Author's Royalty Income from Publishing Contracts Was Subject to Self-Employment Taxes

(Parker Tax Publishing July 2019)

The Tax Court held that all of an author's royalty income derived from her contracts with publishing companies was allocable to her trade or business of writing and was therefore subject to self-employment tax under Code Sec. 1401. The court rejected the taxpayer's contention that a portion of the royalty payments represented a separate and distinct amount paid for her brand. Slaughter v. Comm'r, T.C. Memo. 2019-65.

Background

Karin Slaughter is an author based in Georgia. Since the 1990s, Slaughter has worked to establish herself as a brand author. A brand author is one who provides prestige or reliable profits to a publishing house. When Slaughter decided to become a writer, she set out in a businesslike fashion to obtain stationery, a reputable agent, and a contract with a New York publishing house. She worked with a media coach and publishers to develop her name and likeness into a successful brand. As a result, during 2010 and 2011 (the years at issue), Slaughter spent time meeting with publishers, agents, media contacts, and others to protect and further her status as a brand author.

Under contracts with publishers, Slaughter received two types of payments: nonrefundable advances and royalty payments. The royalties were a portion of the revenue or profits generated by the sales of Slaughter's manuscripts. The contracts specified the royalty rates applied to the revenue or profits from the works. Only the amounts in excess of the advance amounts were paid as royalties. In addition to the rights to her writing, the contracts secured the right to use Slaughter's name and likeness in advertising, promotion, and publicity for the contracted works.

Slaughter was not a brand author when she signed her first contract in 1999. But by 2007, she had become a brand author and her typical advance had grown eightfold. Slaughter now spends the same amount of time writing a book as she did in 1999. The change in her income is due to her cachet as a brand author, i.e., her ability to attract and engage readers, speak in front of a crowd, and recommend other authors within her publishing house. Slaughter's name is valuable to her publisher because it is how book buyers identify her books. Publishers now pay more for Slaughter's work because of her brand.

Slaughter hired a tax preparation firm to prepare her 2010 and 2011 tax returns. Several people from the firm, including a CPA, worked together to prepare Slaughter's returns. The CPA determined that a portion of Slaughter's income was for her name and likeliness and treated these amounts as investment income, i.e. payment for an intangible asset beyond that of her trade or business as an author. The CPA concluded that Slaughter should pay self-employment (SE) tax only on the amount publishers paid her for writing, and not on amounts paid for her name and likeness. Slaughter's returns for 2010 and 2011 reported all of her advances and royalties on a Schedule E, Supplemental Income and Loss, from which the portion relating to the trade or business of writing was subtracted. That amount was reported on Schedule C, Profit or Loss From Business. No SE tax was calculated on the balance of the advances and royalties left on Schedule E. Slaughter also deducted as business expenses the cost of leasing a vehicle in NYC to attend media interviews and promotional events, as well as the cost of an apartment in NYC which she used when was in town to attend meetings, conduct media interviews, and participate in publishing industry events.

The IRS determined SE tax deficiencies of $155,931 for 2010 and $110,670 for 2011 and applied negligence penalties under Code Sec. 6662. Slaughter challenged the IRS's determinations in the Tax Court.

Under Code Sec. 1401(a), self-employment tax applies to net earnings from self-employment, which is defined in Code Sec. 1402(a) as the gross income derived by an individual from any trade or business carried on by the individual, less the deductions attributable to the trade or business. The Tax Court has held that the term "derived" in Code Sec. 1402(a) requires a nexus between the income received and the taxpayer's trade or business. To be engaged in a trade or business, the taxpayer must be involved in an activity with continuity and regularity with the primary purpose of producing income and profit.

Slaughter argued that a portion of her royalties was derived solely from her name and likeness, which she said are personal attributes that are not part of any trade or business. She contended that her publishers intended to pay one amount for her writing and another separate and distinct amount for her brand. Slaughter argued that the nexus test under Code Sec. 1402(a) was limited to cases where taxpayers receive payments in lieu of engaging in their trade or business - for example, termination payments or insurance payments for the taxpayer's inability to work. The IRS responded that there was a sufficient nexus between Slaughter's royalties and her trade or business of writing such that all of her income from publishing contracts was subject to SE tax. There was no separate and distinct payment, according to the IRS, because all of Slaughter's income was directly or indirectly tied to the selling of her books.

Tax Court's Analysis

The Tax Court held that all of the payments to Slaughter under the publishing contracts were income derived from her trade or business as an author, and such income was subject to SE tax. In the court's view, Slaughter's brand was part of her trade or business because she was engaged in developing her brand with continuity and regularity for the primary purpose of income and profit. The court also noted that it is common in the publishing industry for writers to build brands and promote their work. In the court's view, the fact that Slaughter's brand involved personal traits such as her name and likeness did not mean that it could not be part of her trade or business. If Slaughter's brand had commercial value, it could form part of her trade or business, the court reasoned. The court also found it unnecessary to determine the publishers' intent, reasoning that an allocation within the contracts was beside the point if all elements were to be allocated to a trade or business.

The court also concluded that Slaughter misapplied the Code Sec. 1402(a) nexus test. The court explained that, to satisfy the nexus test, earnings must be tied to the quantity or quality of the taxpayer's labor. In the court's view, the question was not whether Slaughter's brand was tied to the quantity and quality of her writing, but rather whether the payments for her brand were tied to the quantity or quality of her efforts in developing her brand. The court noted that Slaughter herself admitted she worked to develop her brand, and the court found that royalties earned from her brand were not solely a result of her publishers' actions.

The court noted that Slaughter's treatment of her expenses was further evidence that payments for her brand derived from a trade or business. For example, Slaughter deducted the rent for the NYC apartment on her Schedule C even though most of her writing was done in Georgia. Slaughter also deducted advertising costs and other promotion and brand-related expenditures. According to the court, if these expenditures were Schedule C trade or business expenses, then the income derived from the brand to which those expenses related was also trade or business income.

Finally, with respect to the negligence penalties, the court held that Slaughter reasonably relied on the advice of her tax preparers and therefore was not liable for the penalties.

For a discussion of net earnings from self-employment, see Parker Tax ¶13,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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