Tackling Tax Planning Issues of Nonresident Alien Artists

Let's take a musician as an example. A musician or a musical group touring the United States from abroad will typically be paid as an independent contractor and play at agreed-upon venues for an agreed-upon fee. A musician's U.S. income-tax-related expense deductions (i.e., expenses that are deductible against U.S. earnings because they are connected to performing in the United States) wouldn't run afoul of the sorts of limitations imposed on individuals who aren't independent contractors, but are instead considered employees of the payer of the fees. Such limitations affect business expenses that must typically be claimed as itemized deductions (under the category of employee business expenses on Form 2106), which have limits on their effectiveness as deductions based on the taxpayer's Adjusted Gross Income (AGI) (effectively a floor that must be cleared before any of these deductions lower the U.S. income tax), or from alternative minimum tax (AMT) implications (effectively a ceiling on the amount of these deductions that can be utilized to lower the U.S. income tax).

As opposed to a typical musician, an actor on a film, based on long-established history, is always considered the employee of a film production entity, due mostly to the degree of control the film producer exercises over the actor (e.g., when and where to show up on set, what lines to read and how to read them, etc.). Accordingly, an actor's employment-related expenses, such as agent's and manager's commissions, union dues, publicist, legal and accounting and the like, would always have to be subjected to limits affecting employee business expenses.

Loan-Out Corporations

An often-utilized tax plan for an artist that will be treated as an employee is to a loan-out corporation as a tax strategy. This is well-established in law, and can be either a C or S corporation owned by the artist. The term loan-out corporation is derived from the typical industry contract that stipulates the corporation, in return for a fee, agrees to 'lend' the services of its employee-artist to the production entity paying the fee.
Use of a loan-out entity allows all the aforementioned business deductions to be paid by the corporation and the remainder after these deductions is then paid out mostly as salary (in the case of an S corporation), or all as salary (in the case of a C corporation) to the employee-shareholder artist, thereby thwarting the effect of the AGI and AMT limitations imposed at the individual level, as all deductions are taken at the corporate level. In the case of a NRA, only the C corporation is an option, because an S corporation may only have U.S. persons as shareholders.

The considerations for using a loan-out entity are essentially: how much income tax will be saved vs. how costly will running the extra entity structure cost? While these considerations enter the evaluation for even resident artists, the decision tree is more complex for the NRA artist.

Generally speaking, a resident artist will (hopefully) work in the U.S. frequently and the tax savings of using a loan-out over working as an individual can be dramatic. In order to make economic sense, though, these income tax savings must more than offset the additional costs associated with the loan-out structure. These costs will include: legal and accounting fees (e.g., organizational costs, ongoing corporate-structure maintenance, and a second set of tax records and filings); potential additional income taxes at the loan-out entity level; additional payroll-related taxes (being now in the role of both employer and employee, the cost of Social Security and Medicare effectively doubles, in addition to unemployment, disability and other payroll-related taxes); and property and casualty forms of insurance (such as workers compensation and general liability policies). There may be some additional benefits, too, such as the ability to form a corporate retirement plan, potential medical benefits (e.g., a C Corporation can adopt a medical reimbursement plan), and a common belief that the artist's business deductions may draw less attention to be audited by the IRS inside a loan-out entity filing a return separate from its owner.

These considerations are the same for the NRA. However, they may not work as frequently inside the United States, which would be the only tax-advantaged opportunity to use a loan-out. Accordingly, the less the NRA works in the United States, the less opportunity to save on U.S. income taxes. However, many of the additional costs identified above continue once a loan-out corporation has been formed, thereby making the hurdle of achieving a greater overall savings from use of a loan-out much more challenging.

For instance, once a loan-out company has been formed, it is required to file an annual tax return with the IRS. Additionally, the loan-out will also likely be required to make state jurisdictional filings and often in more than a single jurisdiction. Besides the state of incorporation, states in which revenues have been earned will also be entitled to continuation of tax reporting. Considering the artist over time will have likely worked in several tax jurisdictions, many of which will have continued revenues from residual earnings, the professional costs of continuing tax compliance can prove expensive and the additional possible corporate minimum taxes imposed by these states are also to be considered.

Second Corporate Layer

While absent a loan-out the multi-jurisdictional tax compliance would also be present for the NRA as an individual, there is now a second corporate layer to consider. If income is consistent and plentiful, this is a minor issue; but not when meaningful income is earned only every few years. Furthermore, a NRA individual may often fall below the individual state income-tax filing threshold in years when not actively working in the United States and only receiving residual payments; the NRA could chose not to file in those jurisdictions, even if there had been state taxes withheld. That is generally not an option for a loan-out corporation. Even when a NRA chooses to file, or must file, as an individual, the return complexity for an individual is generally far below that encountered with state (and city) corporate returns.

