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The Business of Music, Part 2: Death and Taxes
By Jon O'Neil on August 7 2008 12:00 AM | Permalink | Author Info
Cheery title eh?  Good news is the death part; I'm not talking about your death, but rather the death of your clients.  Well, the injury of your clients.  And you getting sued, which might feel like death!  Then we'll look at some common misconceptions about taxation.

Disclaimer:  this column does not constitute legal or tax advice, and should not be construed as offering legal or tax advice for any particular person or situation.  Hire a lawyer, dude!  This is my whole point here!  This column is also strictly for US readers; other countries, I don't know!


OK, so you're up and running, and lots of cool musicians are hanging out at your house.  Legally, that should terrify you!  How can you protect yourself?  Two ways--and you need them both--a lawyer and an insurance agent.

The lawyer will tell you that you need to limit your liability in order to protect your personal assets from claims against your business.  That's very true, and you should heed her advice.  She might recommend incorporating, or forming a LLC (limited liability company).  The legal twists and turns of those a little different, and different by state, that's why YOU NEED A LAWYER to set one up.

But let's be frank about the limits of limited liability. If it's your house, and you are the engineer, and your client trips over a cable you laid on the floor, and falls and horribly impales himself on his Dean From Hell guitar, then you are getting sued (and the cable manufacturer, and Dean).  But not just your corporation that was providing the studio service, you personally. This is because the stupid guitarist's non-stupid lawyer obeys none but the one rule of plaintiff's attorneys:  go after the deep pockets (that's why Dean is getting sued too).  Sure, he'd love to seize your corporation's collection of fine quality Naiant microphones.  But he'd much rather have the deed to your house.  And since your personal negligence at your personal residence was involved in the injury, there's a good chance he might prevail.

So while you should never neglect taking your lawyer's advice to limit your liability, you can't stop there.  YOU NEED INSURANCE.  And you need business insurance.  If your homeowner's policy agent learns that cool impaled guitarist dude was paying you money because you're running a business out of your house--guess what?  You aren't covered, man.


While we are on the topic of incorporating, let's talk taxes.  I read a lot of bizarre notions about the magical tax properties of incorporating.  In addition to being the finest solder monkey maybe on my whole block, two days a week I strap on a gun and pin on a badge, and become . . . a tax accountant (minus the badge and gun)  So I find many of these tales of brave tax loopholes amusing.  Let's discuss just a few:

- if you incorporate, you can magically "write off" all of your living expenses!

Nope.  Sorry.  So you are running a studio in your house.  You may be able to deduct some portion of your house expenses (mortgage interest, real estate taxes, insurance, utilities, repairs, and depreciation).  Some of those are already deductible, but it's better to take them as business expenses.  Also, such deductions are subject to both the home office deduction rules and also potentially the hobby loss rules (if you aren't running a true business, see below).

But the important point here is that none of those potential tax benefits have anything to do with incorporating.  They are available to a sole proprietor.

- if you incorporate, you can magically "write off" all of your gear!

That's similar to the statement above, with a similar conclusion:  yes, but a sole proprietorship can do that too.  And let's talk more about the hobby loss rules.  It's a simple concept, or at least a simple result: if your business is deemed to be a hobby rather than a real business, you can only deduct expenses to the extent of hobby income.  Excess losses are carried forward in case you ever show a net profit in the future.  But the moral of the story is that you won't be able to offset other sources of income (say, your salary from your day job) unless you are really actually truly running a business. Which is the trick; that isn't strictly defined.  It's a facts and circumstances test.  There is a safe harbor rule if you show a profit in three or five years, but hey, if you're showing a profit most of the time, the rule won't matter too much.  Where it really comes into play is when you have a business that will show losses for several years at startup, but will eventually show a profit down the road. And that's where you need to act like a businessperson:  business plan, marketing plan, financial projections, proper books and records, having a local business license, etc.  You need those things anyway, right? Anyway, back to incorporating:  that helps show you are serious, but it isn't a magic bullet.  Losses from an S corporation (see below) that would otherwise flow through your personal return and offset other sources of income are also subject to these rules.

- if you incorporate, you can pay yourself a salary and "write it off!"

This is probably the most misguided advice I see repeated.  That's because while it's true, it's also a rather counterproductive thing to do.

When you incorporate, your corporation will be treated one of two ways: as a taxable entity (a "C" corporation, after the subchapter of the internal revenue code which governs its taxation), or as a flow-through entity (an "S" corporation).  Generally, a small single-shareholder corporation wants to be an S corporation, to avoid double taxation.  But let's look at both:

A C corporation must pay taxes on its earnings, and the shareholders must pay another tax when those earnings are distributed as dividends.  The C corporation can mostly get around that by paying out its earnings as salary to its shareholder/employee, within reason.  The result of that is all of the earnings of the studio will be taxed as salary, and will be subject to payroll taxes, including FICA (15.3%, that's employer and employee shares) and federal and state unemployment taxes.  There is a lot of paperwork involved with even a single employee, and the tax authorities really take unkindly to employers who don't toe the line on payroll tax filings.  Fail to make deposits and they will seize your bank account.  So not only do you have to pony up for the payroll taxes, you also have to hire a payroll service or accounting firm to handle your payroll for you.

The S corporation, as I said, is a "flow-through" entity.  That means that earnings aren't taxed at the corporate level, they are taxed on the shareholder's return.  It's somewhat like operating a sole proprietorship, except that a sole proprietor must pay both FICA shares on their entire earnings (up to the limits, and unlike an employee there is no unemployment tax).  But the S corporation earnings are not subject to payroll taxes at all.  Well, almost at all.  There is a provision that requires the S corporation to pay a shareholder who is actively involved in the business a reasonable salary, such that payroll taxes aren't completely avoided.  But you are good at undervaluing your services, aren't you?

Since most small business corporations will organize as an S corporation, the game is to pay yourself as little salary as reasonable to avoid payroll taxes.  Compared to a sole proprietorship, you save taxes by NOT paying yourself a large salary.  That's the exact opposite answer of the erroneous advice you might hear on the street.

There is also the ever more popular LLC, which is a bit of a twist:  they are usually taxed as partnerships, or a single-member LLC may be disregarded and thus taxed as a sole proprietorship.  For an owner-operated recording studio, the result for FICA taxes is similar.

- if you incorporate, you can buy a car in the business name and writeoff the whole freakin' Canyonero and all the gas, man!

Ah heck, most of my clients don't even bother with incorporating to try and pull this maneuver.  Here's the real deal:  yes, you can, but you are SUPPOSED TO KEEP A MILEAGE LOG of business, personal, and commuting miles.  Only the portion of the expenses related to business travel is deductible.  And those miles must be documented.  So if you are running a mobile recording rig, keep some records and you'll get a nice, audit-proof tax benefit.  Make a SWAG (that's scientific wild-ass guess) on April 15, and it may be disallowed on review.

Again, this has nothing to do with incorporating.  The same deductions are available to a sole proprietor.

I don't really expect anyone to be a tax expert after reading that, or even have any idea what the tax effects of various forms of legal organization are.  And that's the point.  Nobody who isn't a tax specialist really understands the issues involved.  And these days our Congress loves to change tax law frequently to play their "balanced" budget game.  Under the "death" section, I urged you to consult a lawyer regarding formation of a legal entity for your business.  Consult a tax accountant too, but don't let the tax tail wag the legal or business dog.

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