21 TAXES: BEYOND SCHEDULE C
The artist must also be aware of a number of other tax benefits and obligations in order to be able to make rational choices and to seek professional advice when necessary. These provisions, while not gathered neatly in one place like income and expenses on Schedule C, are of great significance to the artist.
Self-Employment Tax
The social security system of the United States creates numerous benefits for those who have contributed from their earnings to the federal social security system. It provides benefits for a person’s family in the event of death or disablement as well as providing a pension and certain medical insurance. Artists, whether employees or self-employed, are covered by the system. Since the payments for social security are not automatically withheld for a self-employed artist, as they are for one who is an employee, the self-employed artist must file with Form 1040 a Schedule SE, Computation of Social Security Self-Employment Tax, and pay the self-employment tax shown on Schedule SE. Self-employment income is basically the net income of the artist reported on Schedule C, subject to certain adjustments. If an artist and spouse both earn self-employment income, each must file a separate Schedule SE. If an artist has more than one business, the combined business earnings should be totaled on Schedule SE for purposes of calculating the self-employment tax.
Social security coverage, to gain the various benefits, is created by having a certain number of quarters for which a worker makes payments for social security. If a minimum number of years of work credit is established, the artist qualifies for benefits. The amount of benefits is based on average yearly earnings covered by social security. Therefore, the artist who pays more self-employment taxes will be eligible for larger benefits from the system.
The self-employed artist must file Schedule SE for any tax year in which net self-employment income is more than $400. The maximum amount of income on which tax must be paid has been increasing constantly over the years—for example, from $14,000 in 1975 to $37,800 in 1984 to $68,400 for 1998 to $106,800 in 2009—and the rate has also increased over the years (for example, the rate was 11.3 percent in 1984 but in recent years has been 12.4 percent for social security). In addition, there is a Medicare tax of 2.9 percent on all self-employed income (but note that self-employment income is multiplied by .9235 to reduce it before the tax calculations are made). One half of the self-employment taxes paid are a deductible expense on Form 1040.
Additional information as to the benefits available under social security to either the artist or the artist’s family is available from the local offices or the Web site (www.ssa.gov) of the Social Security Administration, including a helpful publication titled Understanding the Benefits and an information sheet titled If You Are Self-Employed.
Estimated Tax
Employers withhold income and social security taxes from the wages of their employees. However, the self-employed artist must pay income and social security taxes in quarterly installments computed on Form 1040-ES, Estimated Tax, and mailed on or before April 15, June 15, September 15, and January 15. In most cases, Form 1040-ES is required if the artist estimates that the total of income and self-employment taxes for the next year will exceed any withheld taxes by $1,000 or more.
The failure to pay a sufficient amount of estimated tax subjects the artist to liability for penalties, as well as having to pay the tax deficiency. A simple way to avoid the risk of such penalties is to pay as estimated tax in the current year what the actual tax amount was in the prior year. IRS Publication 505, Tax Withholding and Estimated Tax, gives more detailed information regarding the estimated tax and how to avoid penalties for underpayment.
Retirement Plans
Keogh plans permit a self-employed person, such as an artist, to contribute to a retirement fund and to deduct the amount of the contribution from gross income when computing income taxes. However, the deduction is allowed in any year only if the artist places the amount to be deducted in one of the following retirement funds: a trust, annuity contracts from an insurance company, a custodial account with a bank or another person, special U.S. Government retirement bonds, or certain face-amount certificates purchased from investment companies. Even if the artist is employed by a company with a retirement program, the artist may still have a Keogh plan for self-employment income from the career in art.
There are several ways to determine the amount of contributions to be made to a Keogh plan, which are limited by certain caps. To be able to contribute the maximum amount, the artist would have to have a certain income level. If this level is not achieved, lesser contributions can be made. If an artist has employees, it is quite likely that a plan to benefit the artist will also require contributions for the benefit of the employees.
A contribution to a Keogh plan can be made before the filing date of the tax return, which is usually the following April 15, or any extensions of the filing date, as long as the Keogh plan was in existence during the tax year for which the deduction is to be taken. Because the money contributed to a Keogh plan is deductible, there are penalties for withdrawal of monies from a plan prior to age fifty-nine and a half, unless the artist becomes permanently disabled. No taxes are levied on the growth of a Keogh fund until the funds are withdrawn. Distributions are taxed when made, and must begin no later than age seventy-and-a-half (or, in some cases, the year of retirement if the person is older than seventy-and-a-half on retiring). The artist’s tax bracket then, however, may be much lower than when the contributions were made and the funds have had tax-free growth. If a trust is created, it is possible for the artist to act as trustee and administer the investments. More information about Keogh plans can be obtained from the institutions, such as the local bank or insurance company, which administer them. Also helpful is IRS Publication 560, Retirement Plans for Small Business.
