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Creative Luxury Tax Accounting 201: Jon Lester’s average annual value re-explained

11.08.13 at 9:28 am ET
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Jon Lester's contract option gives the Red Sox more financial flexibility than previously understood. (AP)

Jon Lester’s contract option gives the Red Sox more financial flexibility than previously understood. (AP)

In this look at Red Sox payroll obligations for the 2014 season, two contracts yielded different average annual values (the figure used for calculating payroll against the luxury tax) than previous public documentation (including by this website) would have suggested. The most dramatic instance of the change in value was to Jon Lester‘s AAV calculation. The change merits explanation, as it has implications for how long-term deals with team options are understood, particularly those signed by young players long before they reach free agency.

Prior to the 2009 season, Lester signed a five-year, $30 million deal with a $13 million option for the 2014 season (and a $250,000 buyout of the option). During the life of that contract, the deal was widely understood to represent a $6 million luxury tax hit. That interpretation was incorrect.

Option years that are significantly larger than the average yearly salary of the deal alter the calculation of the Average Annual Value as calculated for determining luxury tax payroll. The relevant language is found in two excerpts of Article XXIII E. (5) (c) of the Collective Bargaining Agreement:

“Highest Guaranteed Year Value” shall be the sum of the Base Salary plus any attributed Signing Bonus, deferred compensation or annuity costs, plus any potential bonuses (other than Award Bonuses) in the Guaranteed Year of the Contract with the highest such sum; provided, however, that if the Highest Guaranteed Year Value is itself greater than 127.5% of the Average Annual Value of the Contract, then 127.5% of the Average Annual Value of the Contract shall be substituted for the Highest Guaranteed Year Value in the calculation called for by subparagraph (ii)(B) below.

(B) Rule. If the Club Option Year Value exceeds 122.5% of the Highest Guaranteed Year Value, then the difference between the Club Option Year Value and 122.5% of the Highest Guaranteed Year Value shall be treated as a Signing Bonus in the calculation of the Contract’s Average Annual Value.

What does that language mean for Lester’s deal? First, a look at how Lester’s contract broke down:

2009 – $1 million

2010 – $3.75 million

2011 – $5.75 million

2012 – $7.625 million

2013 – $11.625 million

2014 – $13 million option ($250,000 buyout)

So, in this case, the average annual salary (which takes the total guaranteed salary plus a signing bonus plus an option buyout divided by the number of guaranteed years of the contract, so $30 million divided by five years) is $6 million. But the highest guaranteed salary ($11.625 million) exceeded by 127.5 percent of that $6 million AAV ($7.65 million). So, for luxury tax purposes, the Highest Guaranteed Year Value is treated as $7.65 million rather than $11.625 million based on the first highlighted paragraph of the CBA.

That becomes important in the second highlighted paragraph of the CBA, since the option ($13 million — or, more precisely, $12.75 million, since the $250,000 buyout was already being treated as guaranteed money) is considerably larger than 122.5 percent of the $7.65 million that represents the Highest Guaranteed Year Value ($9.37125). Because of that disparity, under the language of the CBA, the difference between Lester’s option ($12.75 million) and 122.5 percent of the Highest Guaranteed Year Value ($9.37125) was treated as a signing bonus that factored into the AAV.

What?

Here’s another way of looking at how Lester’s AAV was calculated:

$30 million in guaranteed money divided by five years ($6 million)

PLUS

[$12.75 million (non-guaranteed part of Lester's option) - $9.37125 million (122.5 percent of Highest Guaranteed Year Value)] divided by five years  ($675,750)

So, Lester’s AAV for the last five years was calculated as $6.67575 million — counting for slightly more than previously characterized for the purposes of figuring out luxury tax.

But that, in turn, means that his option is calculated at less than its actual salary value of $13 million. For 2014, the part of Lester’s option that was treated as either guaranteed ($250,000 for the buyout) or a signing bonus over the last five years ($3.37875 million) does not count towards luxury tax payroll calculations for the coming year. Thus, his 2014 AAV (as interpreted for luxury tax purposes) is actually $9.37125 million — thus giving a notable chunk of money with which to play while trying to stay under the luxury tax threshold in 2014.

Only one other Red Sox player (Clay Buchholz, whose 2014 AAV is treated as approximately $7.75 million, rather than the previous characterization of his AAV as being $7.49 million) is impacted significantly by this option calculation.

Of course, all of that likely represents a less prominent concern for the Red Sox than the simple matter of whether or not Lester is money on the mound. And by and large, for the life of his contract, he’s been just that.

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