Paul L. Caron
Dean


Monday, June 17, 2019

Lesson From The Tax Court: Your Brand Is Your Business

Tax Court Logo 2Self-promotion is as American as P.T. Barnum.  So is wanting to avoid tax.  In K. Slaughter v. Commissioner, T.C. Memo. 2019-65 (June 4, 2019), Judge Wells teaches a lesson that all YouTube influencers and their return preparers need to learn: it is difficult to avoid self-employment tax on earnings from self-promotion.  Ms. Slaughter argued that her “brand” was an intangible asset separate from her business of writing crime novels, and so earnings attributed to her brand were not self-employment income.  The Court rejected her attempt to assign part of her earnings to what amounted to her investment in herself.  Her brand was itself her business.  Hey, at least she avoided penalties because her tax position was her accountants’ idea.  However, that leaves the accountants potentially vulnerable to penalties under §6694.  Details below the fold.   

Law: Self-Employment Tax

The Social Security and Medicaid programs are funded, in part, through taxes imposed on labor income.  When one person labors for another, the employee and employer share the tax, each paying 7.65% into the Social Security and Medicaid programs (6.2% into Social Security and 1.45% into Medicaid).  Section 3101 taxes employees on the wages they receive.  Section 3111 hits the employer with an excise tax on the act of employing employees, as measured by the wages paid. 

When one labors for oneself, however, in pursuing a trade or business (“T/B”), one must pay Social Security and Medicaid tax of 15.3% on the income derived from the T/B.  Section 1401 imposes that rate on something called “self-employment income.”  Yes, it’s a term of art.

The self-employment income subject to self-employment tax is that income which is appropriately linked to a T/B activity.  It’s the same test as for determining whether the taxpayer may take §162 deductions.  Courts have used different ways of expressing that idea.  Here are two: Milligan v. Commissioner, T.C. Memo 1992-655 (“Income which derives from self-employment is income which originates from it, which flows from that source."); Newberry v. Commissioner, 76 T.C. 441, 446 (1981) ("there must be a nexus between the income received and a trade or business that is, or was, actually carried on”).   In Slaughter, Judge Wells goes with the “nexus” language.

An income-producing activity becomes a T/B when the taxpayer engages in it “with continuity and regularity” and “the taxpayer's primary purpose for engaging in the activity [is] for income or profit.”  Commissioner v. Groetzinger, 480 U.S. 23, 31 (1987).  If an activity is a T/B for §162 deduction purposes, income from that activity is self-employment income. §1402(c).  Fun fact:  Current Tax Court Judge Albert Lauber argued the case for the government in Groetzinger.   Just one part of a very impressive career.

Not all self-created earnings come from a taxpayer’s T/B.  Earnings from a hobby won’t be subject to self-employment tax.  Rev. Rul. 55-258, 1955-1 CB 433.  Nor are earnings from investment activity if they arise from either “the production or collection of income” or from “the management, conservation, or maintenance of property held for the production of income” within the meaning of §212(1) and (2), respectively.  Unless and until those activities rise to the level of a T/B, they do not produce self-employment income. See Treas. Reg. 1.1402(a)-4 and -5.

This treatment of self-employment income makes it important once again to distinguish between a T/B activity and other activities.  I discussed one distinction recently in the post “Distinguishing Investment From Business Activity.”  Today the lesson involves whether an intangible asset created by the taxpayer is something other than a T/B of the taxpayer.

When a taxpayer creates property that itself produces a stream of income to the taxpayer, the question becomes what is the property’s relationship to the taxpayer’s T/B.  For example, an taxpayer might transfer a patent or invention to a third party in exchange for a royalty contract.  A taxpayer might similarly do that with a copyright or trademark.

