Loan-Out Corporations after Tax Reform and CA Supreme Court Decision in 'Dynamex'

A loan-out corporation is a corporation owned by a service provider, such as an actor, director, producer or writer. The individual is typically the sole owner, director and employee of the corporation.

A studio or network wanting the services of the individual enters into a contract with the individual's loan-out corporation, which provides (lends) the individual's services. Payments are made to the corporation, which pays all expenses, including compensation to the individual. Loan-out corporations that are C corporations zero out their income and generally pay no tax themselves. Loan-out corporations that are S corporations don't pay tax anyway. (As a reminder, certain corporations are permitted to file so-called “S elections” with the IRS, which causes them to be taxed on a flow-through basis, like LLCs and partnerships. Interestingly, while in the old days loan-out corporations were predominantly C corporations, more recently they have been and are predominantly S corporations. The reasons for this are a topic for another day.).

Tax Benefits of Loan-Out Corporations

Over the years, loan-out corporations have provided a host of useful tax benefits, many of which have been or were available primarily because the service provider is a corporation, not an individual. The benefits have included, to name a few: avoiding the individual alternative minimum tax; full deductibility of medical expenses (if the loan-out corporation was a C corporation); avoiding deduction limitations applicable to individuals; and the availability of generous pension benefits.

The tax advantages of a loan-out corporation derive in large part from the fact that in most cases, an individual working directly for a studio or network is treated as an employee for tax purposes. This has nothing to do with a case-by-case analysis as to whether the individual is actually an employee.

For years, the entertainment industry was under attack over its worker classification practices, pursuant to which talent was frequently classified as an independent contractor. Repeated and concerted challenges to such treatment by federal and state taxing authorities left the industry sufficiently bruised that it became common policy to treat individuals as employees, except in rare and specific circumstances. Actors, directors, producers and writers are now invariably classified as employees if they work in their individual capacities.

Studios and networks also impose various limitations on who can use loan-out corporations. For example, it is typical to prohibit below-the-line personnel from using them. It is also typical to not respect loan-out companies that are partnerships or limited liability companies, except perhaps when the entity can demonstrate that it has elected to be taxed as a corporation.

Today, the tax benefits from using loan-out corporations are quite different than they were in the past. Some of the most significant benefits of using a loan-out corporation, such as the deduction of medical expenses and avoiding the percentage limitations on deductions, are no longer applicable for one reason or another.

Still, after tax reform, there is one reason why loan-out corporations are going to be more popular than ever: Beginning in 2018, employee business expenses are no longer deductible.

Deducting Business Expenses

Above-the-line talent can incur an extraordinary amount of business expenses, running in some cases to 35% or more of the talent's gross income. The expenses pile up for those paying percentages and fees to agents, managers, entertainment lawyers, other lawyers, business managers, etc. Those expenses, if incurred by a loan-out corporation, are deductible; if incurred by an employee in 2018 or later, they are not deductible.

Consider an actor earning $10 million in acting fees in 2018. Assume the actor is a California resident and has $3.5 million in business expenses. Assume for simplicity sake that the actor's average tax rate is 37% federal and 13% California (ignoring, among other things, the graduated rate structure, the fact that California's top nominal rate is 13.3% rather than 13%, and the 1% California surtax for income over $1 million).

If the individual works through a loan-out corporation, the corporation will have $10 million in income and cash, and $3.5 million in deductions and payments, leaving $6.5 million in taxable income and cash (simplifying). At a combined federal and California tax rate of 50%, the individual will pay $3.25 million in tax, netting $3.25 million.

Suppose instead that the individual works directly for the hiring entity and is treated as an employee. The individual will pay $3.5 million in nondeductible employee business expenses, leaving $6.5 million in cash before paying tax. But the 50% tax rate will be applied to the $10 million of income because the individual's expenses are not deductible, for a tax of $5 million. That leaves a mere $1.5 million after tax.

Using the loan-out corporation nets the individual $3.25 million as described above, $1.75 million more than it would be had the individual worked without a loan-out corporation. This is obviously a huge difference.

Loan-out corporations are thus going to be more popular than ever beginning in 2018.

While there are many good tax reasons to use loan-out corporations, the non-deductibility of employee business expenses has skyrocketed to the top of the list. This is a shame, because there is absolutely no policy reason for denying employees the ability to deduct their business expenses. And while well-advised film and television personnel might be saved by using loan-out corporations, there is one category of high-expense workers who will not be so lucky: professional athletes participating in team sports.

Players on professional baseball, basketball, football and hockey teams are all treated as employees for tax and non-tax purposes. Sports leagues do not permit the use of loan-out corporations. In fact, the rare victories in the IRS's war against loan-out corporations have occurred when the taxpayer has been a member of a professional sports team.

As described in the numerical example above, it is draconian to deny business expenses to employees who, like professional athletes, have substantial, legitimate business expenses. As of this writing, no one appears to have found a workaround.

Shoring up the Loan-out Corporation to Defend against Attacks

As has always been the case, there are forces lined up in opposition to the use of loan-out corporations. The bulk of those forces are in IRS attempts to disregard or look-through loan-out corporations. Most of the threats can be easily parried with careful planning and attention to detail.

My personal observation is that in some quarters, attention to the formalities of loan-out corporations is more lax than it should be. Although the IRS has been pretty quiet in recent years with respect to attacks on loan-out corporations, the risk is always there. It is also conceivable that the changes made by the tax reform act will reawaken the IRS's interest in challenging loan-out corporations.

