Although many people in the entertainment industry have formed or converted their loan-outs to S corporations, the Tax Cuts and Jobs Act of 2017 (TCJA) changed some of the tax rules that affect these corporations (and their owners!).
Let’s see how these changes affect the choice of what entity to use when forming a loan-out corporation:
● Using an S corporation (S corp) loan-out may cost you most of your deductions.
S corps are required (and have been for many years) to pass out employee business expenses to their shareholders, and not to deduct such expenses at the corporate level. That means that expenses such as the fees for agents, managers, lawyers, and business managers are not deductible by the corporation. Instead these fees are supposed to be only deductible by you, the shareholder, on your individual return, as miscellaneous itemized deductions on your Schedule A. But, under the TCJA changes, miscellaneous itemized deductions are no longer deductible (at all!). In other words, you will now be taxed on all your income and get none of your deductions.
(Now, I know that upwards of 90% of all the accountants in the entertainment industry ignore that rule and deduct these expenses on the S corporation’s return. And I know that most of these accountants know the rule, but they think your return will probably never be audited, so what’s the downside?
It’s true that the audit rate for small corporations is very low. But the IRS’s computer capability and number of computer audits increases every year. It would be a simple matter for the IRS to program its computers to scan for S corp loan-outs that have taken employee business deductions. Then the IRS computers could send out audit adjustments without needing additional personnel.)
● Using an S corp loan-out will not save you Social Security and other payroll taxes.
Some people think that they can avoid Social Security, Federal Unemployment, State Unemployment, and other payroll taxes by using an S corp as a loan-out. These people take only a limited salary and treat the rest of the money they withdraw as a corporate distribution. The problem is that that is only allowed where other employees – not you – and equipment generate the income. In a loan-out, all the income is generated by your efforts, which makes it all earned income, to you, subject to Social Security and all other taxes. The IRS has made an issue of this tactic and has caught many taxpayers doing this. (Don’t be one of them!)
● Using an S corp will prevent you from having a medical reimbursement plan.
Even under the Affordable Care Act, some medical expenses are not covered by health insurance. A medical reimbursement plan can cover costs outside your health insurance coverage, such as dental care, vision care, or psychiatric care. Payments under the plan are deductible by the corporation and not taxed to the employees.
The catch? Actually there are two: first, every employee must be entitled to the same benefits, and second, only C corps may have medical reimbursement plans. (The first catch is not a big problem since many loan-outs have no other employees, and of those which do, employees with less than three years of service, employees under 25, and employees who work less than 35 hours a week need not be covered.) A medical reimbursement plan may be a major tax-free benefit, and S corps just can’t have them.
● Using an S corp will sometimes be necessary.
Having said all that, there are still times when an S corp loan-out will be of great benefit to you. Some states, provinces, and countries, such as Canada or the EU, ignore the existence of loan-outs, and withhold tax on the payments to your loan-out. You can’t pass that tax out to you in your salary, so it will be trapped in your C corp loan-out and not available for use. Since an S corp does pass out withheld foreign taxes to the shareholder, you may need to form an S corp to be used when working in those designated places.
If possible, have your foreign compensation paid to your S corp loan-out, and have the fees of your agents, managers, lawyers, and business managers, and any other expenses, paid out of your C corp loanout. Even better, have your fee payments made to your C corp loan-out in the U.S. as well.
● Using an C corp for your loan-out is generally the better way.
Except in the situation described above, I recommend a C corp rather than an S corp loan-out. You’ll have to zero out the loan-out, but you should have been doing that with an S corp anyway. One final tip: make sure your accountant checks the box that says “Personal Holding Company” on your C corp loan-out tax return. Otherwise, the statute of limitations on your return will be open for six years, not the normal three. (And you don’t want that.)
Don’t do your tax planning based on the hope that the IRS will never audit you. The IRS may only audit a few loan-outs, but what if one of them is yours? What if the IRS just reprograms its computers to target S corp loan-outs? Not only will you owe tax, but you will owe penalties and interest as well.
Have a question? Contact Mitchell R Miller.