If the taxpayer creates that royalty contract as part of the taxpayer’s T/B, the income it produces is self-employment income, with one exception: the taxpayer successfully assigns the income to a third party.  A successful assignment of royalty income allows the taxpayer to escape all taxation on the transferred payments ---both income tax and self-employment tax.  See e.g. Heim v. Fitzpatrick, 262 F.2d 887 (2d Cir. 1959).  But if the taxpayer is unable to make an effective assignment of income, the royalties are self-employment income.  Hittleman v. Commissioner, T.C. Memo 1990-325 (taxpayer in business of yoga instruction required to pay self-employment tax on income from yoga book royalty contracts ineffectively assigned to controlled entity).

Even if the taxpayer creates the income-producing property outside the scope of his or her T/B, the income from that property may still constitute self-employment income if the creation and maintenance of that income-producing property itself rises to the level of a T/B.  For example, in Levinson v. Commissioner, T.C. Memo 1999-212, Mr. Levinson ran a retail store that sold electronics and collectibles such as comic books, stamps, and stamps.  Mr. Levinson had also invented stuff over a forty year period and had sometimes sought and obtained patents.  After he closed up his retail store, Mr. Levinson figured out that some companies were using his previously patented inventions without paying him.  He sued and won.  He started receiving royalties. 

The Tax Court held that the royalties were not self-employment income.  First, the inventions were not within the scope of Mr. Levinson’s retail business.  They were instead the product of his tinkering activities.  The patents lacked a sufficient nexus to the retail store operation for the royalty income to be counted as self-employment income.  Second, the Court held that Mr. Levinson’s activity of creating and maintaining the patents was not itself a T/B.  The Tax Court held that Mr. Levinson’s tinkering lacked the continuity and regularity required by Groetzinger.  It was a hobby, one that happened to eventually produce some good income.

Facts. 

Ms. Karin Slaughter is a writer, mostly of crime fiction.  She writes under her own name.  Here’s her website.  Like McDonald’s, Ms. Slaughter has created a consistent and satisfying product for those who have an appetite for crime fiction.  She reliably serves up at least one new---and yet comfortably familiar---book each year.  Her writing skills would be worth less (but not worthless) without the savvy self-promotion that has made her name a brand.  According to Judge Wells, book buyers “walk into book stores and request petitioner’s books using her name rather than the title.” That’s a good thing for an author!  Indeed, Ms. Slaughter has scaled the heights of publishing to touch Nirvana: converting her books into film and television.  Good on her!

But tax is the constant shadow of success.  The IRS audited her 2010 and 2011 returns and decided that she had underpaid her self-employment taxes by about $156,000 in 2010 and $111,000 in 2011.  If my math is correct that means she declined to pay self-employment tax on some $1 million of income in 2010 and $725,000 of income in 2011.

The dispute centered on how to characterize payments made to her under a series of royalty contracts she had entered into from her first book in 1999 through 2011.  Each contract earned her more and more money because, hey, she is a relentless and successful self-promoter.  Yes, that is actually what she argued in court: she “was not a brand author when she signed her first contract in 1999.  By the time she entered into her contract in 2007, she had become a brand author and typical advance had grown eightfold.  Today, petitioner spends the same amount of time writing a book as she did in 1999.  The change in income is due to petitioner’s cachet as a brand author...”  Op. at 6. 

Dear readers, you don’t get to be a brand without a heckuva lot of self-promotion, whether your brand is your real name---such as Karin Slaughter, Rafael Sabatini, Alexandre Dumas, or James Patterson---or a fake name---such as Hardy Boys author Frank W. Dixon, Nancy Drew author Carolyn Keene (both pseudonyms created and promoted by Edward Stratemeyer,) or Ellery Queen (who, it has been said, did “far more for the detective story than any other two men put together.”).

Ms. Slaughter’s accountants of 20 years prepared the 2010 and 2011 returns.  The accountants decided that part of each stream of royalty payments could be allocated to Ms. Slaughter’s writing activity and part could be allocated to Ms. Slaughter’s self-promotion activity, which included extensive travel, speaking engagements, book tours and meetings “to protect and further her status as a brand author.”  Op. at 3.

