November 2, 2014

Julio Vega22115 NE 182nd Ave.Los Angeles, California 95051

Dear Julio,

You played excellently in last night’s game. Thank you very much for the tickets; my friends and I had a wonderful time cheering you on.

Last Thursday, you requested advice and information regarding the tax consequences of income earned in previous years as a college student, as well as possible tax strategies that minimize your tax liability as a professional athlete. You are also looking to financially secure your future, as you have no plans after retiring from professional baseball to be a sports announcer. In this letter, I will explain the tax consequences of your legal status in the US, strategies to postpone taxes on your salary and bonuses, the tax treatment of your fringe benefits, investments, planning for retirement, and the tax implications depending on whether or not you plan to reside in the US after retiring. Note that some of my tax advice is based on the assumption that you signed the Uniform Player’s Contract used by the Major League Baseball Players Association (MLBPA), the union of professional baseball players.

Residency

When you were a student at State University, you were treated as a nonresident alien and taxed at normal US rates only on income that could be effectively connected to a US trade or business.1 This would include any income you earned from your position on the college baseball team as well as any taxable portions of scholarships or grants that you received.2 Other types of US source income that aren’t effectively with a US trade or business, such as dividends, rents, royalties, and annuities, would be taxed at a flat 30% rate, since the Dominican Republic has no tax treaty with the US.3 Fortunately, any interest income received from portfolio investments is not subject to the withholding tax.4

Now that you have become a successful professional baseball player, you will likely be treated as a resident alien for US tax purposes, meaning that like US citizens, your income from sources all over the world will be subject to the US federal income tax.5 To qualify as a resident alien, you must satisfy either the green card test or the substantial presence test, or make a first year election if applicable.6 The green card test simply means that you were legally admitted into the US under the US immigration law, and your status hasn’t been revoked.7 The substantial presence test is a bit trickier. When you were a student, none of the days you were present in the US will count towards this test.8 As a professional athlete, however, you will be treated differently.

1 §7701(b)(5)(A)(iii); Reg. §1.871-1(a)2 Reg. §1.871-9(b)3 §871(a)(1); Reg. §1.871-7(a)(1)4 §871(h)(2)5 Reg. §1.1-1(b); Reg. §1.871-1(a)6 §7701(b)(1)(A)7 §7701(b)(6)(A); Reg. §301.7701(b)-1(b)8 §7701(b)(5)(A)(iii)

Let’s assume that for 2014, you will be in the US for 240 days, or almost 8 months. You’ve met the first requirement of the substantial presence test, which is to be in the US for at least 31 days.9 Let’s also assume that for the past two years, 2013 and 2012, you are no longer a student and have been a professional baseball player, staying in the US for 240 days as well. Using the required equation, take the number of days you were in the US in 2012 – 240 days – and divide by 6; this is 40. Take the number of days you were in the US in 2013 – also 240 days – and divide by 3; this is 80. Now, add 40 and 80 to the number of days you’ll be present this year – again, 240 days; the total is 360 days. If the resulting number is equal to or greater than 183 days, as it is here, then you’ve passed the substantial presence test.10

If you choose to maintain your primary residence in the Dominican Republic, you will be considered a nonresident alien unless you meet the substantial presence test or you have a green card. While you would be taxed only on income from US sources, you will be unable to deduct any living and traveling expenses incurred while traveling between the two countries.11 Additionally, you would need to allocate your salary between US source and non-US source; the portion of the salary that would be considered US source income is the fraction of the number of days you played baseball in the US over the total number of days of the season.12 If you failed to establish the specific number of days you worked in and outside the US, the entire amount of the compensation will be treated as coming from US sources.13

I recommend that you maintain your status as a resident alien, as it is likely that you will be living in the US for quite a number of years for your professional career. Resident aliens of the US receive all the tax benefits, deductions, and credits as US citizens to offset the tax; nonresident aliens qualify for much fewer benefits. Unless you have a strong personal presence for maintaining closer ties to the Dominican Republic, your tax planning strategy will go more smoothly if you are a US resident alien.

Compensation

After being drafted in the first round by the Major League Baseball, you receive an offer of $1.5 million per year, a bonus for signing, and bonuses based on the number of innings you played in and the number of strike outs you caused. The offer also includes fringe benefits such as health and dental insurance, life insurance, a team car, a clothing allowance, a travel allowance for you and your family, free tickets to the games, and training and fitness coaching as needed. A retirement plan would be separately negotiated at a later time.

