December is an exciting month for sports fans, particularly New York sports fans. The area’s football teams are both bidding for playoff berths; 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 a buzz with the potential of free agent signings.
This year’s biggest baseball free agent star is pitcher Cliff Lee. And to no surprise the New York Yankees are among the few teams bidding for his affection. The Angels, Rangers, and Yankees have all reportedly “pitched” Cliff Lee and have offered him a king’s ransom to play for their team.
Each of the three teams courting Mr. Lee has something different to offer. California has beautiful weather; Texas has no state income tax; and New York has an opportunity to earn millions of dollars above a baseball contract in endorsements and sponsorships. There is little doubt that in addition to his agent, family, and friends Mr. Lee is getting plenty of advice from a variety of marketing, legal, and tax professionals.
Even though I have not been asked, I thought I would give my two cents to Mr. Lee’s quandary. Cliff, stay away from New York. It could be your financial ruin.
Assume 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 compute that during 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 just suppose Cliff Lee decides shortly thereafter that he would be happier living as a bachelor in New York City. Unlike any other state in the union, New York State provides equitable distribution for the enhanced earnings capacity acquired during marriage; a concept that the future ex-Mrs. Lee will shortly learn.
The enhanced earnings capacity (commonly referred to as EEC) is computed as the present value of the enhancement in earnings over an expected work life. In Lee’s case, this expectancy would extend over the next seven years of his new contract and may proceed for many years thereafter, if he should be fortunate enough to become a coach, commentator, or television analyst after his playing days are over.
The approach to calculating the enhanced earnings capacity in New York State was established in 1985 as a result of a New York Appellate Court’s 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 employed to this calculationspecific to Cliff Lee can be broken down into five steps:
- Determine Cliff Lee’s earnings capacity at the commencement of the hypothetical divorce action, resulting from signing with the NY Yankees. This is referred to as Top-Line Earnings.
- Determine Cliff Lee’s earnings capacity if he had not become a baseball phenom and continued the career path chosen at the time of marriage. This is referred to as Base-Line Earnings.
- Compute the after-tax earnings of the Top-Line and Base-Line amounts by applying federal, state and local income tax rates, as well as the social security and medicare tax.
- The difference between the net after-tax earnings of each earnings base is the net enhanced earnings capacity attributable to his record setting contract.
- Compute the present value of the net enhanced earnings capacity over his NY Yankee contract.
For illustrative purposes, let’s assume that Cliff Lee had a bachelor’s degree at the time of marriage. Let’s further assume that a white male with a bachelor’s degree, living in New York City at Mr. Lee’s current age would earn $125,000 per year. This is the amount considered as a proxy for Base-Line earnings.
The following table illustrates the after-tax earnings of both the Top-line and Base-Line amounts; as well as the annual net enhanced earnings capacity.
|(-) Federal Income Taxes||-9,256,731||-24,333|
|(-) State/City Income Taxes||-3,784,335||-12,019|
|Net After Tax Earnings
|Net Enhanced Earnings 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 rate of interest is between 2% and 4%. The courts have historically accepted 3% as the present value factor applied in this computation; but in recent cases have considered rates between 5% and 10%. The present value discount rate is very important. As the present value discount factor increases, the total enhanced earnings computation decreases.
Based upon these computations, the enhanced earnings capacity attributed to Cliff Lee’s potential seven year contract with the NY Yankees is $102 Million (Rounded). The following table illustrates this computation.
||Net Enhanced Earnings Capacity||Present Value Discount Factor @ 3%||Net Present Value|
Since New York is an equitable distribution State, a portion of this amount would belong to his soon to be ex-wife. In some instances the courts have awarded as much as a 50% share and in others as little as 10%.
As you can imagine, there are a variety of things Cliff Lee has to consider when deciding which mound to call home next year. Will he flourish in the California sun; the familiarity of Texas home cooking; or the cement jungle of New York City. Only time will tell. But what we do know is this – getting divorced in New York State after signing a record setting free agent contract could be more painful than losing in the World Series to the San Francisco Giants.