What They'll Never Tell You About the Music Business

by Peter M Thall

  Performing rights societies do not require a music publishing affiliate or member to be a corporation.

  SHOULD YOU “DO BUSINESS AS” OR FORM A PARTNERSHIP?

  A dba is a totally legitimate form of business. But while it cloaks you as a business (banks love them), it does not provide the shelter from liability that a corporation does. Investors do not find the dba an appealing business structure either. From an estate planning point of view, a dba can also complicate your life because there is no differentiation between you and your business. Let me put it another way. The risks and financial liabilities that characterize your dba are absorbed into your own personal identity—and this can have an extremely negative impact on tax planning for yourself and for your family.

  If there are other people who make contributions to your business and share in the profits (and losses), you might want to form a partnership, where each partner has an interest in the earnings and a responsibility for the losses consistent with such person’s partnership interest. If three partners are all equal, they share these equally. Any variation is possible. But partnerships are not usually favored among individual creative people and investors, because the artistic contributions are customarily provided by only one partner and there is no rationale for a partnership structure.

  One reason often given for forming a corporation is that with sole proprietorships and certain kinds of partnerships, the individual (or, in the case of general partners, the partners) is personally liable for the debts of the business. In contrast, the risk of loss for one who has incorporated is generally limited to the value of the corporation, hence the term limited liability. Another is that incorporating gives you—and your manager—more control over your finances. To some extent that is true. If your business is a corporation, you are paid a salary, and within a few days, withholding tax is sent to the government. Unincorporated businesses are required to file—and pay—estimated taxes four times a year (April 15, June 15, September 15, and January 15), which takes far more planning and more careful money management.

  Note two things about these dates. First, the April 15 date coincides with the date on which the personal tax return for the prior calendar year must be filed. A double whammy. Second, there are no estimated taxes due during the summer or the Christmas holidays—times when most people incur out-of-the-ordinary expenses for vacations, gifts, etc.—yet overspending during these periods may result in difficulty meeting the September and January payments, respectively. If you are incorporated, you do not have to plan for those dates; otherwise, you and your business manager must burn them into your mental calendars.

  Despite the above advantages, I am not a big fan of establishing a corporation unless it is absolutely appropriate—and timely. First, although I hate to say it, many lawyers and business managers set up corporations for profit-making reasons. The out-of-pocket cost to establish a corporation is in the $500 to $600 range, and the fee for doing the paperwork is about the same. So the total cost is something in excess of $1,000. Set up one hundred a year and you’re talking $50,000 in fees. Easy money.

  In addition, the costs associated with incorporating are not limited to the initial setup costs and fees. There is an annual franchise fee for the privilege of having a corporation, and now you must file two sets of tax returns: your personal tax return and the corporation’s returns.

  And then there is the little discussed, and little understood, provision of the Internal Revenue Code establishing the personal holding tax. This is a tax that the US government has established to penalize people who set up corporations and take out 100% of the earnings, after expenses, as salary, which is no different from what that person would have done had the business been a sole proprietorship. An artist who creates his or her own income (that is, as a producer, artist, or songwriter) runs the risk annually that his or her corporation may be designated a personal holding company. (In fact, the tax preparer is obligated to check off a box on the corporation tax return specifying that such a company is in fact a personal holding company.) What is wrong with being designated a personal holding company? For starters, the personal holding company tax is significant. I have been told by a highly regarded tax attorney that it can actually amount to as much as 100% or more of the gross income of the corporation once all the applicable taxes have been taken out and interest and penalties assessed.

  However, while the IRS may not “like” personal holding companies, audits are not automatic, and I understand that there is a high rate of success in winning these audits. It is one of those provisions in the law that judges do not value as much as the enforcers do.

  A final argument against going to the trouble of forming a corporation is that under the Copyright Act, infringers cannot hide behind a corporate “veil.” Not only would the corporation be liable in the event of a determination of copyright infringement, but also the officers and writers/artists would remain liable notwithstanding the existence of a corporation.

  Forming a Corporation

  There are several types of corporations that you can establish: a traditional C corporation; an S corporation, and an LLC (limited liability corporation). Which one you establish may depend on whether you are a songwriter, producer, or recording artist—or some combination of both—and whether you are an individual or a group.

  An S corporation is a corporation that has been “branded” special by the stockholder(s) because its purpose is really to protect against liability and would probably not exist but for that benefit; the IRS has determined that this kind of corporation should not subject the shareholder(s) to the same kinds of rigid standards that normal C corporations are subjected to and should allow the shareholder(s) to deal with their corporation as if it were, essentially, a sole proprietorship.

