The Tax Court recently decided a case, Slaughter v. Comm’r (find all the citations in 1 Taxation of Intellectual Property § 1.06 (2019), involving annual royalty payments to an author wherein the IRS argued that instead of treating the payments as royalties that are not subject to self-employment and Medicare tax, the payments should be treated as net earnings from self-employment. The dispute that the Tax Court faced was whether there is a distinction, for self-employment tax purposes, between an author’s royalty income derived from her writing and any royalty income derived from her name and likeness. The author contends that one portion of her royalty payments is derived from her writing, which is a trade or business, and that another portion is derived, not from her writing, but rather solely from her name and likeness which are personal attributes which are not part of any trade or business. The IRS argued that the entire payments the author received from her publishing contracts were derived from her trade or business as an author, thus subject to self-employment tax.

To provide context to the dispute, Karin Slaughter is a bestselling crime author: over 35 million books sold in 37 languages. The Tax Court stated the following details of her publishing contract are standard in the publishing industry. Her contracting publishers receive more than just the right to print, publish, distribute, sell, and license the works and manuscripts written, or to be written. The publisher also secures the right to use the author’s name and likeness in advertising, promotion, and publicity for the contracted works. The author is required to provide photos and be available for promotional activities. The contracts include noncompete clauses that vary in scope, from requiring that the specified manuscript be completed before others, to prohibiting the author from entry into another contract until her writing obligations are met. Publishers also secure the right to advertise other works in the author’s books, qualified by the requirement that the author’s consent to the specific advertisements. Several of the contracts allow for, but do not require, a share of advertising proceeds to be paid to the author as a condition of her consent. Finally, the contracts include an exclusive option for the respective publisher to negotiate the contract for the author’s next works.

The author also receives more than just her advances and royalties. For instance, some contracts include a marketing guaranty requiring the publisher to spend a minimum amount on marketing for the author’s books. Although the publishers fund the marketing plan, the author’s agent retains the authority over its development. Another example is the author’s option to purchase the publisher’s plates at a reduced cost for any book that goes out of print and that the publisher refuses to reissue or license. In that instance, the rights in the work also revert to the author.

On her Federal income tax returns, the author deducted as a business expense the cost of leasing a vehicle to attend media interviews and promotional events. She also deducted the cost of hosting her own promotional events. For marketing purposes, many of her meetings were scheduled in New York City. While there, the author often attended meetings, conducted media interviews, and participated in publishing industry events such as trade shows. During the years in the issue she also met with a fellow writer to collaborate on a script for a possible television series. To facilitate her various activities, the petitioner rented an apartment in New York City and deducted the rent. Petitioner also deducted the cost of business gifts to agents, editors, publishers, and others.

The authors income grew eightfold due to her brand as an author. That brand is monetized by the author’s ability to attract and engage readers, speak in front of a crowd, and recommend other authors within her publishing house. Petitioner’s promotional activities and writing have created a very successful brand and body of work. In petitioner’s case, her brand includes her name and likeness as well as her reputation, goodwill, and existing readership. She maintains contact with her readership through social media, websites, and a newsletter.

The author’s advisors concluded that any amount paid to the author for the use of her name and likeness was “investment income,” i.e., payment for an intangible asset beyond that of her trade or business as an author. The author’s name is a brand.  The author’s expert concluded that the actual writing of a manuscript is but a small percentage of the value a publisher seeks from an author. An author’s work may sell on the basis of the author’s name and readers’ expectations for a particular kind of story, rather than for the quality of the writing. Thus, the author contended that the amount paid for her writing is what a publisher would pay a nonbrand author, and the residual amount is a separate and distinct payment for her brand.

The Tax Court held that the author’s brand became part of her trade or business. The Tax Court focused on the following elements of her behavior. The author was engaged in developing her brand with continuity and regularity. The author set out in a businesslike fashion to obtain stationery, a reputable agent, and a publishing contract. The author worked with a media coach and publishers to develop a successful brand. She has spent time meeting with publishers, agents, media contacts, and others to protect and further her status as a brand author. She attended interviews and promotional events and works to develop and maintain good relationships with booksellers and librarians. The author uses social media, websites, and a newsletter to maintain her brand with her readership. The Tax Court noted that royalties earned from her brand are not solely a result of her publishers’ actions.

