What They'll Never Tell You About the Music Business

by Peter M Thall

  Now, the business manager decides to pay out to the producer the entire $350,000 as a salary, and the producer pays taxes on this as an individual. But the IRS comes in and says, “You know, that’s an awful lot of money for you to earn as a salary; we think your two months in the studio should be worth about $150,000 and that’s a wonderful annual salary for an executive of this tiny corporation.” Where is your employment contract, they might ask? How can you possibly justify a $350,000 salary for such a wimpy contribution of time and effort—on a Caribbean Island no less (like the legendary Nassau studio of Island Records, Compass Sound). Put simply, the IRS does not like an individual owner of a corporation taking 100% of the money out of it for “salary.”

  So the corporation agrees with the IRS that the producer’s salary should be $150,000. What happens to the remaining $200,000? Why, it is put back into the corporation…, except for one problem. You can’t put back what you have taken out. The corporation winds up with a profit that year of $200,000, which is subject to a tax of more than 50%. And, once you take out of a corporation that which is not yours, it constitutes a dividend; this is further taxed so that in the end you have your $150,000 (salary), which is subject to ordinary income tax, and $200,000, which is absolutely decimated. A dangerous game.

  Beyond this, there is the reality that by the time the IRS gets around to informing you that it has disallowed a portion of your salary, you will have incurred incredible amounts of interest and penalties. And that’s just the federal tax. Now the state steps in and charges even more taxes, interest, and penalties, and for entertainers who work in many states, there can be multiple state taxes due as a result of an unfavorable ruling by the IRS. There may be city taxes as well (as is the case in New York City).

  Worse still, your behavior may trigger a general audit, not only for the year in question but for years down the road. The IRS can go back only three years (unless fraud or substantial underreporting is involved, in which case it can go back much longer), but it can continue to knock on your door forever. It is not unusual for the IRS to audit taxpayers for as many as five consecutive years once they get started. Your cost for accounting services to assist you in dealing with all of these government agencies can be enormous.

  What were your options in the first place? You could have avoided a corporation, but once the corporation is formed, and once used to funnel your income from personal services, the potential of steep taxation exists.

  Given all of the potential problems associated with incorporating—no matter what kind of corporate structure you choose—it remains beyond my comprehension why so many people in the music industry want to create a new taxable entity when there is no compelling reason to do so. I don’t mean to suggest that there are never times and reasons to form one. For example, it may be good business and sound legal management to form a corporation for touring purposes, to limit liability if someone is hurt at a show. But suffice it to say that walking away from your business manager’s office on the first day carrying a corporate “set” of books and seals (not the animal kind) might not turn out to be exactly the thrill you thought it would be. And I suggest that musicians, songwriters, and producers should be highly suspicious of any business manager whose specialty is creating corporations.

  As I have said, conducting a business through a corporate structure does not legitimize it, and doing so can add to your problems rather than solve them. It creates new burdens, and at the same time may not relieve you of old ones. It creates new work and costs that were not there before. It can not only be costly, but, potentially, devastatingly expensive.

  I think I have made my point.

  MONEY MEANS OPTIONS: RESISTING THE “KEEP ’EM POOR” PHILOSOPHY

  When others are handling your money, anything is possible, and everything under the sun has happened to someone you know or have read about. Therefore, I feel it is necessary to describe a particular horrifying scenario. As you read on, keep in mind that if you choose your advisors wisely, and pay attention to what they are doing, this won’t happen to you.

  There is an old music business adage: keep ’em poor. Why? Because then they have to work. And if they work, they earn gross income. And if they earn gross income, the manager and business manager (and more and more frequently, the lawyer) will commission it. A client who is content, satisfied, and financially comfortable is not as likely to go back to the drudgery of “the road.” The last thing commissioning professionals want is for their clients to retire.

  Commissions are only applied against what artists earn, not what their investments generate, and therein lies a potential for abuse. Even if the client is in debt, the “gross” commissioning professional cannot lose—and therein lies another potential for abuse.

  A client wants a new car. He has one by noon the same day. A client wants a new house. He has his mortgage in twenty-four hours. The business manager has done magic for him. But weren’t we all taught there is no such thing as magic? There isn’t. There is a cost for this convenience. A client may receive her mortgage approval in twenty-four hours, but may not be able to handle the carrying charges.

  Some clients believe that if they have some money, they can do most anything; if they have a lot of money, they can do everything. This is categorically untrue. Although a fledgling artist may qualify for a car or house loan on paper, once the mortgage has been approved, the artist may end up with unmanageable cash-flow problems. The more you have, the more you can squander. If you had to be careful before you achieved your first successful financial goal, you will have to be even more careful afterward.