The $1.5 million salary per year is compensation for the services you perform for your baseball team, and thus included in your gross income.14 The amount of the signing bonus is treated as taxable ordinary income in the year received as compensation for the promise to perform for the baseball team, since your contract doesn’t have guaranteed years.15 The incentive bonuses based on the number of innings you play and the number of strikeouts that occur are also treated as taxable compensation includible in your gross income in the year you earn them. However, it is important to note that the MLB disallows contracts that contain bonuses for playing, pitching or batting skills; therefore, the incentive bonus for the number of strikeouts you make is invalid.16 Talk with your sports agent and your baseball club employer to ensure that your Uniform Player’s Contract is valid under MLB rules. You also mentioned that you were pulled from the last

9 §7701(b)(3)(A)(i)10 §7701(b)(3)(A)11 Stemkowski, 690 F2d 40 (CA 2, 1982)12 Rev. Rul. 87-38, 1987-1 CB 17613 Speck, 28 Fed. Cl. 254 (Ct Fed Cl, 1993)14 §61(a)(1); Reg. 1.61-2(a)(1)15 Rev. Rul. 55-727, 1955-2 CB 2516 Major League Rule 3(b)(5)

game by the field manager; you were four innings away from qualifying for your innings played incentive bonus. If you feel that your treatment was unfair, you can discuss the potential grievance with a club representative, and if no agreement can be reached, you can file a grievance alleging the manager’s lack of compliance with your contract, which will be decided by a panel of up to three impartial arbitrators.17

Typically, you are required to report on your tax return the compensation you’ve received for the year.18 However, there are ways that would allow you to defer the income and avoid taxes until a later date. The Basic Agreement between the Major League Baseball and the union stipulates that you’re allowed to defer compensation, but does not specify the type of arrangement.19 It is likely that the compensation you elect to defer will be to a nonqualifed deferred compensation plan; deferred compensation is excluded from gross income.20 Once distributions are eligible to be paid out, the contributions and the earnings are thus taxable.21

Another way to postpone income taxes is by participating in a qualified cash or deferred arrangement (CODA) offered by your employer that allows you the option to make a contribution to a trust or plan similar to retirement plans.22 The MLB offers such §401(k) plans – a defined contribution plan with a profit-sharing component – for their players. If you make choose to make contributions to a qualified CODA, those amounts will not be included in your gross income.23 These are also called elective contributions, and are treated as if they were contributed to the plan by your employer.24 Taxation of the contribution amounts, as well as any related investment gain, will be postponed until they are distributed in the future.25 This also allows for another advantage: once you retire, you will likely be in a lower tax bracket, which means lower tax rates than you would pay today. Remember that these contributions must come from your compensation for the professional baseball services you provide to your employer, such as the $1.5 million yearly salary or your bonuses; contributions from other sources of income, like investment income, are not allowed.26 Whether a CODA is qualified or nonqualified depends on your employer, so be sure to ask.

There are several restrictions and limitations for CODAs. Similar to qualified retirement plans, there is a limit to how much you can contribute tax-free, as well as when you are allowed to receive distributions from the trust. While your contract likely stipulates that there is no limitation as to the amount of compensation you can defer, elective contributions are tax-free up to $17,500 for the tax year 2014, and any elective deferrals that exceed the limit will be included in gross income to be taxed.27 You have until April 15 of the following year to remove the excess contribution amounts; after the deadline, it will be taxed once as a part of this year’s gross income, and again at distribution in the future.28

Distributions from a qualified CODA aren’t allowed until you reach the age 59.5, or if you die, suffer a disability, are severed from your employment, or encounter hardship, or if the plan is terminated.29 If you’re traded to another baseball team, this is not considered severance from employment. Severance from employment only occurs if you’re no longer an employee of your baseball team, which maintains the

17 Basic Agreement, Article XI.A18 §451(a); Reg. §1.451-1(a)19 [Basic Agreement, 2012-2016, Article XVI]20 [§409A(d)(1) & (a)(1)(A)(i); Reg. §1.409A-1(a)21 [§409A(d)(5)22 Reg. §1.401(k)-1(a)(2)(i)23 Reg. §1.402(a)-1(a)(1)(i)24 Reg. §1.401(k)-625 §402(a)26 Reg. §1.401(k)-1(e)(8); Reg. §1.415(c)-2(b)(1)27 Reg. §1.402(g)-1(d)(1); §402(g)(1)(B)28 §402(g)(6); Reg. §1.402(g)-1(e)(8)(iii)29 §401(k)(2)(B)

CODA plan.30 If you are suddenly exposed to a large, immediate financial expense and need to pay it off, you are allowed to make early withdrawals from your CODA account to pay it off.31 Depending on the facts and circumstances surrounding a possible hardship circumstance, anything from medical expenses to tuition to funeral costs can apply.32 You are only allowed to withdraw enough money to cover those required expenses; excess distributions are subject to penalties.33 It is important to remember that the amounts you withdraw for hardship will be included in your gross income.34 Early withdrawals are subject to a 10% penalty.35 Otherwise, once you reach 59.5 years, you are free to distribute the money as you wish.

