Financial Management for Musicians' Author Offers Tax Tips (Part I)
Cathy McCormack Let's talk about the myths of money management and audits, to start the event. The definition of a hobby has several factors, and includes a test to determine whether there has been a loss in three of the proceeding five years. That is just one of the criteria in determining whether or not you have a hobby. A hobby can exist with respect top raising horses, painting, writing or anything that you can get involved in. They could be considered a business or a hobby. There are a lot more criteria to consider, and one important and significant issue is whether you have intent to make a profit.
Most people who launch into something that takes eighty percent of their time obviously have a profit motive. Your job is to prove that you have a profit motive and to keep good records to show how much time that you spend on the business. The time issue is extremely important. Keep your calendar in outlook or a manual calendar or on post-it notes, whatever that you do to document your schedule. It is one of the leading ways to prove that you have spent substantial time in trying to produce profit.
[Question] Should you keep track of time and expenses after your first two years of losses?
Cathy McCormack This is something that you should have for every year you are in business. When people first start to write, they do not think of it as a business so they don't track time or expenses very well. Some people knew from the minute that they are born what they wanted to do and immediately launched into it. When people get started in songwriting and have a different career "day job," they tend not to keep good records. Then they hear they cannot take losses for three years in a row, so they do not even bother with keeping the records.
I encourage you when you first start writing songs to keep track of your expenses, keep a good calendar, and track of everything that would help your accountant to support what you are doing for your songwriting career. You can show losses your entire life. Many people fear of getting audited and will not deduct their expenses. Don't lose opportunities for fear of the audit myth. Take your losses every single year.
I have had clients get audited because they have taken losses over a period of years. I represented them, proving profit motive and everything was fine. Two years ago a client was audited. He has a studio in his home, has been writing all his life. He has a wife who has made money and she off set her income with his losses. He had a big hit and is going to start showing substantial profit, which solidified the fact that he is a writer with profit motive. In addition, he had a calendar and sufficient data to show that he spent his life trying to launch this business.
There was a court case about ten years ago with respect to a painter that was audited and the IRS agent ruled the painter had a hobby. The painter had very good records; they went on to tax court and the painter won, as the judge ruled it was a proven fact that many artists did not become famous until after they died. (Laughter in the room.) One time is all it takes to put you on a map after all the years of working toward that goal. That court case has been used several times in the music business and other creative industries.
[Question] So you are saying that you need a calendar to prove a profit motive?
Cathy McCormack You need a calendar to prove the amount of time that you spent on your craft.
[Question] Is there a minimum amount of time to prove you had a profit motive?
Cathy McCormack It is about you being a member of organizations that support your efforts, keeping brochures and pamphlets of seminars that you have attended, keeping records of your co-writing appointments or interviewing people to get ideas. You calendar is a support for the other things that you do with your songwriting career.
[Question] The point of the profit motive is for your taxes?
Cathy McCormack No, the profit motive is to prove your songwriting is not just a hobby. It shows you are very serious about it and you want to make money at the songwriting. Make sure that you do act like a business, keep good records of your time and expenses.
[Question] What happens if you have many years of no income in the songwriting business?
Cathy McCormack That happens and that is OK. You deduct it on a schedule C with your tax return and show your losses against other income that you make during the year.
[Question] Is there any rule about how much money that you can make and still have a loss on your taxes?
Cathy McCormack You can have negative income, but the thing that triggers an audit is to show an income below the standards that the IRS has set that they feel you can live on. To continue to show poverty level income on your return can trigger an audit. They will audit you because they believe that you have an income that you are not showing on your tax forms. I have represented people in those categories. They ask how can you live and eat in the kind of house and survive making this low amount of money? They come in to make sure you are reporting all of your income.
[Question] I have been living on inheritance in the past year. Is this going to trigger an audit?
Cathy McCormack If you have inheritance money, you likely have it invested, and can show investment income. If I were looking at your tax return, I would look to see how you have been able to sustain those losses. If I saw that you had interest and dividend income, then I would say this person has money saved up that has sustained your lifestyle during the process of trying to launch your business. Those kinds of things are taken into consideration when the IRS triggers audits.
You would not get audited because you continue to have losses. If you had no income at all and you showed losses and carried those losses forward, then you would probably get triggered for an audit because it looked like you had unreported income. If they audit you, come in and find you clean, they put a note in your file that says this was a clean audit. That establishes a good track record for you. If you come back with those ratios mentioned previously about audits, then they will probably skip you from an audit. If they audit you and find errors, they can recommend that you be audited in the future.
[Question] What about forming your own publishing company for business and tax issues?