A self-employed person may also create a SEP (Simplified Employee Pension), which is not as flexible as a Keogh plan in terms of being customized. However, SEPs need not be set up by the end of the year for which the contribution is to be made and do not have the same annual filing requirements as Keoghs. For artists who want to make the largest possible contributions, the Keogh is preferable to the SEP.
Separate from either a Keogh plan or a SEP, the artist may begin an IRA (Individual Retirement Account) and contribute into this account each year. A married artist with a nonworking spouse may be able to contribute for him- or herself and make an additional IRA contribution and deduction for a nonworking spouse, subject to certain qualifications and limitations.
To qualify to make a deductible contribution to an IRA, an artist must either (1) not be covered by another retirement plan (such as a Keogh or SEP), or (2) if covered by another retirement plan, the artist must not exceed certain limits on adjusted gross income (which increase if the artist is married).
The amount of the IRA contribution is a deduction from gross income. Again, the funds contributed must be taken out of the artist’s hands and placed in a trust, a custodial account with a bank or other person, annuity contracts with a life insurance company, or special U.S. Government retirement bonds. The payment, to be deductible, must be made by April 15 of the year following the tax year for which the deduction will be taken. More information may be obtained from the institutions administering Individual Retirement Accounts, as well as IRS Publication 590, Individual Retirement Arrangements (IRAs).
If an artist were covered by a retirement plan and could not make a deductible contribution to an IRA, it might be worthwhile to make a nondeductible contribution (subject to the current limitations on the amount of the contribution). Several types of nondeductible IRAs have been created. While contributions are nondeductible, any growth in value of a Roth IRA or an education IRA will escape taxation because distributions are not taxed. While these new IRAs apply to all taxpayers and are beyond the scope of this book to cover in detail, they are worth considering when the artist is planning for retirement or education (such as education of the artist’s children).
Keogh, SEP, and IRA plan contributions are claimed on Form 1040. The artist should consult with the plan administrator to determine what additional forms may have to be filed. Also, the custodial fees charged by a plan administrator may be deducted as investment expenses on Schedule A if these fees are separately billed and paid for. Commissions paid on transactions in the retirement fund do not qualify as deductible.
Child and Disabled Dependent Care
An artist’s payments for child or disabled dependent care may create a tax credit. A tax credit is subtracted directly from the tax owed, so it is more beneficial than a deduction of the same amount that merely reduces income prior to application of the tax rates. Basically, this credit is available to the artist who maintains a household including either a child under age thirteen or a disabled dependent or spouse for the care of whom it is necessary to hire someone so the artist can gainfully pursue employment, self-employment, or the search for employment. IRS Publication 503, Child and Dependent Care Expenses, describes in greater detail the availability of and limitations on this credit.
Contributions
Contributions to qualified organizations are deductible if personal deductions are itemized on Schedule A. Since the artist’s own artworks, and any gifts of works by other artists, have a tax basis of zero (if the artist is on a cash basis) or the cost of materials (if the artist is on an accrual basis), the artist’s deduction is limited to such basis.
For example, an artist claimed an advertising and public relations expense for six paintings he donated to charities. The expense was at what the artist considered to be fair market value, despite the fact that he had already deducted the cost of materials in prior years. The court concluded that the tax law “does not permit a business expense deduction based on the value of the taxpayer’s own labor and… expressly limits taxpayer’s charitable contribution deduction for his own labor as an artist to his cost basis” (Maniscalco v. Commissioner, 632 F.2d 6). Rejecting the artist’s contention that the tax code is unconstitutional on this point, the court observed, “Artists, while a unique segment of the population, must be treated equally with all others by the tax laws. Creativity, unfortunately, does not support a tax deduction as an ordinary and necessary business expense.” Numerous bills have been proposed to rectify this inequitable treatment, and perhaps the artist will someday be able to deduct either part or all of the fair market value of contributed works.
The rule, of course, is otherwise for the collector who purchases work that increases in value. The deductions for a collector’s contributions are discussed on page 240. A number of states have enacted laws giving artists the right to deduct their own contributed art on the basis of fair market value for the purpose of state taxes. These states include Arkansas, Maryland, Michigan, and Oregon.
Bad Debts
A common error is the belief that if an artist (on the cash basis) sells a work for $1,000 and the purchaser never pays, the artist can take a bad debt deduction. The artist cannot take such a deduction, since the $1,000 purchase price has never been received and included in income. As stated in Publication 334, Tax Guide for Small Business, “If you use the cash basis of accounting, you normally report income when you receive payment. You cannot take a bad debt deduction for amounts owed to you that you have not received and cannot collect if you never included those amounts in income.”