As you mentioned in our initial meeting, you do not mind postponing your enjoyment of your income as long as it means that you will be financially secure in your future. The nonqualifed deferred compensation plan is a great opportunity for you to defer taxes while guaranteeing a steady income after retirement. CODAs would be very helpful in this endeavor, but unfortunately, you are very limited in the amount of compensation you can defer. I recommend that you talk with your sports agent about whether or not your employer offers these services.

You may also be entitled to additional earnings depending on your team’s performance through the championship season. The MLB creates a large pool of money from ticket revenues and allocates it to various winners and losers of the World Series and three other titles. If you received pool money as a part of the winning team of the World Series, you should include it in your gross income, as it is an award for your athletic achievement.36 If you receive money from the pool as part of a losing team, this is similar to being a lottery winner, since it is based heavily on chance; the money would be included in your gross income as prize money.37

Fringe Benefits

The fringe benefits are generally taxable, with various exceptions.38 The free tickets you receive for each baseball game from your employer are not taxable, as there is no substantial additional cost incurred by your employer in providing those tickets to you.39

The team car provided for your use will either be a taxable fringe benefit for personal use or a nontaxable working condition fringe benefit.40 If you use the car primarily for personal purposes, such as getting groceries or visiting friends, then you will be taxed on the fair market value of leasing the car.41 To qualify as a nontaxable benefit, consider if you would have been able to deduct the costs if you had bought it yourself. If you had purchased the car and used it mainly to drive to the stadium for training or to attend games, then you would have been able to deduct the costs as business expenses. Thus, the team car would qualify as a working condition fringe benefit.42 Make sure to record your use of the car in order to have

30 Reg. §1.401(k)-1(d)(2)31 §401(k)(2)(B)(i)(IV); Reg. §1.401(k)-1(d)(3)(i)32 Reg. §1.401(k)-1(d)(3)(iii)(A) & (B)33 Reg. §1.401(k)-1(d)(3)(iv)(A)34 §402(a)35 §72(t)36 Paul Hornung, 47 TC 428, 196737 §74(a)38 §61(a)(1); Reg. 1.61-2(a)(1)39 §132(a)(1) & (b)(2)40 §132(a)(3); Reg. §1.61-21(a)(1)41 Reg. §1.61-21(b)(4)(ii)42 §132(d); Reg. §1.132-5(b)(1)

proof of when and how long you used it for work-related activities.43 Your employer may also keep track of everyone’s business use of the car.44 On the other hand, if you notice that your employer has included the value of using the car in your gross income, you must have detailed records in order to be eligible for the deduction.45 How your employer treats the car for tax purposes will affect you, so make sure to speak to someone in your organization about it.

The MLB Players Benefit Plan includes a Welfare Plan for which you are eligible after just one day of active service.46 It funds medical, dental, vision, accident, and life insurance for MLB baseball players, as well as their spouses and dependents.47 If you have at least 4 years of service within the MLB, you will have indefinite, lifetime coverage.48 Certain medical expenses, such as the cost of surgery, hospital stay expenses, or physical therapy, will be 100% covered, while other medical expenses will be covered after a $5,000 deductible.49 You will exclude from gross income the premiums paid by your employer for your health and welfare plan.50

Life insurance is also included in your fringe benefits. In general, if your employer pays the premiums on life insurance for you, you must include it in gross income, where it will be taxed.51 Each baseball club of the MLB participates in the League-wide Player Life Insurance Program, which insures the life of each player. Since your employer is the owner and designated beneficiary of the life insurance, the premiums paid by your employer are not included in your gross income, as your estate would receive no benefits.52 You are also eligible for life insurance covered by the MLB Player Benefits Plan once you have at least 60 days of active service.53 While you’re an active player, you’ll have life insurance benefits of $300,000; after retirement, life insurance benefits are $25,000, payable to beneficiaries.54 These death benefits will not be taxable to you.55 Talk with your employer to know what you are entitled to receive.