A major issue that can often be overlooked regards the obligation to contribute to Social Security and Medicare. As previously mentioned, when an artist is an employee, his or her employer withholds Social Security and Medicare taxes from that individual's salary (the employee share) and then matches those contributions with like amounts (the employer share). When a loan-out is formed, the artist effectively becomes responsible for both portions on any salary the loan-out entity pays him or her, creating an additional expense. While the salary received from the loan-out will be less than what would have been earned by working directly for a third party (the salary from the loan-out having been reduced by the effects of the deductions taken within it before salary is paid to the shareholder-employee), the overall Social Security and Medicare bite will still typically be bigger (unless the loan-out deductions are so high that the salary from it is half, or less, than would have come directly from the third party).

For the NRA, this situation can be far worse, as the NRA may be eligible to avoid all Social Security and Medicare withholdings when working for a third party by reliance on a special type of tax treaty, known as a Bilateral Social Security Agreement (there are 17 countries that have such agreements with the United States). However, such a position cannot be achieved when working for an entity that the artist owns. This additional cost can be significant and perhaps the single greatest detriment to the NRA artist forming a loan-out entity.

Besides the ongoing professional fees of tax compliance, as well as corporate maintenance costs (e.g., legal fees to prepare written actions in lieu of an annual meeting), and of state filing fees and minimum taxes, corporate loan-out entities must consider the ongoing maintenance of general liability and workers compensation insurance policies. Working through a corporate loan-out argues in favor of maintaining such protection. As a NRA may never be sure when an assignment might arise, such policies are generally maintained year-round for a loan-out corporation. Such policies would not be maintained for an individual, so this is an extra operating cost that essentially goes to waste in years the NRA does not work in the United States.

Accordingly, the general rule is that a loan-out formed for a U.S. tax resident will almost assuredly save sufficient income tax to offset the extra operating costs. The same though cannot be said of the NRA and most NRA taxpayers in these circumstances will not form a loan-out entity. However, the use by the NRA artist of a single-member of a LLC as a loan-out entity appears to have almost all of the advantages of the traditional C or S corporation varieties and very few of the disadvantages. But there can be significant difficulties encountered in using a single-member LLC as a loan-out entity.

Other Issues

So, what is there left to be concerned about? Some issues are common to both NRAs operating as independent contractors and those operating as employees of a third party. Other issues depend on whether the talent is going to be viewed as an independent contractor or an employee.

All NRAs must have sufficient records to prove their U.S. tax deductions. While all taxpayers must prove their deductions, the more difficult challenge is when a NRA must prove that a business deduction relates to U.S. income. Sometimes this will be easily done, such as an agent's commission taken directly on U.S. income, and other times not so easily done, such as determining what portion of an ongoing public relations representative fees are deductible against U.S. income vs. non-U.S. income.

NRA independent contractors may look to an income tax treaty for protection from U.S. income taxation. Unless they are an athlete or entertainer, they may qualify for complete U.S. income taxation relief under treaty provisions. So, while a musician (an entertainer) typically has a very low treaty threshold before tax kicks in (entertainers are generally allowed a small annual amount of U.S. earnings before U.S. income tax applies), a creative artist (talent that is not considered an entertainer, such as a director) can avoid U.S. income tax by being in the United States for less than half a year and not having a permanent place of business here.

All NRAs, though, should certainly give consideration to avoiding payment of self-employment (SE) tax. This requires exploration to determine if there is an applicable bilateral agreement, the steps to obtaining exemption and if the long-range plan is such that the NRA will not regret accruing the benefits in the United States. Generally, this is an easier issue for a NRA who is an independent contractor, as avoidance of the SE tax is avoiding payment of an amount nearly double that of a NRA who is an employee.

Andrew B. Blackman, CPA ([email protected]) is a partner at Schulman Lobel Wolfson Zand Abruzzo Katzen & Blackman LLP (www.SchulmanLobel.com), which has offices in New York City and North Brunswick, NJ. A Certified Financial Planner, a Personal Financial Specialist, and Certified in Financial Forensics, he provides business management for performing and creative artists, athletes and other celebrities ' including nonresident aliens ' as well as tax and financial planning for high net-worth individuals and their closely held businesses. His predominant clientele have careers in screen, television, live stage and music, including several nominees and winners of Academy, Emmy and Tony Awards.

One of the challenging areas of income tax planning is working on behalf of nonresident alien (NRA) performing and creative artists. Integrating the typical rules of the Internal Revenue Code that apply to U.S. income tax residents with what might apply to a NRA coming to work in the United States, as a result of their specific facts and circumstances and applicable tax treaties, can be a confusing maze.

