Drawbacks to Incorporating

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Before an entertainer decides to incorporate, he/she must first evaluate the application of Internal Revenue Code Section 269A. This section can be debilitating to the tax benefits of incorporating. Section 269A addresses the PSC and the services performed by it.

§ 269A(a): “If (1) substantially all of the services of the personal service corporation are performed for (or on behalf of) 1(sic) other corporation, partnership or other entity, and (2) the principal purpose for forming, or availing of, or such personal service corporation is the avoidance or evasion of Federal income tax by reducing the income of, or securing the benefit of any expense, deduction, credit, exclusion, or other allowance for, any employee-owner which would not otherwise be available, then the Secretary may allocate all income, deductions, credits, exclusions, and other allowances between such personal service corporation and its employee-owners, if such allocation is necessary to prevent avoidance or evasion of Federal income tax or clearly to reflect the income of the personal service corporation or any of its employee-owners.”

These words empower the government to disregard all of the tax planning done by the employee. If the government feels that “substantially all” of the income of the employee is from one source, the tax benefits afforded the loan-out corporation can be set aside. This issue was addressed by the United States Court of Appeals for the 8th Circuit in Sargent v. Commissioner of Internal Revenue. The case involved a hockey player who incorporated in order to place money in a pension plan for himself.

As discussed above, § 401 of the Internal Revenue Code allows for the corporate retirement plan contribution to be deducted by the corporation while not constituting income to the employee until the money is distributed by the plan. The hockey club contracted with Sargent’s PSC for his services and paid the corporation its contractual fee. The IRS issued a tax deficiency notice to Sargent for unpaid taxes, which was appealed to the Tax Court for consideration.

The Tax Court agreed with the IRS that the corporation set up by Sargent was merely a form of assigning income to the corporation and that Sargent was still liable for the taxes. The issue in the Tax Court was whether Sargent was an employee of the hockey team or his PSC. If he was an employee of the PSC, then the deductions taken for pension plan contributions were allowable. If he was an employee of the hockey club, then his pension plan contributions were not deductible, and the income from the hockey club would be attributed to Sargent as an individual and not to his PSC.

* For specific inquiries regarding a business legal matter that you may have, you are contact our Tax Attorney in Los Angeles.

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Alternative Minimum Tax: The Effect on Itemized Deductions

 

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This is also part of third section of  Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the alternative minimum tax and its effect on medical and miscellaneous itemized deductions.

An additional issue with regard to the deductibility of both medical and miscellaneous itemized deductions is the imposition of the Alternative Minimum Tax. “Congress enacted the alternative minimum tax (AMT) in 1969 to make wealthy taxpayers pay their fair share instead of using tax shelters and other means to reduce, or even eliminate, their federal tax liability.” (Kern, 1999). “The alternative minimum tax generally can be described as a flat tax rate which is imposed on a broader income base than the taxable income yardstick used for the regular corporate tax.” (Lind, supra note 11 at 15).  “The tax is designed to ensure that all taxpayers pay at least a minimum amount of taxes.” (Blacks Law Dictionary, 1990). “Without the alternative minimum tax, some of these taxpayers might be able to escape income taxation entirely. In essence, the AMT functions as a recapture mechanism, reclaiming some of the tax breaks primarily available to high-income taxpayers, and represents an attempt to maintain tax equity.” (Commerce Clearing House, 1999).

The AMT is paid in addition to any other income tax imposed and calculated as the excess of the tentative minimum tax for the taxable year over the regular tax for the taxable year. The definition for tentative minimum tax, though, depends on the status of the taxpayer, whether noncorporate or corporate. The tentative minimum tax for the noncorporate taxpayer is the sum of 26% of so much of the taxable excess as does not exceed $175,000 plus 28% of so much of the taxable excess as exceeds $175,000. The Internal Revenue Code also provides for tax exemption status, evidencing the congressional intent of taxing the high-income taxpayers. If the taxpayer’s taxable income does not exceed $45,000 for taxpayers filing a joint return, $33,750 for the individual taxpayer, or $22,500 for the married taxpayer filing separately, the taxpayer is exempt from alternative minimum tax treatment. This means that, depending on the individual taxpayer, there could be an exemption from AMT for the lower income brackets. After the $33,750 exemption, the next $175,000 will be taxed at a rate of 26%. Taxable income exceeding this will be taxed at 28%. At the corporate level, the first $40,000 of taxable income is exempt from AMT treatment.

As previously discussed, the PSC will have little or no taxable income as a result of “zeroing-out.” Therefore, no discussion of corporate AMT is necessary.

When analyzing the application of AMT to the noncorporate taxpayer, the focus of the discussion turns to the medical and miscellaneous itemized deductions. For Regular Income Tax (“RIT”) purposes, medical expenses are deductible when they exceed 7.5% of adjusted gross income (“AGI“). For AMT purposes, medical expenses are deductible only when they exceed 10% of AGI. With regard to miscellaneous deductions, the difference between RIT and AMT is even more conspicuous. For RIT purposes, miscellaneous itemized deductions (specifically unreimbursed employee business expenses) are deductible to the extent they exceed 2% of AGI. Under AMT, however, miscellaneous itemized deductions are not allowed. This is significant since an employee working in a noncorporate structure will be considered an employee for whom she provides services.

Therefore, any business expenses she incurs will be considered unreimbursed employee business expenses, shown as miscellaneous itemized deductions subject to the 2% of AGI limitation and rendered non-deductible for AMT purposes. Under the PSC, these business expenses escape both the RIT limitation and the AMT exclusion.

* For specific inquiries regarding a business legal matter that you may have, you are welcome to visit our Tax Attorney in Los Angeles.

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The Tax Benefits of Incorporation to the Entertainer (Part 1)

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This is the second section of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question” regarding the tax benefits of incorporation to the entertainer.

“In general, the tax benefits available to loan-out corporations compare favorably with those available to individuals under their two unincorporated alternatives:

  1. providing services as a direct employee of the unrelated party consuming the services
  2. providing services as a sole proprietor

“(La France, 1995)

The concepts employed to determine a corporation’s tax liability are the same broad principles of gross income, deductions, assignment of income, timing, and characterization of the income employed by the individual taxpayer. Taxable income is gross income less certain authorized deductions. Gross income is all income from whatever source derived. Internal Revenue Code § 61 provides a non-exclusive list of sources of income which qualify as gross income under that section, including compensation for services, gains derived from dealings in property interest, and dividends.

From gross income, deductions are made if specifically allowed by the Internal Revenue Code as properly deductible. Such deductions include those ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, deductions on interest paid during the taxable year and ordinary and necessary expenses paid or incurred during the taxable year for the production of income.

* For specific inquiries regarding a tax planning legal matter that you may have, you are welcome to visit our Los Angeles Tax Planning Attorney services page.

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