Generally, you are allowed to deduct any ordinary and necessary business expenses incurred.56 Unfortunately, the travel expenses incurred by your family are not deductible because they are not connected to you playing baseball. Unless you can provide a legitimate business purpose for your parents to accompany you to away games, the travel expenses incurred by your parents and paid for by your employer is included in your gross income.57

The MLB offers accountable plans, so your allowances for clothing and travel will be excluded entirely from gross income, although you will not be allowed to deduct the expenses.58 To qualify as an accountable plan, the allowances you received must only be used for expenses in connection with playing baseball, such

43 Reg. §1.274-5T(e)(1)(i) 44 Reg. §1.274-5T(e)(2)(ii); Reg. §1.274-6T(a) 45 Reg. §1.274-5T(e)(1)(ii) 46 Major League Baseball Players Benefit Plan (MLBPBP), Section 3.8, 199747 MLBPBP, Section 1 & 248 MLBPBP, Section 13.1 & 13.4(e)49 MLBPBP, Section 14.3 & 450 §106(a); Reg. §1.106-1(a)51 Reg. §1.61-2(d)(2)(ii)(A) 52 Rev. Rul. 68-99, 1968-1 CB 193; David Centre, 55 TC 16 (1970)53 MLBPBP, Section 12.154 MLBPBP, Section 12.2 & 12.555 Reg. §1.79-1(a)56 §162(a) 57 Gotcher, 401 F2d 118 (CA5 1968)58 Reg. §1.62-2(c)(4); Basic Agreement, ArticleVII.B(5)

as buying new uniforms or paying for a hotel for away games.59 As a portion of your travel allowance may be spent on your family, that amount will be included in your gross income; the remainder still satisfies the business connection test.60 The expenses must also be substantiated with evidence, and any remainder of the allowance that hasn’t been spent must be returned to your employer.61

The hometown of the baseball team you belong to will be your tax home, as it is where you conduct your business; thus, any lodging or meal expenses incurred while staying in your tax home are not deductible.62 If your primary residence is different from your tax home, any travel expenses between the two locations are also nondeductible, and any allowances for the expenses provided to you by the club will be taxable income.63

Your contract also provides you with all the coaching and training that you need. The tax consequences of this benefit are trickier, as they depend on whether you primarily reside in the US or in another country and whether your contract covers your services in the off-season. In a case regarding a professional hockey player, deductions for off-season conditioning and fitness expenses incurred were allowed, as long as they related to the business of hockey, and were not for leisure, like golfing or bowling.64 However, any athletic facilities provided for your use by your employer on business premises are treated as nontaxable fringe benefits.65 In your case, it seems as if the coaching and fitness staff and equipment are provided to you in order to stay in the physical condition that your baseball team requires, and it is also mentioned in your contract. It is unlikely that you will need to include the cost of coaching and training in your gross income.

Retirement Planning

Your contract also offers a retirement plan, a separate benefit to be negotiated later. The cost of any qualified retirement planning service provided by your employer is a fringe benefit that is not included in your gross income.66 Qualified retirement planning services mean retirement planning services provided to you (and a spouse, if applicable) by your employer, who maintains a qualified employer plan.67 Qualified employer retirement plans include qualified pension plans68, qualified annuity plans or contracts69, simplified employee pension plans, or simple retirement accounts.70 These, and others, provide a wide range of options as you prepare for your retirement.

Qualified pension plans are either defined contribution plans or defined benefit plans.71 Your contract provides you with a defined benefit pension plan that you qualify for after just a one day vesting period.72 Defined benefit plans promise to pay you a set amount that can be specifically determined based on a variety of factors, like age or years of service.73 The pension plan offered by the MLB will pay you monthly

59 Reg. §1.62-2(d) 60 Reg. §1.62-2(d)(2) 61 Reg. §1.62-2(e) & (f) 62 §62(2)(b); §162(a)(2); Gardin, 64 TC 1079, (1975) 63 M. M. Wills, 411 F2d 537 (CA 9, 1969). 64 Stemkowski, 690 F2d 40, (CA 2,1982) 65 §132(j)(4) 66 §132(a)(7) 67 §132(m)(1) 68 §401(a)(1) 69 §403(a) & (b) 70 §408(k) & (p) §132(m)(3); §219(g)(5) 71 §414(j) 72 MLBPBP, Section 3.9(d)(iii)73 §414(i); Reg. §1.401-1(b)(1)(i)

retirement benefits once you retire; benefits are determined based on your retirement age and your years of service in the MLB.74 Your annual retirement benefit received can’t exceed $210,000 for 2015.75 Contributions made by your employer to the qualified pension plan, as well as the earnings on the contributions are not taxed until they are distributed to you in the future.76

Investments

When you decide to retire from professional baseball, you wish to have a comfortable and secure financial future. As English is not your first language, you don’t plan on taking another job, such as broadcasting for sports games. It is very important that you decide now whether you wish to apply for US citizenship, remain a resident alien, or move back to your home country, the Dominican Republic. Investing in US sources as a US citizen or resident ensures that you will be taxed at the normal US rates. As a US citizen or resident alien, you will be taxed at different rates depending on the type of investments you make.

