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Julio Gonzalez, National Tax Reform Expert and CEO of Engineered Tax Services (ETS), The Growth Partnership and ABLE CRM.
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We may be on the verge of seeing a radical shift in the way athletes and other professional entertainers are paid.
A tax provision that came into effect last year deprives professional athletes and entertainers working as W-2 employees (as opposed to self-employed individuals filing a Schedule K-1 or Form 1099) of their ability to deduct losses against their wages. Unless they get immediate help changing their employment status to preserve their wealth, they face significantly higher tax burdens. Professional athletes and entertainers who file W-2s may need to work with their employers to change their contract language and convert their compensation to self-employment income to avert a huge tax bill.
The issue stems from section 461(l) of the 2017 Tax Cuts and Jobs Act, which limits the deductible loss related to a trade or business in the taxable year in which the loss is incurred, known as the excess business loss. The rules were suspended retroactively from 2018 through 2020 through the enactment of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, but now they are active and effective through taxable years that begin before 2029.
This rule creates a situation in which some may end up losing more money in a year than they make, with no way to protect their preexisting wealth. The statute may disallow losses for individuals, trusts and estates to the extent that such losses (aggregate deductions) attributable to a trade or business conducted by the taxpayer exceed the amount of aggregate gross income or gain of the taxpayer attributable to such trades or businesses.
For tax filings 2021 and after, single filers and joint filers have their respective income thresholds set at $262,000 and $524,000, respectively; these figures are adjusted for inflation. Any net business losses that exceed the aforementioned amounts will not be allowed on tax returns after 2021.
The central issue of concern is that the 461(l) calculation excludes from “aggregate gross income or gain of the taxpayer” items of income and deduction that are attributable to a trade or business of performing services as an employee.
One solution for athletes, entertainers and other high earners is to consider becoming self-employed. Treating an individual differently based on whether he is an employee or a so-called self-employed person is not a good tax policy, especially since the services being rendered are the same.
Whether or not a professional athlete (or any other worker) may be considered self-employed rather than an employee for tax purposes is based upon an IRS multifactor test.
Tax advisors need to look at each individual’s situation to determine the best options, as independent contractor agreements may work for some (those fresh out of college or changing teams, for example) but not others. A team ownership’s desire for certain controls, the underlying terms of the existing contract, collective bargaining and labor laws would all come into play, and a review may reveal that a change isn’t possible.
There are other possible solutions.
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In cases where the employer is a partnership or LLC treated as a partnership for tax purposes, granting the athlete a “profits interest” as some portion of his compensation should, under U.S. Treasury regulations, automatically convert the athlete’s total compensation from “wages” reportable on a Form W-2, to self-employment compensation reportable on Schedule K-1.
Consider a hypothetical executive, CEO John Doe. Doe is married, files a joint return and receives a flat salary plus a bonus. He also has separate investments in real estate derived from a “trade or business” under the tax code. Let’s say that his compensation is $5 million in the same year he experiences real estate losses of $2 million (these losses are not otherwise restricted by the “passive loss” and “at risk” rules). He has no other income or loss for the year.
Under section 461(l), the amount of Doe’s real estate losses that can be considered to offset his $5 million compensation is limited to $500,000. The $1.5 million excess will then be carried forward to future years and will be deductible to the extent allowed under NOL (Net Operating Losses) rules.
However, if Doe, instead of having employee status, were a partner in a partnership or a member of an LLC treated as a partnership, any of his compensation likely would be self-employment income rather than salary or wages, and therefore could be considered in determining the amount of trade or business losses deductible in the current year. Thus, in this example, Doe would have derived his $5 million of compensation as guaranteed payments and/or profits passed through from the partnership or LLC, and would have been able to deduct the entire $2 million real estate loss in the current year.
The profits interest award must be computed in a specific way. It would have to be measurable and limited so that the total cost to the employer of such individual’s compensation, with the inclusion of this profits interest, would be no greater than it would otherwise be if the individual remained an employee.
This award would turn the individual from an employee to self-employed for tax purposes going forward. As a result, all compensation, both his fixed income (so-called “guaranteed payments”) and any profits allocated to him for distribution, would qualify as “good income” under IRC section 461(l) for purposes of determining the level of current loss that would be allowed.
Losses disallowed in 2022 would be carried forward to 2023 during which the individual’s total compensation would be “good income.” The documents and laws relating to the existing employment arrangement first would need to be reviewed.
Even though the change would be effective on a going-forward basis, making the change now will increase the likelihood of all 2022 losses being allowed, if not fully in 2022, at least in 2023 or 2024.
Successful professional athletes and entertainers all have two things in common—talent and work ethic. They have worked hard to create what they’ve earned—now they must work to protect it.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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