.5 percent

Second-time offenders: 30 percent

Third-time offenders: 40 percent

Four-time or more offenders: 50 percent

The Phillies have said they wish to avoid paying luxury tax not simply for the actual tax dollars but to avoid the draconian penalties that follow.

Logically, it would make most sense for the Phillies to be amenable to paying the luxury tax in 2013 because with the higher ceiling in 2014, they could avoid paying an increased penalty. Once a team skips a year in paying luxury tax, they receive amnesty and return to the original rate of 17.5 percent.

No National League team has ever paid luxury tax.

III. Where do the Phillies stand in 2012?

Here is a worksheet 3 detailing the Phillies current budget commitments (all figures in millions) for 2012:

Source: www.philly.com

Category: Taxes

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