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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The Tax Benefits of Incorporation to the Entertainer (Part 3)

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This is part 3 of 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 order to minimize the obvious deleterious effects of the higher tax rate applied to PSCs, it is common for the PSC to “zero-out” at the end of its tax year. This means that the net income of the corporation is paid to the shareholder-employees in the form of compensation and retirement benefits, leaving little or no taxable income for the imposition of tax. This also eliminates any risk of a taxing agency re-characterizing the income as constructive dividends, imposing taxes on shareholders and the corporation.

The most significant tax benefit of using a loan-out is the increased deductibility of their business, medical, and in some cases, even personal expenses.  As opposed to the individual taxpayer, the corporate taxpayer has more tax-beneficial requirements and limitations on deductible expenses. First, an individual taxpayer is limited in the amount of itemized deductions she may have. Section 67 of the Internal Revenue Code states that miscellaneous itemized deductions are allowable only to the extent that the aggregate of the expenses exceeds two percent of the adjusted gross income. This means that all of the itemized deductions over two percent of the adjusted gross income is deductible.

For example, if the adjusted gross income for an individual taxpayer is $500,000 and the miscellaneous itemized deductions are $50,000, the first $10,000 (2% of $500,000) will not be deductible. Therefore the individual taxpayer will be able to deduct only $40,000. Therefore, the taxpayer will still be taxed on the non-deductible $10,000 at the federal rate of 39.6%, approximately $3,960. When adding to this the state tax rate, the amount taxed could approach 50%.

* 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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To Incorporate or Not to Incorporate? THAT is the Question (Part 5)

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This is part 5 of Anker Reed HSC’s blog series entitled “To Incorporate or Not to Incorporate? That is the Question”.

Partnerships and limited liability companies are treated for tax purposes as conduits whose income and deductions pass through to the partners or members as they are realized, with the various items retaining their original character in the process.” (Fundamentals of Corporate Taxation 703, 4th ed. 1997) The partnership will still file an income tax return with the government, but this tax return will solely be for informational purposes. The individual partners pay the actual tax.

For example, a partnership that has taxable income of $1,000,000 for the taxable year will pay no tax on this income. The partners will pay the tax. Should there be two partners, each partner will have taxable income before individual deductions of $500,000. It is important to note that percentage of control in a partnership may be negotiated amongst the partners, in that a partnership may not always be 50/50. For this analysis, and in the interest of simplicity, we will assume a 50/50 partnership. This amount does not include amounts paid by the partnership to the partners as compensation, or in any other form, received during the taxable year.

In applying § 1 (c) of the Internal Revenue Code, each partner’s assessed tax before individual deductions will be $77,485 plus 39.6% of all income over $250,000. Therefore, in the absence of any other personal deductions, each partner’s tax will be approximately $176,485.  The partnership itself will not be subject to tax, but “the persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.” (I.R.C. § 701, Supp. 2000).

* 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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