  There is one caveat to this “budget alert.” Sometimes artists are so bull-headed that a business manager can do only so much to protect them. Some artists simply do not want to live on a budget, or even think about retirement. (After all, they have just begun to live!) Ultimately, their business managers have to say, “Enough with the wise financial advice. Let them be happy.” If clients are determined to consciously reject making the right decisions, what can a business manager do? Take away their credit cards? Give them a limited-amount debit card? Take away their toys? I don’t think so. My advice to these well-meaning souls is, “Just make sure you have made it abundantly clear to the clients—and often—what the consequences of their actions are likely to be. Hopefully, they will come to terms with reality sooner rather than later.”

  At the same time, too many people telling an artist that he or she does not know anything about anything results in a certain deafness (and, I would say, an understandable deafness). Sometimes the best that a conscientious business manager can do is keep the artist, the artist’s family, if possible, and the artist’s other representatives advised of the status of the artist’s business. This should be enough to ward off disasters while accepting that it is the client, after all, who has the right to be wrong.

  MANAGING YOUR MONEY

  Everyone has trends. Expense trends and income trends. Among the most important functions of a business manager is to identify these trends and to guide the client’s expenditures and investment opportunities accordingly. Predicting trends on the basis of data gathered over a reasonably long period is relatively easy. This is especially true with respect to artists whose biggest income-producing years are behind them but who are continuing to receive significant income from catalogue sales. It is less easy—but nonetheless important—to predict trends for artists who are in the beginning—more erratic—stages of their careers.

  INVESTING: IS ANYONE IN CHARGE HERE?

  Let’s say that you have invested your career-long savings in an IRA. How is it invested? Who is paying attention? Is it invested in a money market fund at 4.5%? Is it deposited into one, undiversified, mutual fund with the business manager’s favorite broker in charge of it?

  Are your investments, though sound or even shrewd, consistent with your own value system and principles? Is a portion of your portfolio invested in Philip Morris? Is this something you, who have proselytize
d about the dangers of smoking or alcohol, want disclosed in a tabloid or industry rag? Maybe Delta Airlines? Enron, anyone? There is no surefire investment strategy that works for everyone. But there are guidelines that you and your representatives can follow and options to consider no matter what stage of your career you are in.

  The danger young artists face is to be so tunnel-visioned that they focus only on their music or their fans or their live performances, while all the people around them—their lawyers and business and personal managers—are so buried in the day-to-day effort to make all of these things work in tandem that no one is paying attention to either the economic or the tax consequences of what they are doing—or not doing.

  Although the following information on investments is applicable to everyone from every walk of life, I have included it in this book because many artists, record producers, and even managers, especially those who are beginning their careers, make unwise investment decisions (or no investment decisions at all) or have unwise investment decisions made for them.

  Types of Investments

  Let’s say you have a $10,000 surplus in your bank account. Do you want to invest it? To keep it under the mattress? And if you choose to invest it, what do you want to get out of it? The safety of knowing that the entire $10,000 will still be there when you need it? Growth? Super-growth? And what are the down-the-road tax consequences of decisions you make today? How does the rate of inflation affect your investments and your goals? These are things that you need to determine, with the informed help of your advisors.

  Fixed-Interest Vehicles Certificates of deposit (CDs) are time deposits issued by a bank at a fixed interest rate for a period of time—three months, one year, five years—whatever is offered. When considering investing in CDs, you need to consider what can be serious tax consequences. If you buy a one-year CD with your $10,000 at a 5% interest rate (I will use 5% to simplify the math although since the recession of 2007, interest on CDs has barely exceeded 2%—and that for a ten-year CD!), your return will be $500. At the end of the year, you will also get a Form 1099, a copy of which has been filed with the IRS, stating what you have earned in interest. (The same thing happens if you hold mutual funds in a taxable, versus a retirement, account.) If you are in a 50% tax bracket (federal, state, and city combined), you will owe the various governments $250, and your bottom-line return on your investment is not 5%, but 2.5%. (One rule of thumb about investment growth is called the rule of 70: Divide 70 by the current interest rate, and the result is the number of years it will take you to double your money. In my example, taking into account taxes paid, it would take twenty-eight years. A long time.) That $250 you paid in taxes could have been used for further investment or purchase of growth assets—or it could have been applied toward your winter vacation. But it is lost forever once the tax is incurred. Then again, the CD is safe and federally insured. A growth fund is not. As with all investments, performance is a balance between risk and reward: with a CD, there is little risk, little reward. And note that if you retain the CD, or its term extends, for more than one year, you will not be able to pull the $250 out of it in order to pay your income taxes. The income from a CD is the same as ordinary income. You have to make $500 to keep $250. But in the case of CDs, you will have to find the $250 somewhere else. And, since you are in a high tax bracket, you will have to have earned $500 more dollars in order to keep $250 long enough to send it to the IRS to pay the taxes due on the gain in the CD. This situation is not dissimilar to the ones earlier noted where you have to pay taxes of undepreciated capital assets, or the value of the health insurance paid on your behalf. It is all counted as income even if you never “receive” it.

