Often times, professional athletes are paid a signing bonus. Their contract may specify how much money they make each year throughout the term of their contract, but they also may receive a large, lump sum payment up-front, just for signing their name to the contract. While this rarely occurs for rank and file employees in the American work force, there are several other professions where this is common.
Many doctors are paid a signing bonus, sometimes in the form of a direct check and sometimes their employer pays off the doctor’s student loans as an inducement to join the hospital or medical practice. Sales people and executives also receive signing bonuses many times when they switch companies. Because these employees receive a large portion of their income in the form of commissions and bonuses which take time to build up, a new employer who is recruiting the sales person often has to pay them a signing bonus to make it worth walking away from commissions or bonuses from their current employer that they would forfeit by leaving.
Sounds like a great deal to the untrained eye – “You mean I get paid before I even do any work!” Not so fast, these signing bonuses almost always have to be paid back if the athlete, doctor, sales person, or other employee does not perform under the contract. For example, the doctor may receive a $100,000 signing bonus on day one of her new job, but the contract that she signs to receive that signing bonus requires her to work for the hospital for 5 years. If the doctor leaves the hospital for any reason after two years, then she must pay back $60,000, 60% of the signing bonus, because she only provided 40% (2 of the 5 years) of the services required by the contract. This happens with athletes, as well, and has been well publicized for athletes who become ineligible to play in the league due to suspensions for various offenses.
The taxation of these signing bonuses can be harmful if misreported. In our example of the doctor who received the $100,000 signing bonus for promising to work for at least 5 years, she has an obligation to repay any amount that is unearned by her early departure. This means that although she received the cash on day one, she did not receive any taxable income in year one, what she really received was a $100,000 loan. If she never worked a day at the hospital, then she would have to repay the full loan amount. However, if she works the first year, then $20,000 of the loan is forgiven, which is treated as though she earned $20,000 in the first year and she therefore must report $20,000 of earned income in the first year. Each subsequent year would be treated similarly. Spreading $100,000 of income out over 5 years is beneficial to the doctor because she may stay in a lower tax bracket in the first year than if she had an additional $80,000 of income that year, and also because she can defer the payment of those taxes. If she was unaware of this concept, then she would report an extra $80,000 of taxable income in the first year that she didn’t have to!
Most Americans are familiar with our favorite uncle, Uncle Sam, who taxes all income earned in the US, and for US citizens, taxes all worldwide income. Thus, anyone earning money in the US, with the exception of very low income earners, must file a federal tax return and pay federal income tax on their income. Additionally, anyone who earns income in one of the many states that levies an income tax must allocate their income between the states where it was earned, file a state tax return for each state, and pay tax to that state. The majority of Americans earn all of their income in the state where they live, so they only file one state tax return. However, the professional athletes, who play road games against 28-32 other teams, earn a portion of their income with each game that they play. Therefore, portions of their income are earned in many different states, and maybe even in another county – think Toronto Raptors. There are plenty of other professions in which people travel for work, or earn income in various states as a result of specific types of income, like rental real estate. These Americans, like their athletic counterparts, must also allocate their income by state, file state tax returns, and pay taxes to each state. On top of that, there are even some municipalities that levy an income tax for any income earned in their city, town, or county, which is in addition to the state and federal income tax.
Here is a systemic difference between professional athlete’s income and the average American worker. Many professional athlete’s contracts now provide for at least some amount of guaranteed income. Professional athletes, perhaps more than any other profession, have a high risk of disability due to injuries. There are several reasons for this. First of all, some of the sports are quite dangerous in themselves and come with a higher risk of injury to any participants. Secondly, professional athletes’ job descriptions require such a highly-tuned level of performance that an injury that might not keep a forklift operator off his forklift, or a computer programmer away from his computer desk, will keep an athlete off of the field. Similar to most other industries, if you are not able to work and contribute to the company, then you are not worth anything to the company and they don’t want to pay you. The difference, however, is that the average American worker who becomes disabled and doesn’t go to work simply doesn’t get paid. The professional athlete on the other hand, has probably negotiated a contract that will pay them a minimum level of income even if they are injured and cannot play.
Here is the fortunate and unfortunate news for most American workers: The fortunate news is that although most American workers cannot contract with their employer to get paid even if they can’t work, they can contract with a disability insurance company to replace their income for them if they cannot work. The unfortunate news is that most Americans do not contract with insurance companies for disability income insurance, and when they get hurt or sick and can’t work, they simply go bankrupt. Of course, if one studies the financial lives of professional athletes, they would find than an alarming number of them file bankruptcy, too, except theirs is usually a result of reckless spending and poor investment choices. Considering that nearly anyone could purchase disability income insurance, not doing so could be considered reckless. I guess we’re not all that different after all…