'Financial Management for Musicians' Author Offers Tax Tips for Songwriters
Workshop Hosted by Songwriters Guild Office, Nashville, TN
by Doak Turner,
The Songwriters Guild of America Nashville Office recently hosted a tax and accounting seminar with Certified Public Accountant Cathy McCormack of Nashville, TN. Cathy McCormack is co-author of the book, "Financial Management for Musicians," (Hal Leonard) by Pam Gaines and Cathy McCormack. Many of McCormack's clients are musicians and songwriters. "Financial Management For Musicians" is the title of the book, but she says it is really more about organizing your financial life for what she calls this business of music. She offered to speak to the Songwriters Guild seminar participants about accounting, bookkeeping and money, and asked what the attendees would like to have covered in the seminar. Below is a summary of her presentation:
Cathy McCormack Let's talk about the myths of money management and audits, to start the event. The definition of a hobby has several factors, and includes a test to determine whether there has been a loss in three of the proceeding five years. That is just one of the criteria in determining whether or not you have a hobby. A hobby can exist with respect top raising horses, painting, writing or anything that you can get involved in. They could be considered a business or a hobby. There are a lot more criteria to consider, and one important and significant issue is whether you have intent to make a profit.
Most people who launch into something that takes eighty percent of their time obviously have a profit motive. Your job is to prove that you have a profit motive and to keep good records to show how much time that you spend on the business. The time issue is extremely important. Keep your calendar in outlook or a manual calendar or on post-it notes, whatever that you do to document your schedule. It is one of the leading ways to prove that you have spent substantial time in trying to produce profit.
[Question] Should you keep track of time and expenses after your first two years of losses?
Cathy McCormack This is something that you should have for every year you are in business. When people first start to write, they do not think of it as a business so they don't track time or expenses very well. Some people knew from the minute that they are born what they wanted to do and immediately launched into it. When people get started in songwriting and have a different career "day job," they tend not to keep good records. Then they hear they cannot take losses for three years in a row, so they do not even bother with keeping the records.
I encourage you when you first start writing songs to keep track of your expenses, keep a good calendar, and track of everything that would help your accountant to support what you are doing for your songwriting career. You can show losses your entire life. Many people fear of getting audited and will not deduct their expenses. Don't lose opportunities for fear of the audit myth. Take your losses every single year.
I have had clients get audited because they have taken losses over a period of years. I represented them, proving profit motive and everything was fine. Two years ago a client was audited. He has a studio in his home, has been writing all his life. He has a wife who has made money and she off set her income with his losses. He had a big hit and is going to start showing substantial profit, which solidified the fact that he is a writer with profit motive. In addition, he had a calendar and sufficient data to show that he spent his life trying to launch this business.
There was a court case about ten years ago with respect to a painter that was audited and the IRS agent ruled the painter had a hobby. The painter had very good records; they went on to tax court and the painter won, as the judge ruled it was a proven fact that many artists did not become famous until after they died. (Laughter in the room.) One time is all it takes to put you on a map after all the years of working toward that goal. That court case has been used several times in the music business and other creative industries.
[Question] So you are saying that you need a calendar to prove a profit motive?
Cathy McCormack You need a calendar to prove the amount of time that you spent on your craft.
[Question] Is there a minimum amount of time to prove you had a profit motive?
Cathy McCormack It is about you being a member of organizations that support your efforts, keeping brochures and pamphlets of seminars that you have attended, keeping records of your co-writing appointments or interviewing people to get ideas. You calendar is a support for the other things that you do with your songwriting career.
[Question] The point of the profit motive is for your taxes?
Cathy McCormack No, the profit motive is to prove your songwriting is not just a hobby. It shows you are very serious about it and you want to make money at the songwriting. Make sure that you do act like a business, keep good records of your time and expenses.
[Question] What happens if you have many years of no income in the songwriting business?
Cathy McCormack That happens and that is OK. You deduct it on a schedule C with your tax return and show your losses against other income that you make during the year.