The accountants had a problem, however.  None of the royalty contracts said anything about what part of the payments was for Ms. Slaughter’s writing and what part was for her brand.  So the accountants had to devise an allocation method.  They decided to allocate using the percentage of time Ms. Slaughter said that she spent on writing compared to her total work time, including those activities undertaken "to protect and further her status as a brand author."   So the accountant reported on Schedule C only those amounts representing “the percentage of the year which petitioner spent writing to the total payments she received for the year.”  Op. at 9.  The rest was reported on Schedule E as income from §212 activity.  The accountant apparently used days as the relevant unit of time.  Ms. Slaughter said she spent between 12 and 15 weeks each year on writing and the accountant assumed five-day workweeks.  That method would put the great bulk of payments on Schedule E. 

Lesson 1: The Brand is a Trade Or Business

The parties appeared to focus on the nexus issue. The IRS argued that Ms. Slaughter’s self-promotion was part and parcel of her business of being a writer, relying heavily on the fact that the royalty contracts contained no allocations.  Ms. Slaughter argued to the contrary, that her self-promotion was disconnected from her writing activity, reflected by the increasing value of what she was paid for licensing her name.  She gave the Court expert testimony on that disconnect. 

Judge Wells saw no need to resolve that particular nexus dispute because he accepted the IRS's alternative argument that her self-promotion was, in and of itself, a trade or business activity.  He held that “petitioner was engaged in developing her brand with continuity and regularity for the primary purpose of income and profit.” Op. at 18.  Judge Wells tells a compelling story to support that conclusion.  You can read the opinion to see why.  Because her self-promotion was itself a trade or business, all income derived from that activity was self-employment income subject to self-employment tax. 

End of story?  Not quite.  While Ms. Slaughter’s tax story---at least for her 2010 and 2011 returns---may be over, stay alert for a potential spin-off, a cautionary tale on penalties that gives us our second Lesson.

Lesson 2:  Of Rubber and Glue

I am rubber.  You are glue.  What bounces off me will stick on you.

The IRS sought to impose a §6662 penalty on Ms. Slaughter for negligence.  The Tax Court rejected the penalties because Ms. Slaughter had reasonably relied on her long-time accountants who came up with the return position.  Although the accountants admitted to Ms. Slaughter “that they did not find authority for treating the income in the manner they suggested,” and although they did not give her a formal opinion letter, the Court found that her reliance was reasonable and in good faith under the circumstances. So the penalties bounced off of Ms. Slaughter.  But where might they land? 

Why, on the accountants, under §6694.

Section 6694 imposes a penalty on return preparers when the return they prepared takes an “unreasonable position.”  Obviously, if the position is sustained, either by the IRS or by the Tax Court, it is a reasonable position!  So you only need worry about §6694 if your client loses.

Ms. Slaughter lost. 

Section 6694 says that what makes a position unreasonable depends on circumstances.  First, if the position is with respect to a tax shelter or a listed transaction, the position is unreasonable “unless it is reasonable to believe that the position would more likely than not be sustained on its merits.”  §6694(a)(2)(C).  Call that the more-likely-than-not standard.  That does not apply here.

Second, if the “relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return,” (§6662(d)(2)(B)(ii)(I)) then the position is unreasonable “unless there is a reasonable basis for the position.”   §6694(a)(2)(B).  Call that the reasonable basis standard.  That does not apply here, either.  At least I see nothing in the record to suggest that the accountants disclosed what they were doing as between Schedule E and Schedule C.  

Finally, under all other circumstances, a position is unreasonable “unless there is or was substantial authority for the position.”  §6694(a)(2)(A).  Call that the substantial authority standard.

