We recently participated in a panel discussion for the Producers Guild of America on the 2017 Tax Reform Act (the Act), which went into effect in 2018, for most taxpayer changes. This seminar discussed the law, as we know it, and provides options to freelance employees on how to best keep their hard-earned dollars, especially for those in the entertainment sector.
Our panel was moderated by Carrie Lynn Certa (VP, Chair of AP Council and independent producer) and also included Schuyler (Sky) Moore (Partner, Corporate Entertainment, Greenberg Glusker LLP).
During the panel, we focused on how the Act dramatically reshaped the tax dimensions for individuals and employers this year. Specifically, Section 199A of the Act is enormously complicated (see here for how “simple” the new section is: “Tax Geek Tuesday: Making Sense of the New '20-percent Qualified Business Income Deduction'”), and the IRS recently published a nearly 200-page clarification. We did note that the IRS lawyers are still working on it, though — so expect more clarifications in the future. However, below are some insights we shared with the Producers Guild that may be relevant to your own business.
Of particular interest to everyone at the event (and the entertainment business as a whole) is that unreimbursed business expenses of employment – agent fees, management fees, lawyer fees and entertainment expenses, including meals – are no longer eligible deductions allowed for tax purposes. These expenses were historically allowed as itemized deductions.
Section 199A created a new deduction. Essentially, the law allows the owner of a flow-through entity an additional deduction of up to 20 percent of Qualified Business Income (QBI). This deduction is subject to limitations – one of the limitations is up to 50 percent of the wages of the business.
What we need clarification on is who qualifies for this 199A 20-percent reduction. The regulations say who doesn’t qualify: actors, musicians, directors and the like. We would like to know who are the other people “like that”?
Directors do not qualify for the benefit but producers may qualify for it as long as they are independent contractors operating through a flow-through entity. Producers are “consultants” within the meaning of the regulations.
For example, if an actor pays 10 percent to their agent, 10 percent to their manager and 5 percent to their lawyer, their effective tax rate – because they cannot deduct that – can be about 90 percent.
As if Section 199A of the Tax Act — which deals with federal taxes — were not complicated enough, the California Supreme Court, in its recent Dynamex decision (see “The California Supreme Court Deals A Blow To Independent Contractors”), essentially said that subcontractors of all sorts are now considered employees. Combining Federal Tax regulations with California Labor Law is whole other discussion for another day, but our professionals can help you navigate this territory with respect to your personal circumstances.
What’s at Stake?
Whoever hires you, if they incorrectly treat you as a contractor, and if they do not withhold, it is a personal liability to them – the CEO, the CFO, whomever the IRS can tag – and it is a personal liability that is not dischargeable in bankruptcy. From the company’s perspective, to mischaracterize you as an independent contractor and to not withhold means that even if they go bankrupt it does not absolve them, so they have an incredible incentive to treat everybody as employees.
For federal purposes, the contractor/employee test is whether or not the payer has the right to direct the manner and means by which the worker performs the services – it is the control test.
Not only does the payer direct the manner and means, but also the worker cannot perform services that are in the ordinary course of the payer’s business. Everybody in Hollywood is rendering services that are in the ordinary course of the payer’s services and, therefore, now everybody in Hollywood is an employee under California law under the Dynamex interpretation.
You do not want to be an employee because you lose all your deductions, and there is generally only one answer: to become a Loan-Out, or to work through a Loan-Out entity.
Qualified Business Income
As mentioned, QBI may be eligible for the 20-percent tax reduction under Section 199A, from 37 percent to 29 percent. There could be a means by which those subcontractors and others accustomed to deducting business expenses can do so by establishing a Loan-Out entity, which would generally to be a pass-through corporation, specifically an S-Corporation.
A Loan-Out entity is an entity that loans out the services of the owner – an S-Corporation is a pass-through entity because the income and losses passes through to the owners.
This alternative has income thresholds of $157,500 for single filers and $315,00 for joint filers, subject to phase out above certain thresholds and the wage basis limit (ie: 50% of W-2 wage)
The S-Corporation must also be approved by the IRS as well as the studios paying for the services. Studios, in particular, could be a tough sell as they may be more motivated to retain the QBI tax reduction for themselves.
If you pay yourself as an employee, your W-2 wages do not qualify for the 199A benefit because that is employment income. What you want to do is minimize the amount you take out as compensation and maximize what passes to you under the pass-through provision because that can qualify for the 20-percent QBI reduction under 199A.
That is why it’s a very important incentive for employers to classify you as an employee because it increases their limitation, so if the wages are higher, potentially the limitation is higher.
Unemployment: Loan-Out Entity vs S-Corporation
A lot of people in the entertainment industry below the line survive on unemployment when they are between gigs. If you set up an S-Corporation you may no longer live off that unemployment – in some cases you can get unemployment in others you cannot.
If you are an employee of a Loan-Out (not the owner or shareholder of the Loan-Out), typically the Loan-Out should pay withholding, unemployment insurance and so forth. In that circumstance you would be able to qualify for unemployment. The tricky part is when you're the owner, or the shareholder. For example, if you are an employee of your S-Corporation, typically you are not going to be able to file for unemployment in those circumstances. Because of the way the Loan-Out is set up, you would not be technically unemployed.
Proceed with Caution
There are cost and tax considerations to starting an S-Corporation that need to be weighed against the potential benefits of being able to retain business expense deductions and the QBI tax reduction.
In addition, many people tried to take this route after the new tax law was passed only to be disallowed by the IRS or designated a services business ineligible for the QBI deduction.
Mixing federal tax law (Section199A) with state labor laws (Dynamex) is a recipe for enormous complexity. The wise approach is to wait for clarity on Section 199A from the IRS, in particular, before expending the costs and efforts of trying to radically reformat your business life.
The complexities of the new Tax Act, coupled with the new California labor law, will have far reaching implications for everyone, especially in the entertainment business. Everybody’s personal circumstances are unique so it is imperative to work with a professional team to determine the best approach to move forward.
While we covered a lot of content during the panel, we know that there is still much more to review and many more questions to answer. To contact someone to discuss your personal situation please visit our web site at GHJ Tax Practice or call us at 310.873.1600.
Dan Li, CPA, has over 15 years of public tax and accounting experience providing tax compliance and consulting services to a wide range of clients. The industries she services includes entertainment and media, real estate, manufacturing, wholesale trade and distribution. Her experience includes…Learn More
Frances Ellington, DBA, CPA, is the State and Local Tax Practice Leader at GHJ with a focus on multistate income and franchise tax, indirect tax and credits and incentives. Frances assists her clients on state and local tax issues related to tax audit controversy, nexus and reporting requirements,…Learn More
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