The passage of the massive tax reform bill will be impacting all major industries, and the music business is no exception. Here we look at who the winners and losers in the music business will be when the 2018 tax changes go into effect.
Guest post by Magda Szabo, CPA, JD, LL.M., Tax Partner, Janover LLC with contributions from Steven White, CPA, Principal, Janover, LLC
On December 22, 2017, President Trump signed one of the most sweeping tax reform bills in thirty years. The tax bill, known as the 2017 Tax Cuts and Jobs Act, impacts every taxpayer and every industry. The bill is controversial, lengthy and complex. There are winners and there are losers. It’s a mixed bag for those in the music industry though music publishers are more advantaged.
A review of the detailed provisions regarding rates, repeal of various deductions and increased ability to expense assets will be the topic of a follow up article. This article is focusing on two key areas of change: (1) the passthrough income deduction; and (2) the deduction for outbound (offshore) licensing.
One of the most significant favorable business tax changes is the reduction of the corporate tax rate to a flat 21%. This is limited to “C” corporations. Congress therefore also sought to reduce the effective rate for passthrough businesses by promulgating a “passthrough income deduction” of 20% for partnerships, sole proprietorships and “S” corporations, but as is detailed in the following paragraphs, made it so complex and restrictive that taxpayers with passthrough income, depending on their situation, may find themselves unable to even claim it.
A detailed explanation of the mechanics of this deduction would take many pages. At a very simplified level, the deduction is calculated to be the lesser of (1) “combined qualified business income” or (2) taxable income less capital gains. This net lower number is essentially taken at 20% for the “passthrough income” or “qualified business income” deduction.
Drilling down, “qualified business income,” calculated at an aggregate amount, is the lesser of (1) essentially the allocable share operating income less operating expenses; or (2) the greater of (a) the allocable share 50% of W-2 wages paid; or (b) the allocable share of 25% of W-2 wages + 2.5% of the acquisition cost of all “qualified property.” The “qualified property” adjustment was intended to benefit real estate businesses. It is limited to tangible property. Intangibles such as copyrights for music would not appear to qualify. If taxable income is below the key “threshold amounts,” detailed in the following paragraph, only operating income less expenses is taken into account as “qualified business income.”
The taxable income “threshold amounts” are $315,000 (phased out at $415,000) if filing joint; $157,500 (phased out a $207,000) if filing in any other status. The threshold is to be inflation adjusted and is measured at the taxpayer level. Critically, the QBI deduction for services in the following specified trades or businesses is likewise limited for deduction eligibility to these threshold amounts: performing arts, health, law, accounting, actuarial science, consulting, athletics, financial, brokerage and a wide range of specified investment services as well as any trade or business where the principal asset is the reputation or skill of a proprietary individual or employee.
Hence, performing musicians are not eligible for this deduction if their passthrough taxable income is above the threshold level. However, their managers are eligible. Music publishing businesses should also qualify for this deduction if properly structured where taxable income is above the threshold amounts.
Depending on circumstances, the deduction may rest on the amount of W-2 wages a business has paid out in a given year and/or cost of its qualified property rather than net income of the business for the year. If a business has no W-2 wages or qualified property, the taxpayer may wind up unable to claim a deduction.
On the other hand, if a business has no qualified income but has wages and qualified property, the deduction could also be limited because the lesser of two net amounts applies for eligible income above the threshold. Where net operating income is less than wages expense and 2.5% of acquisition property, the deduction appears to bottom line at wages expense plus 2.5% of the cost of acquisition property if taxable income is above the threshold amounts.
Hence, while it’s labeled “qualified income passthrough deduction,” with a stated intent of equalization between tax treatment of corporations taxed at 21% and passthrough entities, this result is not achieved consistently. Unlike a rate reduction, it’s not a deduction per se for passthrough businesses in all circumstances.
Given that W-2 wages are a limitation, some may consider re-structuring as an S corp vs. a partnership as owners are issued W-2s by S corps, but not if partners in a partnership. However, the tax effects of adopting a corporate vs complete passthrough structure has its own set of limitations and drawbacks which should be carefully weighed beforehand.
For example, owners reverting to sole proprietorship or partnership status after an S election can only be achieved by means a technical tax liquidation of the S corporation even if the legal entity remains intact. This generally triggers taxable gain on the variance between tax basis and fair market value of all S corp. assets, including intangibles. In contrast to partnerships and sole proprietorships where such an action is more likely to be tax exempt, any distributions of assets from an S corporation to its owners invariably triggers tax gain recognition on the difference between asset basis and fair market value.
Switching to a “C” corporation, may seem like a good choice since a 21% rate is imposed across the board regardless of the type of income or activity, amount of property held or wages. However, the analysis should not stop there. This is because any earnings that are distributed from a “C” corporation are subject to additional federal tax of 23.8%. Adding the two rates together, you are higher than a single top rate of 37%. In addition, an “accumulated earnings tax” is also imposed at the corporate level where too much in earnings is retained and not distributed by a “C” corporation. States with income tax, generally the income twice also - at the corporate level first and then again for dividends received by the shareholder but, unlike federal, not accorded reduced tax rates as a dividend. Unlike passthrough businesses, “C” corporations are not eligible for reduced tax rates on capital gains. Also, change in entity elections are generally tied to a five-year term so switching to a “C” corporation can’t necessarily be undone overnight. Hence the pros and cons of switching to this type of entity along with what assets and type of business activity should be weighed very carefully beforehand.
Turning to international taxes, while on the one hand international businesses structured as “C” corporations face a mandatory deemed repatriation of all their offshore earnings with tax liabilities reflected as a hit to their Q4 2017 earnings, a new royalty export incentive now exists. Specifically there is now a 37.5% deduction for foreign derived intangible income, namely outbound licenses of any intellectual property. While interpretive guidance has yet to be issued, on its face, it would appear to include licensing rights for artistic and musical compositions. After 2025 the rate goes to 21.875%.
The 2017 Tax Act impacts each taxpayer and business in the U.S. There are numerous issues raised in interpretation that will require the Service’s clarification in time. In the meanwhile, taxpayers should have a review of their structure to ensure that they are availing themselves of potential tax benefits under the new law and, to the extent possible, avoiding increased liabilities.
Magda Szabo is a Partner at Janover LLC in New York City and specializes in domestic and international income & estate/gift tax matters, including in the entertainment industry.
Steve White is a Principal at Janover LLC where he provides business management, tax, and royalty services to entertainment clients, and is also Treasurer of The New York Chapter of The Association of Independent Music Publishers.
** Szabo and White will further discuss the implications of the new tax law at the AIMP-New York Chapter event, “Tax Planning Under The Tax Cuts and Jobs Act,” on Thursday, February 15 at 6pm. Registration is free to AIMP members and $15 for non-members; video will be available to AIMP members after the event: https://www.aimp.org/event/2018/02/15/871/Tax_Planning_Under_The_Tax_Cuts_and_Jobs_Act