At the outset, a practitioner needs a solid understanding of how artists are compensated. Additionally, practitioners will benefit from developing an understanding of what to expect from the U.S. contracting parties in customarily hiring and paying artists.

Musicians and Actors

Let's take a musician as an example. A musician or a musical group touring the United States from abroad will typically be paid as an independent contractor and play at agreed-upon venues for an agreed-upon fee. A musician's U.S. income-tax-related expense deductions (i.e., expenses that are deductible against U.S. earnings because they are connected to performing in the United States) wouldn't run afoul of the sorts of limitations imposed on individuals who aren't independent contractors, but are instead considered employees of the payer of the fees. Such limitations affect business expenses that must typically be claimed as itemized deductions (under the category of employee business expenses on Form 2106), which have limits on their effectiveness as deductions based on the taxpayer's Adjusted Gross Income (AGI) (effectively a floor that must be cleared before any of these deductions lower the U.S. income tax), or from alternative minimum tax (AMT) implications (effectively a ceiling on the amount of these deductions that can be utilized to lower the U.S. income tax).

As opposed to a typical musician, an actor on a film, based on long-established history, is always considered the employee of a film production entity, due mostly to the degree of control the film producer exercises over the actor (e.g., when and where to show up on set, what lines to read and how to read them, etc.). Accordingly, an actor's employment-related expenses, such as agent's and manager's commissions, union dues, publicist, legal and accounting and the like, would always have to be subjected to limits affecting employee business expenses.

Loan-Out Corporations

An often-utilized tax plan for an artist that will be treated as an employee is to a loan-out corporation as a tax strategy. This is well-established in law, and can be either a C or S corporation owned by the artist. The term loan-out corporation is derived from the typical industry contract that stipulates the corporation, in return for a fee, agrees to 'lend' the services of its employee-artist to the production entity paying the fee.
Use of a loan-out entity allows all the aforementioned business deductions to be paid by the corporation and the remainder after these deductions is then paid out mostly as salary (in the case of an S corporation), or all as salary (in the case of a C corporation) to the employee-shareholder artist, thereby thwarting the effect of the AGI and AMT limitations imposed at the individual level, as all deductions are taken at the corporate level. In the case of a NRA, only the C corporation is an option, because an S corporation may only have U.S. persons as shareholders.

The considerations for using a loan-out entity are essentially: how much income tax will be saved vs. how costly will running the extra entity structure cost? While these considerations enter the evaluation for even resident artists, the decision tree is more complex for the NRA artist.

Generally speaking, a resident artist will (hopefully) work in the U.S. frequently and the tax savings of using a loan-out over working as an individual can be dramatic. In order to make economic sense, though, these income tax savings must more than offset the additional costs associated with the loan-out structure. These costs will include: legal and accounting fees (e.g., organizational costs, ongoing corporate-structure maintenance, and a second set of tax records and filings); potential additional income taxes at the loan-out entity level; additional payroll-related taxes (being now in the role of both employer and employee, the cost of Social Security and Medicare effectively doubles, in addition to unemployment, disability and other payroll-related taxes); and property and casualty forms of insurance (such as workers compensation and general liability policies). There may be some additional benefits, too, such as the ability to form a corporate retirement plan, potential medical benefits (e.g., a C Corporation can adopt a medical reimbursement plan), and a common belief that the artist's business deductions may draw less attention to be audited by the IRS inside a loan-out entity filing a return separate from its owner.

These considerations are the same for the NRA. However, they may not work as frequently inside the United States, which would be the only tax-advantaged opportunity to use a loan-out. Accordingly, the less the NRA works in the United States, the less opportunity to save on U.S. income taxes. However, many of the additional costs identified above continue once a loan-out corporation has been formed, thereby making the hurdle of achieving a greater overall savings from use of a loan-out much more challenging.

For instance, once a loan-out company has been formed, it is required to file an annual tax return with the IRS. Additionally, the loan-out will also likely be required to make state jurisdictional filings and often in more than a single jurisdiction. Besides the state of incorporation, states in which revenues have been earned will also be entitled to continuation of tax reporting. Considering the artist over time will have likely worked in several tax jurisdictions, many of which will have continued revenues from residual earnings, the professional costs of continuing tax compliance can prove expensive and the additional possible corporate minimum taxes imposed by these states are also to be considered.