You also become eligible for the MLB Players Investment Plan once you sign a Uniform Player’s contract with a baseball club.77 Once you have at least 60 days of service, you’re allowed to accept contributions of up to $7,500 per year, as allocated to your account by the pension committee; contributions are invested, and investment earnings are allocated pro rata to you.78 You’ll receive a lump-sum distribution from your investment plan account when you retire, or it can go to a designated beneficiary.79

There are countless other possibilities for investment. You can invest in bonds, stocks, capital assets, partnerships, or mutual funds, among other options. If you purchase any state or local bonds, the interest income you earn is completely tax free.80 Otherwise, interest income is included in gross income.81 Income from royalties, dividends, and capital gains are likewise included in gross income.82

Expatriation

If you are a resident alien at the time you retire and you plan on returning to the Dominican Republic, you may face tax consequences as a result of terminating your long-term US residency as an expatriate.83 To be treated as an expatriate, you must have been a long-term US resident for at least 8 out of the last 15 years before the expatriation date.84 If you are a covered expatriate, determined by meeting one of three tests, you are subject to tax on property owned, with a few exceptions, such as your pension plan, your IRA, or your CODA. A covered expatriate either has a net worth of at least $2 million on the date of expatriation,85 average annual net income tax for the last five years that exceeds $157,000 per year,86 or can’t prove that he’s followed US tax laws correctly for the last five years.87 Assuming you are a covered expatriate, all the

74 MLBPBP, Section 7.175 §415(b)(1);Reg. §1.415(b)-1(a)(1)76 §402(a); §403(a)(1) 77 MLBPBP, Section 3.1 & 3.278 MLBPBP, Section 8.1(b), (d), & (e)79 MLBPBP, Section 8.4 & 8.580 §103(a) 81 §64(a)(4) 82 §61(a) 83 §877A(g)(2)(B) 84 §877A(g)(5); §877(e)(2) 85 §877(a)(2)(A) 86 §877(a)(2)(B) 87 §877(a)(2)(C)

property you own will be treated as sold on the day before expatriation at its fair market value88 and any gain or loss recognized on the deemed sale in excess of a $680,000 exemption amount will be included in gross income.89 Several types of deferred compensation items are excluded from the expatriation tax as well; qualified pension plan, profit sharing plans, simplified employee pensions and items of deferred compensation are among the exceptions.90

As your yearly base salary is $1.5 million, not including bonuses and other income, it is highly likely you will be subject to tax as an expatriate. Additionally, any highly appreciated items you own will also be taxed, like a house. If you wish to establish permanent residency right now, this is a decision you should follow through with. Assuming that you plan on playing Major League Baseball for the next 10 to 15 years, barring any unforeseen events, it would be extremely difficult to avoid owning appreciated property. You would need to consider the personal preferences of returning to the Dominican Republic over the tax benefits and convenience of remaining in the US.

Incorporating Yourself

Another possible tax planning strategy to consider is forming a personal service corporation (PSC) in an attempt to shift some of the income tax to the corporation. You become the employee-owner if you own at least 10% of the corporation’s stock directly or indirectly; stock owned by certain family members will be treated as if you own the stock as well.91 The corporation then enters into an employment contract with the baseball team and pays you a salary. This has been done before by professional hockey players, and the court had agreed that the athletes were considered employees of the PSCs rather than employees of the hockey team.92 If no employee-employer relationship between the personal service corporation and the athlete exists, the athlete would be directly taxed on his wages. However, in another court case, it was decided that the professional athlete would be treated as the employee of the sports team, as the employment contract essentially gave the team the right to control the athlete’s activities.93 I would not recommend this option for you, as the IRS would likely disagree.

I hope that you have gained a better understanding of the relevant tax consequences. If you have any more questions, or require more clarification, please contact me.

Sincerely,

Yuechiang Stephanie Luo

88 §877A(a)(1) 89 §877A(a)(2) & (a)(3); Rev. Proc. 2013-35, 2013-47 IRB 537 90 §877A(d)(4) 91 §269A(b)(2) 92 Sargent, 929 F2d 1252, (CA8, 1991) 93 Leavell, 104 TC 140 (1995)