A cash basis taxpayer can, however, gain a tax benefit from either business or nonbusiness bad debts of the proper kind. In almost all cases, the artist’s bad debts will be nonbusiness. For example, if the artist makes a loan to a friend who never repays the loan, the amount of the loan will be a nonbusiness bad debt. The loan cannot be a gift, however, and must be legally enforceable against the borrower. The nonbusiness bad debt deduction is taken in the year in which the debt becomes worthless. It is reported as a short-term capital loss on Schedule D.
Net Operating Losses
The artist who experiences a business loss as determined on Schedule C will carry the loss to Form 1040, where it is eventually subtracted from gross income in the calculations to reach taxable income. However, if the loss is large enough to wipe out other taxable income for the year, the excess loss can first be carried back to reduce taxable income in two prior years and then carried forward for twenty future taxable years. This type of loss is likely to arise when a professional artist is changing over from being employed to devoting all working time to art. The result is that the artist will be entitled to a tax refund (if taxable income in previous years is reduced) or will save on taxes in future years. IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, describes the net operating loss, but the artist will probably need an accountant’s help for the computation of a net operating loss.
American Artists Living Abroad
American citizens, whether or not they live in the United States, are taxable by the United States government on all of their income from anywhere in the world. However, a tax benefit for many American citizens living abroad is the exclusion from American taxable income of $91,400 of earned income from foreign sources. The $91,400 exclusion apples for 2009, having increased from $72,000 for 1998. This exclusion can result in substantial tax benefits when the tax rates of the foreign country—such as Ireland, where a qualified artist can live tax free—are lower than the tax rates in the United States. The exclusion can be negatively affected if an artist travels in countries restricted to United States citizens under the Trade with the Enemy Act of the International Emergency Economic Powers Act.
Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, generally explains the guidelines for eligibility for these exclusions. The basic requirements are either a one-year residence or a physical presence in a foreign country and earned income created from work done in the foreign country. Residence is a flexible concept based on the circumstances of each individual. While the residence must be uninterrupted (for example, by owning or renting a home continually), remaining abroad for all the taxable year in question is not necessary. Brief trips to the United States do not affect the tax status as a resident abroad. However, the length of each visit and the total time spent in the United States must be watched carefully. Physical presence requires the taxpayer to be present in a foreign country or countries for at least 330 days (about eleven months) during a period of twelve consecutive months. Regardless of which test is met, the income to be excluded must be received no later than the year after the year in which the work was performed which generated the income. Certain foreign housing costs may also be excludable or deductible from income.
Assuming the artist met either the residence or physical presence test, the requirement that the income to be excluded had to be earned income often proved fatal to the artist’s attempt to benefit from the exclusion. The reason for this was the definition, once found in Publication 54, of most of the income of an artist as unearned.
This unjust rule was rectified, however, in a case involving the painter, Mark Tobey, while he was a resident of Switzerland. In Tobey v. Commissioner, the issue before the tax court was whether Mark Tobey, all of whose “works were executed…without prior commission, contract, order, or any such prior arrangement,” had earned income such that he could avail himself of the exclusion from United States taxable income. The court, noting that “earned” generally implies a product of one’s own work, reasoned:
The concept of the artist as not “earning” his income for the purposes of Section 911 would place him in an unfavorable light. For the most part, the present day artist is a hard-working, trained, career-oriented individual. His education, whether acquired formally or through personal practice, growth and experience, is often costly and exacting. He has keen competition from many other artists who must create and sell their works to survive. To avoid discriminatory treatment, we perceive no sound reasons for treating income earned by the personal efforts, skill and creativity of a Tobey or a Picasso any differently from the income earned by a confidence man, a brain surgeon, a movie star or, for that matter, a tax attorney (Tobey v. Commissioner, 60 T.C. 227).
This rationale necessarily led to the conclusion that Tobey’s income was earned. Publication 54 now reflects this by stating, “Income of an artist. Income you receive from the sale of paintings you created is earned income.”
Each artist hoping to benefit from the exclusion for income earned abroad must, of course, consult with a lawyer or an accountant to determine the effect of the foregoing legal provisions on his or her unique situation. Artists already living abroad should also inquire at their American consulate to determine whether any treaty regarding taxation between the United States and the country in which they live might affect their tax status.
The artist living abroad should also consider whether any income taxes paid to a foreign government may be taken as either a deduction or a tax credit. No such credit or deduction will be allowed on foreign income taxes paid on earned income excluded from the United States taxation. IRS Publication 514, Foreign Tax Credit for Individuals, explains these provisions further.
Foreign Artists in the United States
Foreign artists who are residents of the United States are generally taxed in the same way as United States citizens. Foreign artists who are not residents in the United States are taxed on income from sources in the United States under special rules. A foreigner who is merely visiting or whose stay is limited by immigration laws will usually be considered a nonresident. A foreigner who intends, at least temporarily, to establish a home in the United States and has a visa permitting permanent residence will probably be considered a resident. IRS Publication 519, United States Tax Guide for Aliens, should be consulted by foreign artists for a more extensive discussion of their tax status.