  The S corporation, which is not subject to a personal holding tax, is not for everyone. For example, a foreign citizen (one without an alien resident green card) cannot be a shareholder in an S corporation. There are ways to convert a C corporation into an S corporation, but there are also risks. Because of the importance of the personal holding company status of a C corporation, the IRS may not want to lose its edge, which it may do when a C corporation is converted into the S structure. Therefore, in such a situation, there is a risk that the corporation, with its new shiny S designation, can be taxed on what the IRS deems to be “excess passive income” (for example, royalty income derived from song or record earnings). An S corporation that was once a C corporation can have its S status revoked if 25% of its income is passive for three years. Once you take out a salary in excess of $400,000 or $500,000, you are beginning to push the envelope and you may draw the attention of an IRS auditor.

  S corporations still have to file corporate tax returns (1120S). Whereas, for the most part, they do not pay federal corporate taxes, there may be no way to avoid state or city corporate taxes. For example, New York City does not recognize S corporations. The state and city tax can exceed 8% and you cannot reduce profits to zero (thereby absolving your corporation any obligation to pay corporate taxes) simply by paying out high salaries. In New York City, there is an alternative tax that is charged without regard to whether or not your corporation even had a profit.

  Pros and Cons: C Corporation, S Corporation, and LLC Let’s explore first how C corporations and S corporations handle profits in the situation in which a company grosses $100,000 and has $20,000 in expenses.

  If your company is a traditional C corporation, there will be $80,000 left. If $50,000 is paid out to you or to your band members, federal corporate taxes will be payable on approximately $30,000. There are two sets of tax returns to be prepared and filed: the corporation’s and yours and those of your band members. If the corporation purchases capital equipment, only a certain percentage of the cost of that equipment can be expensed in the year it is purchased; taxes must be paid on the remainder. So, for example, if the corporation purchases a Pro-Tools rig for $25,000, it may be allowed to deduct 10%, or $2,500, as expenses
in the year it is purchased, leaving 90%, or $22,500, spent but not deductible. (This is called depreciation of a capital asset.) There will be federal and state corporate taxes payable that year not only on the $30,000 referred to above, but also on the $22,500 as if it were income—which of course, as a practical matter, it is not. There may not be money left in the coffers of the corporation to pay the taxes on the $52,500. Indeed, if the $30,000 is also paid out as salary to you or to you and your band members, there won’t. This reality must be taken into account each time the corporation purchases something of lasting value, such as a guitar or a van, or even if it makes capital improvements to a rehearsal hall.

  If your company is an S corporation, the $80,000 will constitute income and will be divided among your band mates. Each band member will be taxed whether or not the member takes the money. This means that if some of the money is left in the corporation for contingencies or future expenses, the shareholders will nevertheless be taxed as if they had taken the money themselves. Each shareholder files his or her own tax return. There is no corporate tax return to be prepared or filed. Each of the band members can deal with his or her share of the $80,000 in whatever creative tax-planning manner they see fit—for example, paying some money into an IRA or 401(k)—and the aggregate tax paid may be well under the tax that the C corporation would have to pay. The capital equipment purchases, unfortunately, are dealt with in the same way as with the C corporation, but this time each individual shareholder has to bear his or her share of the portion that the government does not allow to be deducted as an expense (in my earlier example, 90% of $25,000, or $22,500).

  Another area in which taxes will be payable on earnings never actually received is in the area of health insurance. At the end of the year, band members are faced with the fact that what their corporations paid to the insurance company for health insurance is taxed to them personally as income.

  Those band members with extra money are able to bear the burdens of paying taxes on the nondepreciable portion of a capital asset, or on health insurance costs never actually passing through their bank accounts. Those with little money are not. Those who earn extra money through songwriting income will be better off than those who do not; those who are married presumably will be less well off than those who are not if their incomes have to be shared among their family members. In fact, the economic disparity among band members may be even more glaring after a year of S corporation activity than it would have been after a year of C corporation activity.

  I am beginning to sound like Tevya in Fiddler on the Roof, who was fond of saying “On the one hand…on the other hand…on the other hand…etc.” But here it is: The C corporation may in fact be more advantageous to you in this situation than the S corporation. For example, you can move money around more easily within a C corporation, and you can establish a fiscal tax year, which does not have to run from January 1 to December 31. You can have your corporate tax year begin in September and end at the end of August. Thus, if the corporation expects to receive a lot of money in December, instead of having to pay taxes on this by April 15 at the latest, the taxes can be delayed until, let’s say, October 15, or even later, by virtue of your having manipulated the tax year. The S corporation has to maintain a traditional calendar year tax period. In addition, if you are thinking of having investors in your business, they would be far more comfortable with a C corporation or an LLC than with an S corporation structure, which is more suitable when there are a tiny number of shareholders. Even though you are permitted up to seventy-five shareholders in an S corporation, one to five is the norm among entertainers.