[Question] Is there any rule about how much money that you can make and still have a loss on your taxes?
Cathy McCormack You can have negative income, but the thing that triggers an audit is to show an income below the standards that the IRS has set that they feel you can live on. To continue to show poverty level income on your return can trigger an audit. They will audit you because they believe that you have an income that you are not showing on your tax forms. I have represented people in those categories. They ask how can you live and eat in the kind of house and survive making this low amount of money? They come in to make sure you are reporting all of your income.
[Question] I have been living on inheritance in the past year. Is this going to trigger an audit?
Cathy McCormack If you have inheritance money, you likely have it invested, and can show investment income. If I were looking at your tax return, I would look to see how you have been able to sustain those losses. If I saw that you had interest and dividend income, then I would say this person has money saved up that has sustained your lifestyle during the process of trying to launch your business. Those kinds of things are taken into consideration when the IRS triggers audits.
You would not get audited because you continue to have losses. If you had no income at all and you showed losses and carried those losses forward, then you would probably get triggered for an audit because it looked like you had unreported income. If they audit you, come in and find you clean, they put a note in your file that says this was a clean audit. That establishes a good track record for you. If you come back with those ratios mentioned previously about audits, then they will probably skip you from an audit. If they audit you and find errors, they can recommend that you be audited in the future.
[Question] What about forming your own publishing company for business and tax issues?
Cathy McCormack The type of entity is very important and heavily debated of whether you should incorporate. When you incorporate or form another entity, you are complicating your life. It does supply a limited liability, which should be the only reason that you incorporate. Joint relationships require a second entity, and that can be complicated if there are substantial dollars at stake. Then you need to incorporate.
[Question] What about self-publishing. Do I need a separate entity?
Cathy McCormack No, you don't need to incorporate. It is best if you keep it simple, not incorporating or forming other types of entities. Even as you start to make money, people think they should immediately set up a business and incorporate. Unless you accumulate substantial wealth and in a risky business, there is really NO reason to incorporate. It would make your life more complex. There is this myth out there that it will save you taxes if you incorporate and it is absolutely false - it will cost you more money! You would also have to prepare more tax forms. It would involve more income for us accountants, but it is not in the best interest of the clients.
[Question] To collect royalties, you have to have a name for your publishing, but you do not have to have a separate business - right?
Cathy McCormack Yes - you could have a "dba" (doing business as) and that will work for you. You are a sole proprietor and it does not add an extra level of complexity.
[Question] I started getting royalties in about 1990, was doing my own taxes, and filed my royalties under schedule E. I even called the IRS and the agent said what I was doing was OK. Later when I hired an accountant, they said that was wrong. Could you explain a Schedule E?
Cathy McCormack Schedule C is where you report self-employment income, an activity that you are involved in as a business like your publishing company. Schedule E is for passive activities such as activities that you are not heavily involved in or rental properties. If you were a passive owner of an oil well, then royalties would get reported on a Schedule E. It is not subject to self-employment tax - social security and Medicare.
If you are a songwriter, you are actively involved with the production of royalty income and as a result, that is considered an active activity, not a passive activity. You will not win in an audit if you put it in a Schedule E. If you inherit a song catalog from someone and you were not the one who generated that money, then it is correct to report royalties on Schedule E. If you are involved in the writing of the songs, then put it on Schedule C of your tax forms.
If you have had income in the past and you generate what we call a net operating loss, that loss can be carried back to years where you had revenue and you can recover taxes for years past. You may be a candidate for loss carry back. If you had a loss in the 2002 year, you can go back to 1997 though 1998, 1999 and up to that particular year. For losses in 2003 and later, you can do a two-year carry back.
If you are looking at your 1040 and have a negative number on that bottom line, you have what is called a net operating loss, and that loss can be carried back - use that loss against income in the future, forward or against income tax that you have already paid. You can go back to previous years, report the loss against the income you reported that year, and get a refund for the tax you paid for that particular year. You can carry the loss forward for many years before those losses expire.