Second Corporate Layer

While absent a loan-out the multi-jurisdictional tax compliance would also be present for the NRA as an individual, there is now a second corporate layer to consider. If income is consistent and plentiful, this is a minor issue; but not when meaningful income is earned only every few years. Furthermore, a NRA individual may often fall below the individual state income-tax filing threshold in years when not actively working in the United States and only receiving residual payments; the NRA could chose not to file in those jurisdictions, even if there had been state taxes withheld. That is generally not an option for a loan-out corporation. Even when a NRA chooses to file, or must file, as an individual, the return complexity for an individual is generally far below that encountered with state (and city) corporate returns.

A major issue that can often be overlooked regards the obligation to contribute to Social Security and Medicare. As previously mentioned, when an artist is an employee, his or her employer withholds Social Security and Medicare taxes from that individual's salary (the employee share) and then matches those contributions with like amounts (the employer share). When a loan-out is formed, the artist effectively becomes responsible for both portions on any salary the loan-out entity pays him or her, creating an additional expense. While the salary received from the loan-out will be less than what would have been earned by working directly for a third party (the salary from the loan-out having been reduced by the effects of the deductions taken within it before salary is paid to the shareholder-employee), the overall Social Security and Medicare bite will still typically be bigger (unless the loan-out deductions are so high that the salary from it is half, or less, than would have come directly from the third party).

For the NRA, this situation can be far worse, as the NRA may be eligible to avoid all Social Security and Medicare withholdings when working for a third party by reliance on a special type of tax treaty, known as a Bilateral Social Security Agreement (there are 17 countries that have such agreements with the United States). However, such a position cannot be achieved when working for an entity that the artist owns. This additional cost can be significant and perhaps the single greatest detriment to the NRA artist forming a loan-out entity.

Besides the ongoing professional fees of tax compliance, as well as corporate maintenance costs (e.g., legal fees to prepare written actions in lieu of an annual meeting), and of state filing fees and minimum taxes, corporate loan-out entities must consider the ongoing maintenance of general liability and workers compensation insurance policies. Working through a corporate loan-out argues in favor of maintaining such protection. As a NRA may never be sure when an assignment might arise, such policies are generally maintained year-round for a loan-out corporation. Such policies would not be maintained for an individual, so this is an extra operating cost that essentially goes to waste in years the NRA does not work in the United States.

Accordingly, the general rule is that a loan-out formed for a U.S. tax resident will almost assuredly save sufficient income tax to offset the extra operating costs. The same though cannot be said of the NRA and most NRA taxpayers in these circumstances will not form a loan-out entity. However, the use by the NRA artist of a single-member of a LLC as a loan-out entity appears to have almost all of the advantages of the traditional C or S corporation varieties and very few of the disadvantages. But there can be significant difficulties encountered in using a single-member LLC as a loan-out entity.

Other Issues

So, what is there left to be concerned about? Some issues are common to both NRAs operating as independent contractors and those operating as employees of a third party. Other issues depend on whether the talent is going to be viewed as an independent contractor or an employee.

All NRAs must have sufficient records to prove their U.S. tax deductions. While all taxpayers must prove their deductions, the more difficult challenge is when a NRA must prove that a business deduction relates to U.S. income. Sometimes this will be easily done, such as an agent's commission taken directly on U.S. income, and other times not so easily done, such as determining what portion of an ongoing public relations representative fees are deductible against U.S. income vs. non-U.S. income.

NRA independent contractors may look to an income tax treaty for protection from U.S. income taxation. Unless they are an athlete or entertainer, they may qualify for complete U.S. income taxation relief under treaty provisions. So, while a musician (an entertainer) typically has a very low treaty threshold before tax kicks in (entertainers are generally allowed a small annual amount of U.S. earnings before U.S. income tax applies), a creative artist (talent that is not considered an entertainer, such as a director) can avoid U.S. income tax by being in the United States for less than half a year and not having a permanent place of business here.

All NRAs, though, should certainly give consideration to avoiding payment of self-employment (SE) tax. This requires exploration to determine if there is an applicable bilateral agreement, the steps to obtaining exemption and if the long-range plan is such that the NRA will not regret accruing the benefits in the United States. Generally, this is an easier issue for a NRA who is an independent contractor, as avoidance of the SE tax is avoiding payment of an amount nearly double that of a NRA who is an employee.

Andrew B. Blackman, CPA ([email protected]) is a partner at Schulman Lobel Wolfson Zand Abruzzo Katzen & Blackman LLP (www.SchulmanLobel.com), which has offices in New York City and North Brunswick, NJ. A Certified Financial Planner, a Personal Financial Specialist, and Certified in Financial Forensics, he provides business management for performing and creative artists, athletes and other celebrities ' including nonresident aliens ' as well as tax and financial planning for high net-worth individuals and their closely held businesses. His predominant clientele have careers in screen, television, live stage and music, including several nominees and winners of Academy, Emmy and Tony Awards.