A hit from an NFL linebacker pales in comparison to the pain a professional athlete may feel from the "tax man." With federal tax rates approaching 40% and state tax rates as high as 10%, professional athletes, who generally derive income from contract salary, endorsements, outside businesses and investments, face a "taxing" situation. Proactive planning and expert counsel can help reduce the tax an athlete may have to pay, as well as reduce the likelihood of a tax audit. *

Federal Income Taxes. A person's income is generally subject to federal tax when they receive it, but there are several techniques that can possibly reduce, eliminate or defer federal taxes. One technique is to defer the receipt of income, but this must be put in place before the income is ever received and therefore should be part of contract negotiations. Another technique is establishing qualified retirement plans for the athlete, his spouse and, quite possibly, his children.

State Income Taxes. Commonly referred to as the "jock tax," professional athletes are subject to tax in every state in which they render services. Because of their high incomes, this is potentially very costly for professional athletes. For example, a player with the Florida Marlins may think he will not have to pay state income tax on his salary because Florida does not have a state income tax. However, when the athlete plays a game in another state that does have an income tax, that state will tax a pro rata share of the athlete's salary.

Another issue, which may be a relevant factor in contract negotiations, is the state tax of the player's home team. For example, if Lebron James had joined the New York Knicks and made New York City his home, he would have had to pay New York State and City tax on his entire salary, regardless of where the games were played. He would also have been subject to those taxes on all other sources of income. So if his annual contract paid him $10 million, playing for the Knicks would have likely resulted in an additional $600,000 or more a year in taxes. Instead, James chose to take his talents to Miami, where he will pay tax only on the games he plays in other states. Why did James turn down the bright lights of Broadway? Not paying state income tax on more than half of his NBA salary (or on his other income (see below)) is likely part of the answer.

Deciding where to reside (not just where to play) is also important. A professional athlete who plays for the Knicks is not necessarily a tax resident of New York. This is important because the other sources of income (e.g., endorsements, other businesses, investments, etc.) and wages allocated to games outside of the state are not taxed in the state where the player's team is located, but instead taxed (if there is a tax) in the state where the player resides. Therefore, if Lebron James played for the Knicks, but resided in Florida, he would pay New York tax only on the pro rata share of his NBA salary based on the games played in New York. A word of caution—athletes must plan carefully to ensure that the tax residency declaration is respected.

Today's professional athlete trains extensively to excel on the field. Athletes must pay similar attention to their finances if they want to excel financially once their playing days are over. Professional athletes' advisors should make tax planning a significant part of the athlete's financial game plan to maximize wealth. Careful planning and attention will help shield the professional athlete from a tax audit.