Lights, Camera, Taxation! A Look into Tax Issues of the Entertainment Industry
"There’s no business like show business." This is true especially when it comes to tax planning for entertainers.
Although taxpayers in the entertainment industry face tax planning issues similar to those of other high net worth individuals, the nature of the industry creates unique areas of exposure. From the various types of income, to the maximization of deductions and benefits, this article will highlight the need for tax planning that is as creative as the individuals being taxed.
Types of Income
The type of income entertainers receive depends on the activities or services performed and their rights as per contractual agreement. Entertainers involved in film and television production, including actors and other employees of studios and production companies, generally receive wages or salaries for their performance or compensation based on net profits or gross receipts of the production. Additionally, actors may receive residuals—payments for past performances and re-runs of television shows, movies, and commercials—which are considered personal services income and are treated as wages.
Copyright owners, such as authors, recording artists, and songwriters, receive payments in the form of royalties or license fees. Royalties are periodic payments generated by the sale of copyrighted material (e.g., books, records and merchandising) through the performance (by someone other than the artist), exhibition or distribution of such. As [intellectual] property protected under copyright laws, the sale and license of copyrights could be subject to favorable capital gains treatment as opposed to being treated as ordinary income.
Athletes and other celebrities receive endorsement income for recommending products or making appearances, and participating in photograph sessions for their sponsors. Whether such income will be treated as royalty income (i.e., license of intangible property) or personal services income will depend on the actual purpose of compensation (usually defined in the contract). The income will be considered royalty income if the entertainer is paid for the right to use his name and likeness (e.g., his face on a shirt). However, if the entertainer is compensated for a performance, or an appearance in commercials or interviews, the income will be characterized as personal services income.
Entertainers are also compensated in forms other than cash. Fringe benefits and goods, such as wardrobes, housing, meals, travel and transportation, given to entertainers in lieu of, or in addition to, cash payments are considered compensation and should be included in their taxable income.
A loan-out corporation (LOC) is a corporation wholly-owned by the entertainer, who is actually its employee. It can be an LLC, an S corporation or a C corporation. The choice will be dependent upon the facts and circumstances associated with the individual entertainer.
The LOC enters into agreements with third parties whereby the entertainer’s services are provided in exchange for compensation which is then paid out to the entertainer. The benefits of operating through a LOC may include:
- 100% deduction of business expenses;
- deduction for a limited cost of life insurance and 100% deduction for disability insurance;
- the ability to set up a medical reimbursement plan through which medical and insurance costs can be deducted; and
- the ability to set up a richer pension plan other than an IRA. There is also an opportunity to defer income to a later year.
However, Internal Revenue Service (IRS) can disregard LOCs and reallocate income to the individual if: 1) the purpose of the LOC was to evade tax; and 2) the LOC performs services for only one other entity. The rules associated with LOCs are complex and therefore, it is necessary to consult with a qualified professional before establishing an LOC.
Passive Activity Losses
Many entertainers have also tried to take advantage of passive activity loss rules by trying to convert their personal service income into passive activity income. As such, it can be offset by passive activity losses. Passive activities include: 1) equipment rentals; 2) royalties; and 3) any activity in which the entertainer does not “materially participate.” Some entertainers have tried to simultaneously perform personal services while renting out equipment. Others have tried to convert their personal services income into passive activity income by receiving equity interest in a film rather than receiving deferred compensation.
However, the Treasury Department has broad discretion in determining whether such income can be characterized as passive activity income and IRS-issued audit guidelines draw attention to such attempts. For instance, the guidelines state that equipment rentals from entertainers who perform personal services will be considered personal services unless: 1) equipment rent is more than 20% of the entire income attributable to the activity; and 2) equipment is rented for more than seven days.
Trap for the Unwary: Bad Deferred Comp?
Many entertainers are paid under deferred compensation arrangements through which they avoid current taxation by deferring their income to future years. However, only deferred compensation plans that meet strict requirements will be respected. “Permitted plans”:
- follow a fixed payment schedule or are payable on or after the earliest date of a number of specified events;
- do not allow for acceleration of payment;
- are irrevocably chosen (if a choice between deferred compensation and current compensation is given);
- must be paid on the date of scheduled payment;
- do not allow for placement of assets in a foreign trust; and
- are “established” and specify time and form of payment.
Should the permitted plans not comply with these requirements, they will be subject to hefty tax penalties and interest charges.
State and Local Tax Issues
Entertainers often “go where the money is,” that is, where their work takes them. As such, they can be subject to tax in many states, particularly because their whereabouts can easily be tracked due to their celebrity status. Entertainers are normally subject to tax in their resident state based on worldwide income. Entertainers may also be subject to tax in nonresident states to the extent that income was derived or “sourced” to that state. In order to determine the states in which their income is sourced, entertainers must determine “where performance occurs” and how many days they worked within that state over total days worked. Some resident states offer tax credits for taxes paid to other jurisdictions but are likely limited to the tax rate of the resident state. A proper assessment of income sourcing and allocation is the key to avoiding heavy penalties for lack of filing in a necessary jurisdiction.
There are many ways to minimize tax in the entertainment industry but proper tax planning is imperative.
See our next issue of For the Record as we continue to explore additional tax issues in the entertainment industry.