For example, the absence of a written employment agreement between the loan-out corporation and the individual is a problem. Keep in mind that formalities that may seem unnecessary because an individual owns 100% of a loan-out corporation actually are even more necessary to demonstrate to the IRS that real relationships and agreements have been created despite the common ownership. On top of that, if there is any deferred compensation involved, IRC §409A requires that the employment agreement be in writing.

A related problem is the existence of a written employment agreement whose terms are disregarded. For example, suppose that the employment agreement provides that the loan-out corporation will pay the employee base compensation of $10,000 per month, plus a year-end bonus. Because cash collections are sporadic, though, the corporation actually pays $5,000 one month, $15,000 the next, $0 some months and a catch-up at year end.

Ignoring the written agreement is a serious problem. It gives the IRS the argument that the loan-out corporation is a sham and should be disregarded. The employment agreement should be drafted in a way that helps assure it will be followed, or, put differently, in a way that makes it hard not to follow it. A common solution is for the employment agreement to provide that compensation will be determined from time-to-time by the loan-out corporation's board of directors.

Another mistake arises when the written employment agreement between the loan-out corporation and the individual requires the employee's exclusive services. Suppose the individual works in a foreign country and is advised that, because of foreign tax or film financial incentive issues, he should work as an individual. This practice is inconsistent with the employment agreement, which requires that the employee's services be rendered exclusively to the corporation. Either an agreement should be prepared releasing the individual from his exclusivity obligation for the particular project, or the employment agreement itself should provide that the individual's obligations are non-exclusive for services rendered outside the United States. The latter approach is preferable because once the employment agreement has been executed, no one needs to remember to prepare a separate letter.

Using the loan-out corporation as a personal bank account without proper documentation of fund transfers as loans or otherwise is also a too-common mistake.

Dynamex Decision

The benefits of loan-out corporations disappear if loan-out corporations are disregarded for tax and/or other purposes. A California Supreme Court case, having nothing to do with tax, loan-out corporations or the entertainment industry, may create a new avenue for the IRS to resurrect its long-dormant attacks on loan-out corporations.

In Dynamex Operations West Inc. v. The Superior Court of Los Angeles County, 4 Cal. 5th 903 (April 30, 2018), the California Supreme Court concluded that two delivery drivers for a package and document delivery company should have been classified as employees rather than independent contractors. This conclusion was reached in a narrow and specific context: a California wage order, which relates to minimum wage, maximum hours and similar basic working condition issues.

The court engaged in a lengthy discussion of the origins of the method of determining whether a worker is an employee or an independent contractor. The common law test, which focuses on the degree of control that the service recipient has on the details of the work, derives from old case law imposing vicarious liability on employers for torts committed by their employees. In those cases it was critical to determine whether an individual was an employee or independent contractor in order to determine whether the hiring party could be held liable for the errors of the worker. That in turn depended on the degree of control the employer had on the individual's work.

While common law standards apply in general, in 1989 the California Supreme Court in S.G. Borello & Sons Inc. v. Department of Industrial Relations, 48 Cal. 3d 341, a seminal worker classification case, held that the concept of employment as embodied in a statute (in that case, the Workers' Compensation Act) is not necessarily the same as in common law. The social policy goals of a particular form of legislation might not be served by relying on the common law definition, originating as it did in the context of vicarious liability of employers for the negligent acts of their employees. Instead, the remedial purpose of the underlying law must be considered. As a result, the test for determining whether a worker is an employee may not be the same in all contexts.

The Dynamex court extended this analysis to wage order cases. The order at issue in the case was California's Industrial Welfare Commission (IWC) Wage Order No. 9, which governs minimum wages, maximum hours, and meal and rest breaks. The California Supreme Court concluded that the appropriate standard for determining employee status in this situation is the “ABC” test used by a variety of other states.

The ABC test makes it far more likely that an individual will be classified as an employee rather than an independent contractor. Under the ABC test, there is a presumption that a worker is an employee. This puts the burden on the hiring entity to prove that the worker is an independent contractor. To do that, the ABC test requires that all of the following must be true: 1) the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact; 2) the worker performs work that is outside the usual course of the hiring entity's business; and 3) the worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.

The second test is a killer. In order to be an independent contractor, the worker must perform work that is outside the usual course of the hiring entity's business. The court gave the example of a retail store that hires an outside plumber to repair a leak. The services of the plumber have nothing to do with the store's usual business. This is the classic independent contractor example.

In contrast, per the court, work-at-home seamstresses hired by a clothing manufacturer to make dresses from cloth and patterns supplied by the manufacturer are squarely within the hiring entity's business. The seamstresses' work is part of and within the company's business of manufacturing and selling clothing.

The consequences of extending the ABC test to loan-out corporations would be disastrous and could easily result in disregarding the loan-out corporation to treat the individual as an employee of the hiring entity. For example, an actor's services on a film are clearly part of the film company's business. The actor also would likely fail the first part of the ABC test, which requires the worker to be free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

Would this analysis allow a court to look through an actor's loan-out corporation and conclude that the actor is an employee of the studio?

Fortunately, it seems a big stretch to apply Dynamex to loan-out corporations. The Dynamex case considered the worker classification test in the context of the narrow confines of a state wage order, whose specific purpose was to provide basic minimum wages, hours and similar rights to package delivery drivers. There is no similar wage order or other law at work here.

We will all need to keep an eye on how Dynamex might be extended beyond its narrow original scope.

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Bob Jason is a Principal with NKSFB LLC, a leading business management and accounting firm based in Los Angeles and New York. He is also a member of the Board of Editors of Entertainment Law & Finance. Bob graduated from Harvard University, where he majored in mathematics, and Harvard Law School, where he was an editor of the Harvard Law Review. © 2018 Robert M. Jason. All rights reserved.