  Say you earn $240,000 in interest from a CD and have to pay $120,000 in taxes. This $120,000 is gone forever. Consider the following scenario. If the $240,000 were invested in a stable stock fund and allowed to grow at 10% a year (on average, about what the stock market has historically done), it would be worth $264,000 at the end of one year, $290,400 at the end of two years, $319,440 at the end of three years, $351,384 after four years, and $386,522 after five years. In order for the $120,000 remaining after taxes to build up to essentially the same level ($240,000), you would need to achieve growth of more than 25% for each of those five years—a growth rate that has never happened. Then again, the stock fund is not insured. Risk and reward again.

  Individual Retirement Accounts The returns you get on the money you have invested in an individual retirement account (IRA) or 401(k) retirement account are not taxed until you pull the money out of them. The annual contribution limits for IRAs depend, in part, on the age of the contributor. In 2006–2007, the maximum allowable amount an individual can deposit into his or her IRA is $4,000 if the person is under fifty years old, and $5,000 if the person is fifty or older. In 2008, the amounts are $5,000 and $6,000, respectively. The deposits need not be made all at once as long as the total for the year does not exceed the allowable amount. You cannot deposit in one year the maximum amount plus the amount you were deficient in a previous year, in which you deposited less than the maximum.

  Individual retirement accounts are tax-deferred, not tax-free, vehicles. If you take money out of your retirement fund before you are fifty-nine years old, you are taxed according to whatever tax bracket you are in, plus 10%. After age fifty-nine, you are taxed only according to your income bracket. But consider this. Not only are IRAs not tax free, they are not even safe havens. You must start taking money out of your IRA by April 1st in the year following the calendar year in which you turn seventy. The amount you must withdraw is determined by an actuarial schedule that takes into account how long the government thinks you have left to live. The trick is to live precisely as long as the government expects you to. If you disappoint them and die later, while you may not have any money left to pull out, they will not have the chance to penalize you for failing to take it all out before you die. Because when you die, if you still have money in your retirement fund, it will be taxed in the same way as income is taxed, according to what is known as “income in respect of decedent.” There are possible estate taxes as well that may be assessed. The rules are complex, and unless you are an accounting whiz as well as an artist, you should make sure your business manager or account is keeping a watchful eye on your IRA.

  Stocks and Bonds A stock is an ownership interest—a share—in a company. Stock is issued by the company to raise money that the company does not have to guarantee to pay back at any particular price. By owning stock in a company, you actually have a claim on the company’s assets. These are sometimes paid out in regular dividends. Some companies do not pay dividends and your only gain comes when the stock value increases (appreciates) and you sell it. You lose when the stock value decreases (depreciates) and you sell it. Stock prices go up when the company’s profits go up or there is a generally accepted expectation that they will. And vice versa. You can own stock directly in a company or through a mutual fund, which itself holds an array of stocks from different companies, and/or various types of bonds.

  A bond is what you receive after you have lent money to a corporation, a municipality, or the US government in return for a promise to pay you back the loan at a certain date in the future. In the interim, the party issuing the bond and receiving your money agrees to pay you a fixed rate of interest at regular intervals, usually semiannually. Most often, you never see your bonds; they are maintained by your broker or are accumulated in mutual bond funds. As market forces change, the value of bonds changes.

  The ins and outs of stock and bond purchasing and trading are complex, and rather than become an expert in yet another field outside of your own, you may want to select a broker (yet another licensed professional) to perform this function for you. One more to add to the team. But how do you know if the securities recommended by a particular broker are really the best ones for you, your income, your cash flow, and your tax situation? You don’t, but your business manager can help guide you. The market is
a casino. Be careful.

  Let’s say you buy a fund that specializes in the blue chips—stocks issued by the traditionally most stable corporations. All of these generate dividends that themselves may reflect a decent percentage, such as 3% to 4% of the value of the stocks. But you don’t see the dividends. They are reinvested in the fund and contribute to its appearance of growth. Then you get a 1099. This represents the dividends that you earned during the prior year, another form of taxable income you have not actually received. If your fund has gone up, you will say, “Hey, I’m paying taxes because my fund went up. So what?” And your broker is making fees on the maintenance of the fund and your portfolio? Same thing. What do you care? Your fund went up. You ignore these two costs because everything that is presented to you shows that you are making money. If you don’t have the cash to pay the taxes, you can sell some of your shares in the mutual fund (at a profit, remember). No problem!

  Then come years like 2000, or 2008–2009, or even the summer of 2015 when China’s apparent invincibility dissolved, throwing a wrench into an eight-year bull market, when the value of mutual stock funds went down! Yet, even as investors were looking at the sad state of their portfolios at the end of the year, they received 1099s showing what the IRS calls “gain.” Taxable gain. These were the dividends they never saw. They had to find the money to pay the tax on the gain even though their money was still tied up in the mutual funds and they didn’t have the cash to pay the tax out of their other resources. Naturally, they were reluctant to sell their shares at their low point. It was not a happy situation.