The following is an excerpt from Chapter 16, ‘Paying Your Taxes’ of my book, Music Law: How to Run Your Band’s Business © 2009 Nolo
Income Taxes: Different Rules for Different Band Businesses Each band business form—sole proprietorship, partnership, corporation, or LLC—has its own tax rules and procedures. As a general rule, taxes are much simpler for unincorporated businesses such as sole proprietorships and partnerships. That’s because income from unincorporated businesses is simply treated as personal income to the owners. In other words, the business itself is not taxed. For example, if your four-person band is a partnership, any profits the band makes are divided among the four owners, who report them as personal income much like income from a job or investments. Corporations, on the other hand, are considered to be separate entities from their owners, and they pay their own taxes. This section will explain how taxes apply to each different business form and how to file them. For more information on business forms, see Chapter 2.
Flow-Through and Entity Taxation, Defined In this section we use two common tax terms—flow-through (or pass-through) and entity taxation (which is related to double taxation). Flow-through occurs when your band business profits and losses are reported on your individual tax return—that is, they pass through the business to you. Sole proprietorships, partnerships, and, in most cases, LLCs operate as flow-through businesses. Entity taxation occurs when the IRS considers your band business as a separate taxpaying creature. (Corporations and some LLCs operate this way.) Under an entity-taxation business form, the corporation or LLC must pay taxes and file a tax return.
Reporting Band Income The IRS has become sophisticated in sniffing out band income. For example, the IRS guide to auditing musicians advises examiners to contact booking agencies and unions for verification about musician income. Auditors are trained to search out income from record and merchandise sales and may even ask for copies of partnership or individual bank accounts. It is a crime to deliberately fail to report income or to lie to the IRS. If you underreport your income, you could be subject to additional taxes and serious financial penalties—even jail time. In other words, report your band income. When in doubt about whether a payment is considered “income,” speak to an accountant or tax expert for advice.
Partnership Taxes Most bands are partnerships, because any business in which two or more persons are the owners is a partnership. A formal agreement is not necessary to create a partnership, although we recommend that your band use a written band partnership agreement to establish the details of how the partnership will operate. (A sample is provided in Chapter 2.) Technically speaking, a partnership itself does not pay taxes. Instead, any profit or loss of the business is divided among the partners and reported with their personal income tax returns. Since income simply passes through the business to the owners, partnerships are called “pass-through” tax entities. (See the sidebar “Flow-Through and Entity Taxation, Defined,” above.) Though a partnership does not owe taxes, it must complete and file a tax return to report any income or losses. Form 1065, U.S. Partnership Return of Income, is used. Since no taxes are ever due with Form 1065, it is called an “informational return.” Whoever files Form 1065 (a partner, an accountant, or a lawyer, for example) must also give each partner a report called Schedule K-1, which contains all the relevant profit or loss information about the partnership. Based on the information in the K-1 form, and based on the partnership agreement regarding each partner’s share of profit or loss, each band partner declares a portion of the profit or loss on his or her individual tax returns. Each partner reports his or her share of band income or losses on Schedule E, which is submitted with that person’s individual 1040 form. If a band partner has a day job and the band loses money, the partner can deduct his or her share of loss from the other income, which can reduce his or her tax bill. EXAMPLE: Bob is a member of the El Niños, a band that lost money in 2009.
According to Bob’s K-1 Form, Bob can deduct a $2,000 band loss from his total income, which includes wages from working at a music equipment store. By deducting the band loss, Bob pays less income tax for 2009. In addition to income taxes, all band partners must pay self-employment tax on band profits. See the section above on self-employment taxes. Your band will need a federal employer identification number (FEIN) to file a partnership tax return. Later in this chapter we explain how to get one. The FEIN will help your band to open a bank account and deposit checks under your band name. In summary, if your band is classified as a partnership by the IRS, here are some rules to remember: • Partnerships, though not taxed separately, must prepare and file a Form 1065, usually filed on April 15. • The partnership must issue a K-1 form showing each partner’s share of the income or loss. The K-1 is filed with each partner’s individual return. • Each partner must pay a tax based on his or her “distributive share,” not on what the partner may have actually received. Unless a partnership agreement says otherwise, all partners are presumed to have an equal distributive share in the partnership.
• Even if the partnership leaves profits in the business, the partners must pay taxes on those profits. (If your partnership is able to retain profits each year, consider forming a corporation.) • Partners must pay quarterly estimated income taxes, as well as self-employment tax for social security and Medicare contributions.