The Tax Court then turned the fact that the author deducted advertising costs, the cost of a car used, in part, to attend promotional activities around Atlanta, and gifts sent to her contacts in the publishing world. Such expenses, stated the Tax Court, demonstrate that petitioner’s trade or business extends beyond writing to its promotion. If the author takes such promotion and brand-related expenditures on her Schedule C trade or business expenses, then the income derived from the brand to which those expenses relate must also be trade or business income. The Tax Court found on behalf of the IRS.

The Tax Court stated that there was not a particular case on point regarding an author’s income from the business of writing and that attaching to royalties for the sales of an author’s books. The Tax Court distinguished other cases decided in favor of the taxpayer regarding athletes and image rights, albeit these cases arguably are applicable to Karen Slaughter’s situation. For example, in Garcia v. Comm’r, the issues were to what extent to which payments made to the taxpayer under the endorsement agreement were compensation for the performance of the taxpayer’s personal services and the extent to which the payments were royalties for the use of the taxpayer’s image rights. The Tax Court stated that

“Courts have repeatedly characterized payments for the right to use a person’s name and likeness as royalties because the person has an ownership interest in the right.”

The Court therein cited Goosen v. Comm’r that the characterization of a taxpayer’s endorsement fees and bonuses depends on whether the sponsors primarily paid for the taxpayer’s services, for the use of the taxpayer’s name and likeness, or for both. The court held that the payments made by the company were allocated 65 percent to royalties and 35 percent to personal services.

In Kramer v. Comm’r, the Tax Court found that royalties paid primarily for the grant of the exclusive right to use the taxpayer’s name to sell sports equipment, and only secondarily for the personal services rendered by taxpayer under the royalty contract. Herein the Tax Court concluded that commercial success for sales upon which the royalty income derives depended upon accompanying aggressive promotional activities. For Mr. Kramer, the Tax Court concluded that only the portion of the royalties that reflected compensation for the personal services constituted “earned income.” In Boulez v. Comm’r, the Tax Court said if a taxpayer has an ownership interest in the property whose licensing or sale gives rise to the income, then that income should be characterized as a royalty as opposed to personal service income. Therein the Tax Court cited the Fifth Circuit decision of Patterson v. Texas Co, wherein the Court of Appeals adopted the definition of a “royalty” as

“a share of the product or profit reserved by the owner for permitting another to use the property.”

The Slaughter case is ripe for appeal. The weight of jurisprudence perhaps rests on the author’s side regarding whether the royalties should be apportioned and that a portion derives from her brand rights that are not personal service income. Like for the tennis star Mr. Kramer, aggressive promotional activities are necessary to grow the sales of the product. There can be no brand, such as a trademark, without promotion of it. But the promotional activities are not the business of the author but rather those of the publishing company to sell books.

Yet, the weight of the facts perhaps rest on the side of the IRS. If the author’s accountants claimed the full amount of the expenses, such as for the New York apartment, on the author’s Schedule C as a trade or business expense, then correspondingly, as the Tax Court presents, income associated with those expenses is also Schedule C. It does not appear that the accountants undertook any diligence, by example not reading the contracts and not seeking any support records for the guestimate by the author of her time apportionment. It does not appear the accountants undertook any research and analysis other than to dismiss that any cases applied. It does not appear that the accountants undertook any planning research, or at least, the author rejected paying for such advice because it is common practice for authors, artists, and athletes of this income level to operate via a Sub S corporation or LLC. The pass-through business is a well-understood mechanism for mitigating Medicare tax, though with its own host of issues regarding compensation versus distributions.

For more analysis and coverage on this and other related issues, see William Byrnes’ treatise Taxation of Intellectual Property and Technology (2020 edition), a 1,000-page analytical treatise to the federal tax consequences of the development, purchase, sale and licensing of intellectual properties and intangibles.  Primary author William Byrnes leads a team of America’s leading tax senior counsel to analyze tax risk challenges for business and investment decisions concerning intellectual property, technology, intangibles, and the digital economy.

Nine seats remain for the Spring (4 teams of 3 students each) to join the current 4 teams January 13 – April 20 semester for the TRANSFER PRICING course taught by Dr. Lorraine Eden, Prof. William Byrnes, and several industry experts. The courses count toward the INTERNATIONAL TAX online Master curriculum of Texas A&M for tax attorneys, accountants, and economists. Taught live twice weekly using Zoom involving teams working to design positions and solutions for real-world post-BEPS client studies each week, supported by originally authored materials, videos and audio casts, PPTs, and a robust online law & business database library.  For more information, contact Texas A&M Admissions https://info.law.tamu.edu/international-tax