__________________________________________________________________________________________________________ Vol. VIII, No.8Published by Leader Publications, a division of The New York Law Publishing Company November 1992 _____________________________________________________________________________________________
Federal Code Guidelines
Tax Tips on Managing
Artists' Royalty Income
By Richard L. Curtis
This article is the first of a two-part series.
PAYMENTS RECEIVED by those active in the music industry are often designated as "royalties." This includes songwriters' mechanical and performance income, recording artists' income and producers' compensation.
Several areas Of the U.S. federal tax law provide for special treatment of royalty income.
First, Internal Revenue Code (IRC) Sec. 541 imposes a flat 28 percent penalty tax on corporations that have undistributed personal holding company income. Sec. 542 generally defines a personal holding company as one in which greater than 50 percent of the stock's value is held by five or fewer individuals and at least 60 percent of its adjusted gross income is personal holding company income. Sec. 543 defines "personal holding company income" to include royalties with special provisions for copyright royalties.
A songwriter who has an incorporated publishing company that has not elected S status may be classified as personal holding income. (An S corporation is one in which an election has been filed so that it is generally not subject to a corporate level tax, but rather the shareholders individually pay the tax on corporate earnings.) Sec. 1375 imposes a 34 percent penalty tax on excess passive income of an S corporation when it has regular corporation earning and profits accumulated. Passive income is deemed excessive when it exceeds 25 percent of gross receipts in any given year. Sec. 1362 defines passive income to include royalty income.
Consequently, a production company that licenses a record on a nonexclusive basis may find that the license income exceeds 25 percent of gross receipts, meaning the 34 percent penalty tax could apply. An S corporation is not subject to the personal holding company tax. Furthermore, Sec. 1362 provides that, if passive investment income exceeds 25 percent of gross receipts for three consecutive years, the S election will terminate.
Individuals earning "royalty" income report it in a fashion different from normal compensation for services. Individuals are required to report royalties on schedule E of their tax returns; normal compensation for services is reported on schedule C. Furthermore, royalty income is generally not subject to a Social Security tax, which currently is 15.4 percent.
Corporate Tax Issues
Personal holding companies are not only established by the receipt of royalty income, but often arise through the receipt of personal service contract income. Sec. 543 provides that personal holding company income includes amounts received under a contract through which the corporation is to furnish personal services of a 25 percent or more shareholder if some person other than the corporation has the right to designate the individual who is to perform the services or if the
individual who is to perform the services is designated in the contract.
Tax planning for the personal holding company tax can take several forms. Typically, as long as the corporation has no net earnings, the personal holding company tax is not imposed because it is based on a net earnings concept. Consequently, the corporation may pay all net earnings out to the shareholder as salary and often avoid a tax problem. This plan has its risks, however, because the IRS may challenge the deductibility of shareholders' salary payments that become large or "unreasonable."
With the changes in the tax law in the last six years, it is the common view that avoidance of regular corporate tax status is advantageous. Therefore, many existing loan-out corporations are converting to S corporation status. This is also a way to avoid the personal holding company tax.
As mentioned above, S corporation status will terminate if passive income exceeds 25 percent of gross receipts for three consecutive years. In addition, the passive income S corporation tax may apply. Loan-out corporations that convert to S corporation status must deal with this issue. Many times, the loan-out corporation has accumulated earnings from its days as a regular C corporation. As such, the imposition of the passive income S corporation tax, as well as termination of the S election, are real risks.
One of the most significant tax planning issues becomes what "royalties" are for tax purposes. The term is never defined within the Internal Revenue Code. Significant tax ramifications can arise, depending upon whether a receipt is a royalty, compensation for services or rent.
The distinction between "royalties" and "compensation for services" is a relatively settled matter of tax law. This distinction affects the determination of whether such payments are subject to a self-employment tax at the individual level and whether various tax treaty benefits on royalties can be obtained. In addition, the imposition of personal holding company tax and S corporation status and tax will be affected based upon whether income is considered royalties.
Most cases require a determination of whether the payment recipient has an ownership interest in intangible property. That's because the courts have held that, for royalty income to exist, the recipient must have an ownership interest in property (usually intangible) for which the payment is being received. Boulez V. Commissioner; 83 TC 584 (1984). The courts have also looked to the language of contracts giving rise to the income. Although the contract language is not solely controlling, it is given weight by the courts.
Boulez held that payments received by recording artists who had no ownership rights in masters constitute compensation for services rendered. The case dealt with the foreign income treaty issues. Payments were referred to as "royalties" was overlooked due to other contract language, which stated the contract was for the personal services of the artist and that the artist had no ownership in the masters being created. Rather, the contracts had "work for hire" clauses.
Revenue Rulings 68-498 and 79-390 held that royalties received by book writers constituted employment income subject to a Social Security tax. One area open to question may be when a writer retains at least part ownership in the copyrighted material. If a songwriter receives royalties not only for the writer's share of copyright income, but also for part ownership in the publishing share, the payments from the ownership share may be royalties for tax purposes, rather than compensation for services.
Payers of amounts to entertainers often report the income to the IRS as royalties. Most of the time, this is a mistake because these payments, under the case law and rulings cited above, would be payment for services or non-employee compensation. This author is aware of at least two major entertainment companies who have recently changed their reporting in this regard to reflect it as non-employee compensation.
At times, payments may be split into both royalties and non-employee compensation. Such may be the case in the co-owner publishing arrangement mentioned above. Because payments to producers and recording artists are classified by the IRS as compensation for services, the personal holding company income problems should not be present concerning royalties. Personal service contract income could still be problematic. Also, the payments shouldn't be passive income for purposes of S corporation rules, thus allowing the conversion of C corporation status to S corporation status.
Mr. Curtis is a partner in the Brentwood, Tenn., accounting firm of Curtis & Company, PLC
© 1991 Leader Publications, a division of The New York Law Publishing Company. A Price Communications Corporation Publication. All rights reserved. Reprinted by permission
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