Sole Proprietorships A sole proprietorship is a business that is run by just one person. Unlike a partnership, which must submit an informational return, sole proprietorships do not have to file any tax returns for the business. Only the owner reports the income with a personal return. Like partnerships, sole proprietorships are pass-through tax entities. Income from the sole proprietorship is reported on Schedule C, which is submitted with the individual 1040 form. If the sole proprietorship loses money, the sole proprietor can deduct that loss from income from other jobs, reducing the tax obligation. Filing as a sole proprietorship is appropriate if the band is run by one person (the band leader) who hires musicians to perform in the band and pays each musician a fee or a salary. The paid musicians do not have an ownership interest in the band. In that situation, the sole proprietor/band leader may have to file payroll taxes if the other band members were treated like employees. Keep in mind that having employees raises a host of legal issues that you may want to avoid. (See the section below on employees and independent contractors.) An FEIN is not necessary for a sole proprietor to file taxes, because the personal social security number of the owner may be used. However, some tax experts suggest obtaining and using an FEIN for business taxes anyway, in order to keep business and personal tax records separate. Sole proprietorships must pay self-employment taxes. In summary, if the band business is owned by you and you haven’t formed an LLC or corporation: • You must report your business income or loss on a Schedule C, filed with your individual or joint tax return. • You must pay quarterly estimated income taxes, as well as self-employment tax for social security and Medicare contributions. • You are eligible for tax-sheltered retirement plans.
Preparing Taxes Consider hiring a tax preparation expert or accountant knowledgeable in the music business when preparing your tax return. While you can expect to pay $100 to $500 for preparation of tax returns, a savvy tax professional will probably save your band the cost of this fee and more. You may not have to use a professional for each year you file, but it is sometimes helpful to have a professional tax preparer create your returns at least for the first year, so that you can see the form and style that will be suitable. You should also utilize an accounting software program such as Microsoft’s Money or Intuit’s Quicken to track your band’s income and expenses.
Corporations Unlike sole proprietorships and partnerships, corporations are considered to be separate legal entities from their owners (also called shareholders). In other words, when you incorporate your business you create a new legal being that is responsible for taxes and is subject to many state and federal laws. Corporations’ profits do not pass through to the corporate owners for tax purposes, but instead are taxed at special corporate rates. Among other things, this means that corporate losses cannot be deducted from the shareholders’ income on their individual tax returns. In some cases you can save tax money by operating as a corporation, but the fees and legal costs associated with running one often outweigh any financial benefit. In order to become a corporation (to “incorporate”), a band must file incorporation papers with its state’s Secretary of State and pay a number of fees and minimum taxes. If your band is a corporation, you will need the assistance of an accountant or other professional for tax preparation and planning. See Chapter 17, which suggests resources beyond this book. Below we provide a basic summary of corporate tax principles: • Bands that operate as corporations have more tax reporting responsibilities than any other business form. So, get ready for paperwork. • Since corporations are separate tax entities, the owners must prepare a tax return for the corporation and pay corporate taxes, if any are owed. • If you’re an employee of the corporation or receive income from the corporation, you must report that on your individual tax return.
You can avoid the burden of double taxation—for example, by paying higher salaries to shareholders, thereby reducing profits, or by reinvesting profits. An accountant can assist you in legally avoiding corporate income taxes.
Limited Liability Companies (LLCs) A limited liability company (LLC) is a hybrid between a corporation and a partnership. Like a partnership, profits and losses are passed on to the owners of the LLC (your band), who then report them on individual tax returns. But, like a corporation, an LLC generally offers its owners protection from personal liability for business obligations. An LLC does not itself pay taxes but, like a partnership, it does have to file a tax return reporting income and expenses. LLCs are also subject to state fees that make them more expensive to run than partnerships. All band owners in an LLC must pay self-employment tax on the band’s net taxable income (that is, its profit). Below is a summary of rules regarding LLC taxation: • The owners of a band LLC can choose either pass-through or entity taxation. (Most choose pass-through.) Your tax advisor can help you make that decision. • If the owners choose pass-through taxation, the LLC operates like a general partnership and prepares and files a Form 1065. The LLC must also issue its members K-1 forms to be included with their individual returns.
• If the LLC has only one owner (and pass-through taxation has been chosen), the owner operates like a sole proprietorship and files a Schedule C to report the LLC’s income. • Although no federal tax is paid for a pass-through LLC, some states such as California impose taxes on LLCs. This is an excerpt from Chapter 16, of my book, Music Law: How to Run Your Band’s Business © 2009 Nolo.
