Tax Court's Ruling That Author Underpaid Self-Employment Taxes Affirmed on Appeal

(Parker Tax Publishing August 2021)

The Eleventh Circuit upheld a Tax Court ruling that all of a bestselling author's income from her books through contracts with publishers was subject to self-employment tax because it was derived from her trade or business. The court held that the author's trade or business was not limited to the physical labor of writing but also included her promotional activities and licensing of her intangible assets. Slaughter v. Comm'r, 2021 PTC 243 (11th Cir. 2021).

Background

Karin Slaughter is a bestselling crime fiction author who lives in Georgia. During years 2010 and 2011, Slaughter received income for her books through contracts with publishers. Her contractual obligations varied with the publisher. For English-language publishers, Slaughter was required to write an original manuscript for a book. If the manuscript was delivered to and accepted by the publisher, she received a fixed advance payment in installments specified in her contract. Slaughter also received royalties or subsidiary rights income from those sales if they exceeded her advance. For foreign-language publishers, Slaughter also received similar advances in exchange for the right to print, publish, and sell a foreign-language translation of one of her existing books.

Since signing her first publishing contract in 1999, Slaughter has retained the same literary agent to help promote her work with publishers, booksellers, and book reviewers. Slaughter and her agent promote her brand in several ways: maintaining contact with her readership through her website, newsletter, and social media presence; giving interviews; attending promotional and publicity events; giving gifts to business associates and inviting publishers to stay with her in her home; renting an apartment in New York City to attend trade shows and meet publishers there; and paying for a promotional bus poster. Slaughter claimed business expense deductions for all of those activities on her income tax returns for 2010 and 2011.

In 2010, Slaughter received $5,425,652 from her publishing contracts after deducting her agent's fees and expenses. But on her income tax return for that year, she reported only $875,000 as gross business income and paid self-employment tax only on that amount. The remaining $4,550,653 was reported as supplemental income. In 2011, she received $3,623,039 from her publishing contracts after deducting her agent's fees and expenses, but reported only $930,000 as gross business income subject to self-employment tax. She reported the remaining $2,693,039 as supplemental income and again did not report self-employment tax on that amount.

In allocating Slaughter's publishing income for both returns, her accountants began with the fact that she took 12 to 15 weeks to write a book and wrote approximately one book per year. For her 2010 return, they assumed that Slaughter worked five days a week for 12 weeks, meaning that she worked 60 days that year. And because 60 days is about 16.43% of a 365-day year, they reported that percentage of Slaughter's publishing income as her gross business income. For her 2011 return, they used the same method but calculated a higher percentage of publishing income to report as her gross business income because Slaughter had spent more time writing that year.

The IRS concluded that for both returns, Slaughter should have reported all of her publishing income as gross business income instead of just the percentage based on how long she engaged in the physical labor of writing. It issued a notice of deficiency to Slaughter and increased her self-employment taxes accordingly. Slaughter took her case to the Tax Court, but the Tax Court agreed with the IRS and held that all of Slaughter's publishing income was subject to self-employment tax. The Tax Court found that Slaughter's brand, her promotional activities, and the licensing of most of her intangible assets were part of her trade or business. Slaughter appealed to the Eleventh Circuit.

For purposes of the tax on self-employment income under Code Sec. 1401, self-employment income generally means the net earnings from self-employment derived by an individual. The term "net earnings from self-employment" means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions attributable to the trade or business. Under Code Sec. 1402(c), the term "trade or business" has the same meaning for self-employment tax purposes as when used in Code Sec. 162. The Supreme Court held in Comm'r v. Groetzinger, 480 U.S. 23 (1987), that to be engaged in a trade or business, a taxpayer must be involved in the activity with continuity and regularity, and the taxpayer's primary purpose for engaging in the activity must be for income or profit. In Peterson v. Comm'r, 2016 PTC 181 (11th Cir. 2016), the Eleventh Circuit held that for self-employment income to be derived from a trade or business, there must be a nexus between the income received and a trade or business that is, or was, actually carried on.

On appeal, Slaughter contended that her trade or business did not include her promotional activities because they were only sporadic and occasional, rather than continuous and regular. Slaughter also argued that income from her intangible assets - specifically, the rights to her name and likeness, access to her readership, the right to use characters from her previous books, and noncompetition agreements - was not subject to self-employment tax because there was no nexus between that income and her trade or business. In support of this argument, Slaughter cited a Ninth Circuit decision, Milligan v. Comm'r, 38 F.3d 1094 (9th Cir. 1994), which held that a nexus exists between the income received and a trade or business only if the net earnings are tied to the "quantity or quality" of the taxpayer's prior labor, rather than the mere fact that the taxpayer worked for the payor. In addition, Slaughter asserted that the licensing of her name and likeness could not be reasonably described as used predominantly for profit rather than as a "personal right." Therefore, income from that licensing could not be derived from her trade or business because trade or business activity must have the primary purpose of profit. Slaughter further argued that income from an agreement not to compete does not derive from a trade or business under the Tax Court's holding in Ohio Farm Bureau Federation, Inc. v. Comm'r, 106 T.C. 222 (1996).

Analysis

The Eleventh Circuit affirmed the Tax Court's decision. The Eleventh Circuit concuded that the Tax Court's finding that Slaughter's promotional activities were continuous and regular was amply supported by her prior business expense deductions. Slaughter took deductions for (1) the rent for her New York apartment that she used when going to trade shows and meeting with publishers, (2) payments for a car (which the court noted was the same model used by her main character Sara Linton) that she drove to interviews and promotional and networking events, (3) catering expenses and gifts for business associates, and (4) expenses for advertising, her website, and "promotions." The court reasoned that Slaughter could not have claimed deductions for those expenses unless they were paid or incurred in carrying on a trade or business. That she deducted these expenses illustrated to the court that the promotion of Slaughter's written work was part of her writing business. The court observed that the promotion and sale of books is a key factor distinguishing a writing business, which is engaged in for income and profit, from a writing hobby.

The court further found that Slaughter's insistence that her promotional activities were not full time was inconsistent with her own position. The court observed that Slaughter spent only about 16 and 25 percent of 2010 and 2011, respectively, engaged in the physical labor of writing. The court said that by Slaughter's own definition, her writing would qualify only as sporadic and occasional. In the court's view, both common sense and Slaughter's own position therefore required that her promotional activities be considered part of her trade or business.

With respect to Slaughter's "quantity or quality" argument based on the Milligan decision, the court noted that in Peterson the Eleventh Circuit declined to apply that test beyond the context of post-termination payments to insurance agents. Further, the court found that even if the Milligan test did apply in this case, all of Slaughter's publishing income, including the portions from her intangible assets, would readily satisfy it. The court explained that if Slaughter ceased to write or promote her books, then her brand and success as an author would be affected. If she were not writing books, the court said, then publishers would pay less, or even nothing, for her name and likeness, access to her readership, the right to use her characters, and her agreements not to compete.

Regarding Slaughter's name and likeness, the court found no reason to believe that Slaughter licensed those assets for any purpose other than increasing her profit. As for the income from Slaughter's noncompetition agreements, the court found that in Ohio Farm Bureau Federation the Tax Court did not categorically exclude such noncompetition from being a trade or business. Instead, it held that the standard continuity-and-regularity test applied and concluded that a one-time agreement not to engage in certain activities did not constitute the kind of continuous and regular activity characteristic of a trade or business. The court found that Slaughter's noncompetition agreements were not one-time events but rather appeared in every American contract that she signed. Moreover, the court found that the clauses for the most part did not prevent Slaughter from writing for other publishers; they merely required her to complete the contracted books first.

For a discussion of the tax on 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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