Someday, when you have income, you can use your current losses to offset those incomes. You have three years to amend your taxes and show those losses that you were afraid to show in the past. You can carry your loss forward and tell the government that is what you are doing, if you do not want to carry it backward. As soon as I see a client that has an operating loss, I stop right there, call the client and ask what is going to happen next year. If they are expecting to make money the next year, as they may have a song on a popular CD that will make money next year, they may want to carry the loss forward.
[Question] Deductible equipment - for instance software that comes with a rebate - can I use my credit card record as proof that I purchased this equipment or do I need the original receipt?
Cathy McCormack You have to have a receipt. The government is getting very sticky about using credit card receipts. They accept if you can show that those deductions are legitimate in other ways, but they prefer you use a receipt. If you get an agent that is rigid, he or she may not take the credit card as a receipt.
Many times I have clients who buy equipment at a garage sale and need a receipt. We have the garage sale owner sing a piece of paper for documentation, or the client will note in their calendar that they bought a piece of equipment at a garage sale. Cut out the clipping in the paper about the garage sale to prove there was a sale on that date.
[Question] What about using your computer to keep track of your records for the year?
Cathy McCormack One of the best computer software programs is Quicken for keeping up with your personal business. You can use it to even just keep track of your checkbook and credit cards. At the end of the year, you can print out the report for your accountant to do your tax return. I just recently represented someone in an audit that used Quicken and because the client had great records, it really went very smoothly and quickly.
[Question] What kinds of receipts does the IRS want to see when they do an audit?
Cathy McCormack They want to see the actual receipts. In Quicken, you can import your credit card records. The client I referred to had gotten rid of several of their receipts, but luckily, still had some of the receipts. In the end, the agent let us use the receipts that we had to justify expenses for the year. The IRS wants actual receipts from the stores where clients buy their products. A statement form the checkbook or credit card company doesn't meant anything to the IRS.
[Question] What kind of receipts does a songwriter need to keep?
Cathy McCormack If you deduct it on your taxes, you need the receipts. Money in a parking meter is a deduction; you need to write it down somewhere to show how it is an expense. I keep a log in the side of my car door with an ink pen in the middle. If I am somewhere and pay an expense like a meter or something, I write it down beside my mileage and total it up at the end of the year.
[Question] What does it cost someone to get audited - fees for an accountant?
Cathy McCormack The better your records are, the less the cost. Sometimes we have to find court cases to prove the IRS does not know what they are talking about with our clients.
[Question] Whether you are acquitted or not, those fees are your responsibility and not deducted from your taxes- right?
Cathy McCormack It is tax deductible if you have to pay an accountant to represent you. Cost versus benefit - nine out of ten times you are better off with an accountant on your side. You are not going to know how to negotiate or what to look for when dealing with the IRS.
I had a client recently that if he would have represented himself and not know the laws about schedule E and Schedule C, he would have owed the government about $25,000. Instead, he owed them $1,000. My fee was nominal in comparison of how much I saved him in the audit. I try hard to make the client do the legwork so they do not have to pay me to calculate their receipts, mileage and expenses. You do not want to have to pay me $200 an hour or my staff at $60 plus an hour to run a calculator when you can do that yourself. I am very conscientious about keeping fees down for my clients. It is my job to save you money, even on accountant fees.
[Question] I use Quicken and have my receipts. What do you need to see for my records if I came to you?
Cathy McCormack I do not need to see your receipts unless there is an item that I need to break down, such as equipment that you buy. We sometimes make what we call section 179 election. The tax code that allows you to write off equipment for the full purchase price in the year that you buy it. It is a wonderful thing as they have been increasing the limits as we go along. The limit is getting ready to go up to $100,000.00 a year that you can write off, as long as you have earned income to write off against it.
We have to have the details of your equipment, whether we make that election or not. If you put good details in your Quicken, the report will tell me what it is that you are deducting from your taxes. If you know you are going to have a nice income coming forward, you can go ahead and make the election, knowing it is not going to benefit you until next year. I have clients going to buy these big SUVs that they use for at least 50% business and writing them off on their taxes.