Employee Expenses
Often artists who work as employees will find that they are required to incur expenses in the performance of their duties. The nature of the expenses is the same as the expenses that a self-employed person could deduct, such as supplies, work space, equipment, travel, and so on. These expenses, if ordinary and necessary, will be deductible on Schedule A if the artist itemizes (and will be allowed only to the extent that these and certain other expenses total in excess of 2 percent of adjusted gross income). To deduct these expenses, the artist must complete Form 2106, Employee Business Expenses.
The artist who incurs expenses as an employee can consult IRS Publications 521, Moving Expenses, and 535, Business Expenses, for further information on deductibility.
Forms of Doing Business
Depending on the success of the artist, various forms of doing business might be considered. There may be both business and tax advantages to conducting the artist’s business in the form of a corporation or partnership, but there may be disadvantages as well.
Generally, the non-tax advantages of incorporation are limited liability for the stockholders, centralized management, access to capital, transferability of ownership, and continuity of the business. For the artist, the most important of these non-tax advantages will probably be limited liability. This means that a judgment in a lawsuit will affect only the assets of the corporation, not the personal assets of the artist. Limited liability is quite significant when the work locale, machinery, chemicals, or even artwork are potentially hazardous. The attribute of limited liability applies to all corporations—the regular corporation and the Subchapter S corporation. The tax treatment, however, differs significantly between the two types of corporations.
For regular corporations, net corporate income is taxed at 15 percent on net income up to $50,000, 25 percent from $50,000 to $75,000, 34 percent from $75,000 to $100,000, 39 percent from $100,000 to $335,000, 34 percent from $335,000 to $10,000,000, 35 percent from $10,000,000 to $15,000,000, 38 percent from $15,000,000 to $18,333,333, and 35 percent over $18,333,333. Usually the tax on the corporation can be substantially avoided by the payment of a salary to the artist, which creates a deduction for the corporation. Such an arrangement can effectively average the artist’s income from year to year.
The Subchapter S corporation is not taxed at all, but the income is credited directly to the accounts of the stockholders and they are taxed as individuals. Both types of corporations are less likely to be audited than an individual proprietor. It may also be easier to choose a fiscal year (any tax year other than the calendar year) and, particularly in the case of a regular corporation, shift some of the artist’s income into the next tax year. Some of the disadvantages of incorporation are additional recordkeeping, meetings, and paper work, as well as significant expenses both for the initial incorporation and for any ultimate dissolution.
A partnership is an agreement between two or more persons to join together as co-owners of a business in pursuit of profit. Partnerships are not subject to the income tax, but the individual partners are taxable on their share of the partnership income. Partners are personally liable for obligations incurred on behalf of the partnership by any of the partners. A partnership offers to the artist an opportunity to combine with investors under an agreement in which the investors may gain tax advantages by being allocated a greater share of partnership losses. A variation of the usual partnership is the “limited partnership,” in which passive investors have limited liability (but the artist, running the business actively, is still personally liable). Another variation is the “joint venture,” which can be described simply as a partnership created for a single business venture.
Many states have legislated into existence a new form of business entity called a “limited liability company,” which combines the corporate advantage of limited liability for its owners while still being taxed for federal income tax purposes as a partnership. The limited liability company offers great flexibility in terms of the mode of ownership and the capital structure of the company as well as what corporate formalities the company must observe.
In general, the tax law requires that a partnership, an S corporation, or a personal service corporation (which is a corporation whose principal activity is the performance of personal services by an employee-owner) use a calendar tax year, unless there is a business purpose for using a fiscal year.
The artist contemplating doing business as either a corporation, partnership or limited liability company should consult a lawyer for advice based on the artist’s unique needs.
Gifts
The artist can avoid paying income taxes by giving away the artist’s creations. Both artworks and copyrights can be transferred by gift to family members or others whom the artist may wish to benefit. The artwork and copyright on the work can be transferred separately from one another if the artist chooses. The artist could keep the work and transfer the copyright, transfer the copyright and keep the work, or transfer both the work and the copyright.
If the person who receives the gift is in a lower tax bracket than the artist, tax savings will result upon sale by the person who received the gift. Gifts over certain amounts, however, are subject to the gift tax. Transfers of income-producing property from adults to children under eighteen will have a very limited tax advantage. Basically, the unearned income of the child will be taxed at the child’s or parents’ top rate, whichever is greater. Of course, the transfer of art or other assets to the child might still be a wise decision, since the art might appreciate in value without producing income until a sale at a much later date.
The making of gifts and the gift tax are discussed on pages 230–231, but careful planning is a necessity if gifts are to play an effective role in tax planning.