The accountants would be most likely held to this third standard.  The question would be whether they had substantial authority for the position taken on the return.  They did not.  Heck, they admitted to Ms. Slaughter that they had no authority!  Zip.  They were making it up.  They did not even get a CYA opinion letter from a tax attorney.  Even when the case went to Tax Court, the best that her attorneys from Jones Day, led by Charles E. Hodges II, could come up with was an off-point Rev. Rul.   She doubtless paid a lot for that off-point Rev. Rul.    

I doubt the accountants would meet even the most generous standard, the reasonable basis standard.  Sure, they thought it was reasonable.. Double entry bookkeeping will do that to you.  But even if their attempted disassociation of Ms. Slaughter’s name from her writing activity wasn't magical thinking,  they still totally missed the basic rule:  self-employment income is that which is connected to a taxpayer’s T/B.  And relentless self-promotion is, in and of itself, a T/B.  I do not see how they could have a reasonable basis for the position that her branding activity was anything other than a T/B.  She wasn't nearly like Mr. Levinson in tinkering around with her brand.  She was all over it.  Most egregiously, the accountants put a Schedule C deduction for the apartment she maintained in Manhattan, even though her position was that she did her writing in Georgia and used the apartment to further her “brand” activity.  Taking a position on the return that contradicts your supposed reasonable basis really hurts you!

I have no idea whether the IRS will actually assess §6694 penalties against the accountants.  But if it did, the penalty would probably stick.

Bryan Camp? is the George H. Mahon Professor of Law at Texas Tech University School of Law

https://taxprof.typepad.com/taxprof_blog/2019/06/lesson-from-the-tax-court-your-brand-is-your-business.html

Bryan Camp, New Cases, Scholarship, Tax, Tax Practice And Procedure | Permalink

Comments

It's Medicare, not Medicaid. They are two very different programs.

Posted by: Sandra D Cole | Jun 17, 2019 6:59:16 AM

@ Sandra: thanks so much for that catch! Wish I could say it was just a typo, but it was more like a brain fart.

Posted by: bryan | Jun 17, 2019 7:11:10 AM

How do you clearly determine whether book royalty income belongs on Schedule C (subject to SE tax) or Schedule E (not subject to SE tax)? What mechanical test would you apply (spent more than 500 hours per year,...)? Or it is just the soft "with continuity and regularity" approach? I wonder how the majority of writers treat their royalties. I bet many use Schedule E. After all, there is that "'royalties received" line in income and putting it there would theoretically exempt it from SE income.

Posted by: Ramon Fernandez | Jun 17, 2019 9:50:02 AM

@ Ramon: Good question! I don't know the answer or if there is just one answer. It might be one of those "mainsprings of human conduct" issues. (Duberstein) But I do not think if I put royalty income on Schedule E, I would in the same return claim the expenses related to that royalty income on Schedule C! {grin} I imagine folks who inherit or are the otherwise recipients of royalty contracts use Schedule E because, as to them, the contracts are section 212 activity. But I would be interested in hearing from others who have more experience in this area.

Posted by: bryan | Jun 17, 2019 10:20:55 AM

Royalties from a copyright on a product derived from one's performance of personal services, such as an author, artist, or musician, are reported on Schedule C (subject to self-employment tax). This is true even if the person is no longer in that line of work; an example in my reference book is the lead singer of a “one hit wonder” who still must pay seal-employment tax on his royalties, even though he has not performed professionally for the last twenty-five years.

However, if the copyright is sold to a third party, not involved in its creation, it becomes investment property, and the royalties are reported on Schedule E (not subject to self-employment tax).

Also, payments simply for the right to use a person's image or likeness are not considered from the performance of personal services, nor to be royalties. (Although presumably one could be in the trade or business of licensing personal images and likenesses...)

Posted by: David Yos | Jun 20, 2019 8:57:26 AM

You say "If my math is correct..." It is not. The $156,000 2010 tax is likely on over $5.3 million. You only pay the 2.9% Medicare tax after reaching the social security cap. Time to recalculate!

Posted by: Wayne Galloway | Jun 23, 2019 10:06:34 AM