[Question] When I show a positive Schedule C income, what percent of that can I apply to my IRA?
Cathy McCormack There is an algebraic formula when you are self-employed. It is 25% of your income, but because you have to subtract from the income, it actually becomes 20% of your net profit on Schedule C. It used to be 15%, which actually algebraically became 13%. It has recently changed to the new figures on Schedule C.
You can now do a one-person 401K. If you see that you are going to make a lot of money the next year, you may want to go ahead and set up a 401K. That law was new in 2002. If you had up to $12,000 profit for the year, you can put that amount in your 401K. This is ideal when you know you are going to have a huge year.
[Question] Auto expenses: what should we know about them and the records that we keep for them?
Cathy McCormack That is probably one of the area that most people are the weakest in keeping records - everyone hates to keep mileage logs. Unfortunately, the mileage logs are the only perfect way to support you in an audit. You do not have to write down your odometer reading every time you are in and out of the car -- just the business miles for the trip. You do need to write your odometer reading on January first and December 31st.
For your business miles, use your trip counter to track the daily miles. If you are going to 10 places in one day, just write the list and your mileage for the day. Write down where you went and the business purpose of the trip. I keep my business purpose written in my calendar and where I went in my mileage log.
There are two ways to expense your car. You can use the standard mileage rate in effect for that year or your actual expenses at the time of your business percentage usage. The problem is you still have to keep a log either way, because you have to calculate how much you are using your car for business. I use credit card for expenses, and import those charges and records to my Quicken program. It can get you in some deep debt too, so be real careful. I pay my credit card off every month and download my transactions enough to know what I am spending to make sure that I do not overspend. You have to monitor yourself or you will get in trouble with the credit cards.
[Question] I use a Day Runner to write down every day where I am going, the mileage logs and gas expenses. Is the OK?
Cathy McCormack There are a million ways you can keep track of your miles and expenses. I have a lot of clients that spend a lot of time and miles on the road. They may get one of those expandable files to keep their expenses and I have some that just won't keep the records. I just give them an envelope and at the end of the year, someone will spread the expenses out. Put them in stacks by category and pile them up. You have to find the method that works for you. The key is keeping the receipts and the proof of your expenses. You have to think that if this is in any way a business expense, that you are keeping that receipt. It is lost money if you throw the receipt in the trash and it can add up over the course of a year!
[Question] Working out of your home office, what should we look for in writing down expenses?
Cathy McCormack Using your home, you can deduct a percentage of your rent and all the expenses in relation to where you are staying. You must have a room that is designated 100% business, cannot be multi-use, and you cannot have a bed in the room. You may also write off a percentage of your utilities, insurance and rent. Those items are what we call operating expenses. If you do not have profit, they are not deducted, but they are carried forward.
With respect to your telephone expenses, they go right on your schedule C for business deduction. The government says that the first phone line in your home is personal because all households have one, and you will have it whether you have a business or not. Any features that you add to the phone are tax deductible 100%. Your cell phone is considered a second phone, even if it is multi-use. It is your second telephone and 100% write off. If you do not have a landline phone, just your cell phone, you will have to allocate it based on business and personal calls. You can ask the cell phone company to give you detailed billing. You go through and highlight the business calls. The key to taxes is keeping records as organized as possible!
[Question] Are there other home office deductions that we can claim for our taxes?
Cathy McCormack If you own your home, the property tax and mortgage interest is deductible regardless of whether you have a loss on your schedule C. There are several reasons that you want it on your Schedule C. One in particular relates to medical expenses. Some of the expenses, such as medical that you deduct on your return the limits, are based on your adjusted gross income. When you have Schedule C, that income or loss impacts your adjusted gross income on page one of your 1040. You want that number to be as low as possible. Whenever you can put something on your Schedule C, you want to do it.
[Question] I have a one-bedroom apartment. Do I need to partition it off to write the deductions on my taxes?
