Musicians and the QBI Deduction

This year, there is a new 20% tax deduction for self-employed individuals and pass through entities, commonly called the QBI (Qualified Business Income) deduction, officially IRC Section 199A. While most musicians who file schedule C will be eligible for this deduction, high earners – those making over $157,500 single or $315,000 married – will see this deduction phased out to zero, because they are considered a Specified Service Trade or Business (SSTB).

See: New 20% Pass-Through Tax Deduction

Professions that are considered an SSTB include health, law, accounting, athletics, performing arts, and any company whose principal asset is the skill or reputation of one or more of its employees. That’s pretty broad.

Some musicians may have income that is from an SSTB and other income which is not. For example, consider a musician who has a business managing tours and logistics. If she performs a concert, clearly she is working in an SSTB as a performing artist. If she is making a profit from organizing and promoting a concert tour, that might be considered a different industry.

This possibility of splitting up income into different streams has occupied many accountants this year, to enable high-earning business owners to qualify for the QBI deduction for their non-SSTB income. Since this is a brand new deduction for 2018, this is uncharted territory for taxpayers and financial professionals.

In August, the IRS posted new rules which will greatly limit your ability to carve off income away from an SSTB. Here are some of the details:

  • If an entity has revenue of under $25 million, and received 10% or more of its revenue from an SSTB, then the entire entity is considered an SSTB. If their revenue is over $25 million, the threshold is 5%
  • An endorsement by a performing artist, or the use of your name, likeness, signature, trademark, voice, etc., shall not be considered a separate profession. If you are in an SSTB, an endorsement will also be considered part of the SSTB.
  • 80/50 rule. If a company shares 50% or more ownership with an SSTB, and receives at least 80% of its revenue from that SSTB, it will be considered part of the SSTB. So, if our musician only organizes tours for herself, then that business will be considered part of her SSTB. If the Tour business has at least 21% in revenue from other bands, then it could be considered a separate entity and qualify for the QBI deduction.

Business owners in the top tax bracket of 37% for 2018 (making over $500,000 single or $600,000 married), might be considering forming a C-corporation if they are running into issues with the SSTB. While a C-Corp is not eligible for the QBI deduction, the federal income tax rate for a C-Corp has been lowered to a flat 21% this year.

Of course, the challenge with a C-Corp is the potential for double taxation: the company pays 21% tax on its earnings, and then the dividend paid to the owner may be taxed again from 15% to 23.8% (including the 3.8% Medicare surtax on Net Investment Income.)

Still, there may be some benefits to a C-corp versus a pass-through entity, including the ability to retain profits, being able to deduct state and local taxes without the $10,000 cap, or the ability to deduct charitable donations without itemizing.

If you have questions about the QBI Deduction, the Specified Service Business definition, or other self-employment tax issues for musicians, we can help you understand the new rules. We want to help you keep as much of your money as possible, so let’s talk about how we might be able to help you.

20% Pass Through Deduction for Musicians

You’ve probably heard about the new 20% tax deduction for “Pass Through” entities under the  Tax Cuts and Jobs Act (TCJA), and have wondered if musicians qualify. For those who are self-employed (1099, not W-2) here are five frequently asked questions:

1. Do I have to form a corporation in order to qualify for this benefit?
No. The good news is that you simply need to have Schedule C income, whether you are a sole proprietor (including 1099 independent contractor), or an LLC, Partnership, or S-Corporation.

2. How does it work?
If you report your music earnings on Schedule C, your Qualified Business Income (QBI) may be eligible for this deduction of 20%, meaning that only 80% of your net income will be taxable. Only business income – and not investment income – will qualify for the deduction. Although we call this a deduction, please note that you do not have to “itemize”, the QBI deduction is a new type of below the line deduction to your taxable income. The deduction starts in the 2018 tax year; 2017 is under the old rules.

There are some restrictions on the deduction. For example, your deduction is limited to 20% of QBI or 20% of your household’s taxable ordinary income (i.e. after standard/itemized deductions and excluding capital gains), whichever is less. If 100% of your taxable income was considered QBI, your deduction might be for less than 20% of QBI. If you are owner of a S-corp, you will be expected to pay yourself an appropriate salary, and that income will not be eligible for the QBI. If you have guaranteed draws as an LLC, that income would also be excluded from the QBI deduction.

3. What is the Service business restriction?
In order to prevent a lot of doctors, lawyers, and other high earners from quitting as employees and coming back as contractors to claim the deduction, Congress excluded from this deduction “Specified Service Businesses”, which includes not only health, law, accounting, financial services, athletics, and consulting, but also performing arts. High earning self-employed people in one of these professions will not be eligible for the 20% deduction.

4. Who is considered a high earner under the Specified Service restrictions?
If you are a performing artist and your taxable income is below $157,500 single or $315,000 married, you are eligible for the full 20% deduction. The QBI deduction will then phaseout for income above these levels over the next $50,000 single or $100,000 married. Musicians making above $207,500 single or $415,000 married are excluded completely from the 20% QBI deduction. Please note that these amounts refer to your total household income, not the amount of QBI income.

5. Should I try to change my W-2 job into a 1099 job?
First of all, that may be impossible. Each employer is charged with correctly determining your status as an employee or independent contractor. These are not simply interchangeable categories. The IRS has a list of characteristics for being an employee versus an independent contractor. Primarily, if an employer is able to dictate how you do your work, then you are an employee. It would not be appropriate for an orchestra, university, or contractor, to list one worker as a W-2 and someone else doing the similar work as a 1099.

Second, as a W-2 employee, you have many benefits. Your employer pays half of your Social Security and Medicare payroll tax (half is 7.65%). You might think that 20% is more than 7.65%, but remember that a 20% deduction in taxable income in the 24% tax bracket only saves you 4.8% in tax. That’s less than the value of having your employer pay their 7.65% of the payroll tax.

Employees may be eligible for other benefits including health insurance, vacation, state unemployment benefits, workers comp for injuries, and most importantly, the right to unionize. The Lancaster Symphony spent eight years in court, unsuccessfully trying to assert that musicians were not employees, to prevent them from unionizing. You would have a lot to lose by not being an employee, so I am not recommending anyone try to change their employment status.

Still, I expect many of you have Schedule C income from teaching private lessons, playing weddings, or other one-time gigs. If you do have self-employment income, you should benefit from the new tax law as long as you are under the income levels listed above. If you do other related work in music – publishing, repairing instruments, making accessories, etc. – that income might not be considered a Specified Service, so be sure to talk with your tax advisor about your individual situation. We will continue to study this area looking for ways to help musicians like you take advantage of every benefit you can legally obtain.