The IRS and state departments of taxation have started to crackdown on unreported income from artists, entertainers, and musicians. As the tax laws applicable to these individuals are often complex and not well understood by those operating within those areas, audits of those taxpayers often result in significant revenue generation, making it worthwhile for the federal and state governments to pursue. Given that Cleveland has the second-largest theater district in the U.S. that is second only to New York City’s Broadway/Lincoln Center area, this tax enforcement topic should be of critical importance to those performing in the City of Cleveland. In this installment of Tax Talk, we take a closer look at tax considerations for artists, entertainers, and musicians.
What Are Common Income Streams for Performers?
Artists, entertainers, musicians, and “road crews” may receive both W-2 wages as employees for stage work and Forms 1099 for their services such as coaching and teaching. The IRS has had much success in challenging these taxpayers in the following three areas: (1) deductibility of expenses; (2) worker classification; and (3) income sourcing.
As previously discussed in our first installment, expenses are only deductible if they are ordinary and necessary expenses paid or incurred during the taxable year in the carrying on of a trade or business. Expenses that will be denied include wardrobe, general makeup, hair styles for auditions, or to maintain an image for these taxpayers. Additionally, these taxpayers often find themselves violating rules related to deducting expenses that have a dual purpose (i.e., both business and personal). There is a general presumption that meals, entertainment, gifts, all expenses paid trips, boats, and non-deductible personal expenses are not deductible, unless the taxpayer proves otherwise. This presumption is not easily overcome and requires significant documentation to be provided by the taxpayer to show that these expenses were ordinary and necessary business expenses.
Deductibility of Business Expenses
Employees are not permitted to deduct business expenses. As such, artists, entertainers, and musicians who are employed by a company cannot deduct any of their expenses spent from their own personal funds. However, there is an exception for a qualified performing artist when the artist (1) performs services for at least 2 employers; (2) has allowance expenses that exceed 10% of the artist’s gross income from performing arts; and (3) has an adjusted gross income (“AGI”) not exceeding $16,000. This exception is not that helpful, because the $16,000 AGI limit is not adjusted for inflation, and most artists have an AGI higher than $16,000 per year. As such, if the IRS is successful in arguing that an artist, entertainer, or musician is not an independent contractor but rather than employee, the IRS and state agencies will be able to deny virtually all deductions that were taken by the artist, entertainer, or musician.
State and Local Tax Obligations
The third issue is a state issue that involves sourcing income to the applicable state or states. An artist, entertainer, or musician may create nexus with multiple states by performing in a variety of states during each year. Many states have non-resident return filing requirements and use duty days formulas to allocate income across the state jurisdictions. Many cities, like Cleveland, also have an income tax on performers doing a show within city limits. Many artists, entertainers, and musicians fall into the trap of only filing state income tax returns in the state where they are domiciled (i.e., reside, have a permanent home, etc.). Many states allow taxpayers to take credits for taxes paid in other states to avoid double taxation, but these artists, entertainers, and musicians may find themselves paying significant penalties for non-compliance and interest (to the extent tax was owed to the jurisdiction).
Planning Ahead to Avoid Costly Tax Issues
In conclusion, it is imperative that artists, entertainers, and musicians consider the financial and tax implications of running their respective businesses and select the appropriate business structure to suit their needs. Mistake of law is never a defense in the course of a civil tax audit and if the IRS feels that a taxpayer has willfully failed to report income to the IRS or inflated its tax deductions, these taxpayers could find themselves facing criminal charges for tax fraud in addition to being slapped with civil liabilities.
For more information, or to seek counsel from our Taxation or Business & Corporate practice groups, please reach out to request a consultation or call us at 216-696-1422.