  A partnership does not pay salaries to partners. Their share of profits is paid out as a profit participation, and a K-l, rather than a W-2, is issued by the partnership. An S corporation, being essentially a partnership, may elect not to pay salaries, but it is usually good business practice to pay out something in the form of salaries so that the self-employment tax (Social Security and Medicare combined) is paid first by the corporation and, subsequently, by the employee/shareholder as well. The IRS likes this. Under current rules, the first $90,000 of one’s salary is subject to the social security tax of 6.2% and the Medicare tax of 1.45%. If your S corporation pays you a salary of $90,000, the government will be pleased because you will have caused the Social Security contribution to be made both by your corporation and by yourself, rather than just by yourself, which would be the case if your entire “salary” had been distributed to you as a share of profits. The Social Security system will have been enhanced accordingly by your “employment.” A problem arises, however, with regard to the Medicare portion of the self-employment tax. This portion does not have a cap of $90,000 or, for that matter, any cap. Therefore, if you limit the portion of your profit distribution to $90,000, you will be depriving the government of the employer’s portion of the Medicare tax on any excess. Many accountants will therefore recommend that you take out a salary in excess of $90,000—a good-faith attempt to take care of your federal responsibilities, even though you are probably not required to do so.

  The limited liability corporation (LLC) provides for profit-sharing arrangements that used to be available only in limited partnerships, but it also provides the limited liability that used to be available only in C and S corporations. It is a hybrid and one that has proved extremely popular for small businesses and newly formed companies such as are the norm in the entertainment business. The LLC form is uniquely beneficial to artists who want to raise money from investors either for general career purposes or to pay for recording a master or demo.

  In the past, the only protection afforded investors in a partnership was for the limited partners; the general partners (who operated the company) were personally responsible for the debts of the partnership. The limited partners were merely passive investors. Under the LLC, the general partner’s equivalent, usually called the managing member, has the same unlimited personal liability protection afforded to those investors who are the equivalent of the limited partners in a traditional partnership.

  If you want to put together a film, it is relatively easy to form an LLC that has an investor member and a managing member. To do this in a C or S corporation, you would have to have a shareholders’ agreement, an annual board of directors meeting, an annual election of the officers, etc. In an LLC, you can have meetings and elections as often or as infrequently as you like.

  It is relatively easy to switch from a partnership structure, which until recently was the preferred structure for bands, to an LLC. By doing this, you will have traded a general partnership with no liability protection for an LLC with absolute liability protection. In some states you do not even need to prepare and sign an operating agreement establishing how the company is to be operated. (Of course, having one is appropriate if there is more than one shareholder.)

  There has been some resistance in the bigger money markets to public offerings by LLCs. Financiers who are comfortable with the old system tend to resist new structures. The LLC is less of a structure and more of a conduit. Its house is not built of brick and mortar. It does not yell out solidity, thrift, durability. It is worth noting that although technically, no corporate book, no seal, and no stock certificates are required, corporate stationery companies are not going bankrupt; they still create a virtual “corporate kit”—replete with a sample operating agreement and a seal. Although not necessary, it works for organizational purposes and makes people feel comfortable. Now, I am told, even certificates of membership interest (shades of stock certificates) are provided in the “LLC kit,” and the managing member will often call him- or herself “president” rather than explain why there isn’t any. These are all vestigial remains of the old days.

  Despite the resistance to the LLC structure in some quarters, the LLC is beginning to replace the traditional C or S corporation as the vehicle used for furnishing services of artists, producers, and other creative talent.

  Enter the IRS

  Corporat
ions are often established to provide the services of a creative person to a user of talent. This practice permits flexibility within the tax laws without drawing unwanted attention from the IRS. However, these “loan-out” or “furnishing” companies raise certain issues that might not be present were the client to have simply provided his or her services personally. Remember my warnings about inadvertently creating a personal holding company.

  Having a corporation furnish the services of an artist, or having it own and administer one’s copyrights, involves establishing, somewhat arbitrarily, a salary for the artist whose artistic creations or compensation rights are integrated into the corporation. Suppose a corporation is set up to furnish a record producer’s services and to collect the producer’s advances and royalties, and after a year or so, the advances and royalties amount to $400,000. The costs of operating the corporation are minimal—perhaps some equipment, legal and accountancy fees, and maybe some incidental expenses such as unreimbursed travel and accommodation costs incurred while seeking new business. Let’s say these total $50,000. The balance remaining in the corporation’s coffers at the end of the year will be $350,000.