Cathy McCormack The type of entity is very important and heavily debated of whether you should incorporate. When you incorporate or form another entity, you are complicating your life. It does supply a limited liability, which should be the only reason that you incorporate. Joint relationships require a second entity, and that can be complicated if there are substantial dollars at stake. Then you need to incorporate.
[Question] What about self-publishing. Do I need a separate entity?
Cathy McCormack No, you don't need to incorporate. It is best if you keep it simple, not incorporating or forming other types of entities. Even as you start to make money, people think they should immediately set up a business and incorporate. Unless you accumulate substantial wealth and in a risky business, there is really NO reason to incorporate. It would make your life more complex. There is this myth out there that it will save you taxes if you incorporate and it is absolutely false - it will cost you more money! You would also have to prepare more tax forms. It would involve more income for us accountants, but it is not in the best interest of the clients.
[Question] To collect royalties, you have to have a name for your publishing, but you do not have to have a separate business - right?
Cathy McCormack Yes - you could have a "dba" (doing business as) and that will work for you. You are a sole proprietor and it does not add an extra level of complexity.
[Question] I started getting royalties in about 1990, was doing my own taxes, and filed my royalties under schedule E. I even called the IRS and the agent said what I was doing was OK. Later when I hired an accountant, they said that was wrong. Could you explain a Schedule E?
Cathy McCormack Schedule C is where you report self-employment income, an activity that you are involved in as a business like your publishing company. Schedule E is for passive activities such as activities that you are not heavily involved in or rental properties. If you were a passive owner of an oil well, then royalties would get reported on a Schedule E. It is not subject to self-employment tax - social security and Medicare.
If you are a songwriter, you are actively involved with the production of royalty income and as a result, that is considered an active activity, not a passive activity. You will not win in an audit if you put it in a Schedule E. If you inherit a song catalog from someone and you were not the one who generated that money, then it is correct to report royalties on Schedule E. If you are involved in the writing of the songs, then put it on Schedule C of your tax forms.
If you have had income in the past and you generate what we call a net operating loss, that loss can be carried back to years where you had revenue and you can recover taxes for years past. You may be a candidate for loss carry back. If you had a loss in the 2002 year, you can go back to 1997 though 1998, 1999 and up to that particular year. For losses in 2003 and later, you can do a two-year carry back.
If you are looking at your 1040 and have a negative number on that bottom line, you have what is called a net operating loss, and that loss can be carried back - use that loss against income in the future, forward or against income tax that you have already paid. You can go back to previous years, report the loss against the income you reported that year, and get a refund for the tax you paid for that particular year. You can carry the loss forward for many years before those losses expire.
Someday, when you have income, you can use your current losses to offset those incomes. You have three years to amend your taxes and show those losses that you were afraid to show in the past. You can carry your loss forward and tell the government that is what you are doing, if you do not want to carry it backward. As soon as I see a client that has an operating loss, I stop right there, call the client and ask what is going to happen next year. If they are expecting to make money the next year, as they may have a song on a popular CD that will make money next year, they may want to carry the loss forward.
[Question] Deductible equipment - for instance software that comes with a rebate - can I use my credit card record as proof that I purchased this equipment or do I need the original receipt?
Cathy McCormack You have to have a receipt. The government is getting very sticky about using credit card receipts. They accept if you can show that those deductions are legitimate in other ways, but they prefer you use a receipt. If you get an agent that is rigid, he or she may not take the credit card as a receipt.
Many times I have clients who buy equipment at a garage sale and need a receipt. We have the garage sale owner sing a piece of paper for documentation, or the client will note in their calendar that they bought a piece of equipment at a garage sale. Cut out the clipping in the paper about the garage sale to prove there was a sale on that date.
[Question] What about using your computer to keep track of your records for the year?
Cathy McCormack One of the best computer software programs is Quicken for keeping up with your personal business. You can use it to even just keep track of your checkbook and credit cards. At the end of the year, you can print out the report for your accountant to do your tax return. I just recently represented someone in an audit that used Quicken and because the client had great records, it really went very smoothly and quickly.
[Question] What kinds of receipts does the IRS want to see when they do an audit?
Cathy McCormack They want to see the actual receipts. In Quicken, you can import your credit card records. The client I referred to had gotten rid of several of their receipts, but luckily, still had some of the receipts. In the end, the agent let us use the receipts that we had to justify expenses for the year. The IRS wants actual receipts from the stores where clients buy their products. A statement form the checkbook or credit card company doesn't meant anything to the IRS.
[Question] What kind of receipts does a songwriter need to keep?
Cathy McCormack If you deduct it on your taxes, you need the receipts. Money in a parking meter is a deduction; you need to write it down somewhere to show how it is an expense. I keep a log in the side of my car door with an ink pen in the middle. If I am somewhere and pay an expense like a meter or something, I write it down beside my mileage and total it up at the end of the year.