Cole Hamels’ Cap Hit May Actually Be a Little Less Than $20 Million

Everyone from the Cubs brass to bloggers appears to be in agreement on a return engagement for Cole Hamels. But the same can’t quite be said for exactly what that will cost. Bleacher Nation’s Brett Taylor wrote about the idea of a multi-year extension, but noted that he isn’t entirely clear as to how much of Hamels’ $20 million option would count towards the luxury tax. Our own Evan Altman thought the Cubs might only be responsible for $14 million ($20M option minus $6M buyout) if they picked up the option.

I thought I would try to clear up the confusion.

It is my understanding that the Cubs would actually take a roughly $19.65 million cap hit if they exercise Hamels’ 2019 option. When a club option is exercised, the luxury cap hit is the full annual salary of the option. And as a condition of the trade, the Cubs retaining Hamels for 2019 means the Rangers are not obligated to send money to cover the cost of the buyout. But that buyout cost had already been included as part of Hamels’ AAV over the past six seasons, so that must be accounted for.

Since exercising the option means the buyout was never actually paid, that $6 million must be refunded on a pro-rated basis back to each team that employed the player during the contract. In effect, each team gets a deduction on its luxury tax during the option year. Exactly how much of that is split between the Phillies, who signed Hamels to the deal, and the Rangers doesn’t really matter, but the Cubs should get approximately $350,000.

I’m sure for most casual (and even not so casual) fans, the previous paragraphs made very little sense. So let me start at the beginning, with fair warning that what follows is a pretty deep dive.

Multi-year contracts create complicated rules for luxury tax systems since most contracts pay players different amounts each year. For luxury tax purposes, these variations are ignored and the annual average value (AAV) of the contract is used to calculate the cap hit of a player for each year of his contract.

As is often the case, these pacts can also include signing bonuses, opt-out clauses, player options, team options, vesting options, and a variety of other features that further complicate the AAV of a contract. MLB’s collective bargaining agreement (CBA) defines how each of these clauses in a contract will affect the AAV.

For example, a signing bonus is counted as guaranteed salary and just added into the total before obtaining the average. A player option (sometimes called an opt-out) is guaranteed to the player and is considered a contract year. These years are included in the AAV.

A club or team option is not a guaranteed year and is therefore not included as part of a contract. But often these options include a buyout, the amount of which is guaranteed to the player because they will either (1) get the option year with the full salary or (2) get the buyout. As such, the CBA considers a buyout like a signing bonus and adds it to the total value of the contract in calculating the AAV.

Okay, that was all complicated, so let me explain with some examples.

Example 1: I sign Joe Smith to a two-year contract that pays $5 million in 2019 and $10 million in 2020. To calculate the AAV, I take the total amount of salary ($5M + $10M = $15M) and divide that total by the total number of years to get an AAV of $7.5 million.

Example 2: I sign Joe Smith to the same base deal, but with a club option of $15 million in 2021. In this case, Joe’s AAV is still $7.5 million in 2019 and 2020. If I exercise the club option Joe’s AAV in 2021 is $15 million because it is a one-year contract for that amount.

Example 3: Same deal as the first, but with a $3 million signing bonus. Now Joe is guaranteed $18 million, so his AAV is $9 million in each year of the contract.

So far so good, right? Now let’s get weird.

Example 4: Same scenario as Ex. 2, but now we’re going to include a $5 million buyout on that 2021 option year. The buyout is included in the AAV of the original two-year contract, so the total money Joe is guaranteed goes up by that amount ($5M + $10M + $5M = $20M). The contract is still for two guaranteed years, so the AAV is now $10 million.

But what is the AAV of the option year in 2021 if it is exercised? Is it $15 million, the amount the player will be paid in 2021? Or is it $10 million because $5 million was already removed and counted as part of the AAV in the previous two years?

Section E (5) of the CBA governs how club options are calculated for luxury tax purposes. Section E (5)(c) states that if a team exercises a club option, the entire base salary of the option counts towards the luxury tax. So initially Joe’s AAV would be $15 million in 2021.

However, section E (5)(b)(ii) of the CBA (it’s page 121 of the link for those curious) states:

[I]f the Player ultimately does not receive the option buyout, then for the Contract Year covered by that option, no portion of the Buyout shall be included in any Club’s…payroll. In addition any Club whose final Actual Club Payroll in a previous Contract Year had included that Buyout (or a portion thereof) will receive a deduction (in the full amount of the Buyout included in previous Contract Years) in its final Actual Club Payroll in the Contract Year covered by that option.

So to rephrase the CBA: If a player’s club option is exercised in a season that contained a buyout, every team that paid him during the contract will receive a deduction against their luxury cap equal to a pro-rated amount of the buyout’s AAV. The amount of the deduction is the total buyout multiplied by the fraction of the contract length they paid for.

There is one confusing phrase remaining. The CBA says that “no portion of the buyout shall be included in any club’s payroll.” This would seem to indicate that the buyout should be removed altogether from the luxury cap of the team exercising the option. Indeed, I believed this for quite some time. But if that were the case, the deduction would serve as a circumvention of the tax in the event of an trade like we saw with Hamels.

As best I understand, the CBA is distinguishing between the base salary and the buyout and saying that the buyout amount is not double counted when the option triggers. More plainly, exercising the option means that no buyout was ever truly paid and can therefore not be counted against the cap.

So let me return to my final example with Joe Smith, in which he had a $15 million club option with a $5 million buyout for 2021. If I exercise the option, Joe’s AAV in 2021 is the full amount of the option. But if I employed Joe in 2019 and 2020, I then get a credit toward my luxury tax for the full amount of the buyout because I had already paid for it in previous seasons. In effect, Joe’s luxury hit becomes only $10 million.

This seems fair and it makes sense, because I can’t very well be hit twice for the buyout. Now, had I traded Joe after the 2019 season, both my team and his new team would receive equal $2.5 million luxury cap abatements in 2021. So the team with Joe in 2021 would effectively have a cap hit of $12.5 million.

This is what happened with Hamels, who had a six-year contract that included a $6 million buyout clause for 2019. That means a bulk of the $1 million AAV per season that must be refunded to the Rangers and Phillies for their respective employment of Hamels. The Cubs, who paid Hamels for approximately 35 percent of 2018, should get a $350,000 credit for 2019.

Which is why I believe Hamels effectively has a $19.65 million cap hit. Not that the savings will really mean much for the Cubs, who project to be well over the cap even without factoring in Hamels’ salary.

If anyone from MLB is reading this and I got it wrong, please let me know. I’m sick of researching this.

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