Business or Pleasure? The Red Flag Deductions of the Entertainment Industry
In our previous issue of For the Record, we briefly discussed tax planning issues for individuals in the entertainment industry.
This issue will focus on the areas of audit exposure that such individuals face—the areas that raise red flags to Internal Revenue Service (IRS)—namely, the attempts at claiming excessive deductions and expenses. Due to the complexity and uniqueness surrounding these attempts, IRS' Market Segment Specialization Program (MSSP) has issued guidelines to assist IRS examiners in scrutinizing and denying deductions unless they meet stringent requirements.
As Per the Code
The Internal Revenue Code allows for a deduction of all “ordinary and necessary expenses paid or incurred in carrying on any trade or business,” which creates much opportunity for abuse. However, Congress tries to minimize abuse by creating limitations. For example, deductions are not allowed for expenses that have been reimbursed or are reimbursable by the entertainer’s employer, even if the entertainer failed to ask for reimbursement. Generally, union contracts require that producers pay for their employees’ expenses provided that they are connected with the job.
The law bars deductions for “personal, living or family expenses.” These types of expenses include home furnishings, personal credit card interest or everyday meals with no business purpose. Actor Nicolas Cage learned about this the hard way. He and his production company were slapped with $1.8 million in taxes, interest, and penalties after his attempts to write off millions of dollars of limos, meals, gifts, travel and use of his Gulfstream 1159A turbojet were challenged by IRS. IRS deemed these expenses personal in nature. While his business manager claimed the expenses were "customary in the industry," IRS disagreed. The actor ultimately settled, but many of his expenses were disallowed. When challenged, an entertainer must affirmatively prove that any such deductions are not, in fact, personal.
Common “Red Flag” Expenses
Maintaining Skills, Status and Image
Entertainers, particularly high profile individuals, incur many expenses while trying to maintain their skills, status and image. Whether it be wardrobe, cosmetic improvements, physical fitness, education/training, public persona or even personal security, entertainers spend a significant amount on their upkeep. But how much of these expenses really are connected with their jobs?
Though many entertainers argue that the aforementioned expenses are essential to their image and thus, their livelihood, it turns out that the majority of these expenses are, in fact, too personal to be considered business related. Unless the entertainer can affirmatively prove a business purpose for such expenses with substantiation and detail, they will be nondeductible. For example, one can only deduct the cost of clothing if it is required by the employer and not adaptable to general use. On the other hand, costumes are usually deductible. The cost of physical fitness (trainers, gym memberships, etc.) is nondeductible. If physical conditioning is required by an employer, the expense is usually reimbursed. Also, the cost of hiring a bodyguard is nondeductible unless it is clearly related to the entertainer’s business (e.g., protecting the entertainer from fans and paparazzi during a performance or paid appearance).
Alternatively, fees paid to representatives of the entertainers (e.g., agent fees) are deductible. Similarly, the cost of publicity managers, public relations firms, and the like are considered business expenditures but require statements and specific examples of services performed. Further, special training, education or coaching, if required for a job, are also deductible expenses. For example, if an entertainer is required to learn a certain dialect for an acting role, the cost of hiring a coach for such would be considered a business-related expense. Finally, ongoing training to “keep up” one’s skill can be deducted so long as it is a skill that is ordinarily and necessarily used in the entertainer’s business.
Traveling is an essential part of the livelihood of many entertainers as they may be on the road performing, job searching or maintaining skills. Travel expense—the expense incurred while being away from home overnight—is distinguished from transportation expense which is considered the commute within the general area of the entertainer’s regular place of business and is generally nondeductible.
Generally, an entertainer who incurs expenses when traveling away from home for a primarily business-related purpose, will be entitled to a deduction for airfare or other travel related expenses, so long as the expense is not reimbursable by his employer. Meals and lodging can also be deducted for business-related days and for any additional stops that are made so long as they, too, are for business-related purposes.
Alternatively, commuting costs are not deductible and therefore, entertainers need to understand what falls into this category. Driving from home to the studio and back is nondeductible commuting. If the entertainer’s home is his place of business, transportation to and from his home for business purposes is deductible. Further, the expenses of going from one job location to another (e.g., auto mileage, taxi, subway) are also deductible, as is searching for employment, promoting oneself or even auditioning.
The details of all such expenses must be timely documented, for they will most likely be heavily scrutinized. In fact, keeping detailed and accurate records can be one of the best defenses if IRS decides to challenge any expenses as nondeductible. Entertainers undoubtedly incur many expenses in their industry, but the divide between personal and business motives is not always clear. Thus, professional advice should be sought so as to avoid raising red flags to IRS.