Cathy McCormack Some people use their dining room or a little nook that can be written off as you have your computer and desk in the area. Measure off the space, even though you rent it.
[Question] If you have a DSL line or cable Internet, can you write those off?
Cathy McCormack I have cable and Internet and write 100% off on my taxes. Your cable for your TV is NOT going to be 100% deductible. Most musicians write off 50% of cable and those in the TV production business tend to write of more than 50%. We us usually categorize Cable as research - MTV, CMT, GAC - and those types of programs. The cable for your computer is a 100% write off. Also - if you buy CDs of other artists for research, you may write off 100% of the music purchases. A musician's CD collection is ten times what a normal person would have, and is most definitely used for research.
[Question] Where do you list CDs as expenses?
Cathy McCormack On the second page of Schedule C there is a place to put "other deductions" that do not fit into any other category - write down research.
[Question] Demo costs are astronomical and I list them as professional services. What do you recommend that I list demo cost in what category?
Cathy McCormack If they are not much money, I write them off as demo costs under the "other categories." However there is a rule that demo costs are supposed to be capitalized and amortized over the revenue stream. A lot of people have no revenue stream or no determinable revenue stream. There is what we call a Safe Harbor election that you can make to amortize those costs over a three-year period. You get 50% of the demo cost in the first year, then 25% and 25% the following years.
[Question] What is the category "Professional Services" used for in the tax forms?
Cathy McCormack They are used for a lawyer, accountant, songplugger, or consultant that you hire for your business. You do not want that number to be astronomical or it will go into another category.
[Question] Do you 1099 the songplugger and your accountant?
Cathy McCormack You are actually supposed to 1099 your accountant, lawyer, and song plugger. If you hire someone to fix equipment, you are supposed to give him a 1099 form if he makes more than $600.00 from doing business with you.
[Question] How much is the Quicken program?
Cathy McCormack I just got the 2004 version personal version for about $60.00. Something else that I should mention regarding credit cards. When you charge the item, it is deductible when charged, not when you pay the bill. This applies if you charge an item in November, and maybe pay the bill in January. Write it off for the previous year - when you bought the item. Go shopping on December 31st, put it on your credit card, and pay for it the next year. Health insurance is also deductible if you are self-employed and that comes off before your adjusted gross income. However, you must have profit on your Schedule C or it will have to be reported on Schedule A as medical deductions.
[Question] I have paid my quarterly tax bill late this past year. How does that affect my reputation with the IRS - do they flag me?
Cathy McCormack They do not flag you, but charge you interest for late payment based on the number of days that you are late. I always check the IRS penalties, as I have caught them using the wrong figures to penalize some of my clients.
[Question] If I go to lunch with a co-writer, can I deduct our lunch off my taxes?
Cathy McCormack Yes, you deduct half of it, but keep the receipt, even for meals under $25.00. The only time you do not have to have the receipt is when you are on a per diem. Per Diem is deductible for overnight travel only. Travel days are included if it takes you overnight to get to your destination. The IRS website has downloadable per diem amounts for you to use. Each city has it's own per diem rate, so be sure to use the IRS information. Hotels are fully deductible and meals are only 50% deductible.
[Question] I have events for songwriters at my house. What do I need to show that this is not ordinary household expense for the extra food, paper supplies, and beverages?
Cathy McCormack Keep a record of your invites, print out of the invitations, and take notes on how many you are planning on having for the events. That is fully deductible, it is not entertainment. Call it a networking meeting event. It would go under "Other" on your Schedule C, and call it whatever creative name you want to call it.
[Question] What are the most common mistakes songwriters make for their taxes?
Cathy McCormack Probably not keeping good records. I have one client that it is difficult for her to keep receipts. I tell her that if she does not have a receipt, it does not exist and I cannot pull it out of the air. We dig through her wallet, purse and pockets to find receipts. It is the hardest thing to get clients to do - receipts. You need to develop those good habits to keep your records of your expenses. Seek qualified advice to make your decisions. Peers are good to help conjure up questions, but make decisions from advice of a professional.