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June 7, 2019

Does an Author Pay Self-Employment Tax on Royalties?

Employment Tax

Houston Tax Attorney

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Taxpayers are free to structure payments for services rather than for something other than services. This can save self-employment taxes. But can a taxpayer carve out part of their service income by asserting that some part of the income is not from a business? The Slaughter v. Commissioner, T.C. Memo. 2019-65, case addresses this in the context of royalties paid to a self-employed author.

Facts & Procedural History

The taxpayer is a published author. She entered into publishing contracts during the years 1999 through 2011. The contracts provided for advance payments and royalty payments. The royalty payments were based on a percentage of the profits from the book sales.

The tax return preparers split the payments between those allocable to the taxpayer’s business and those that were not. They did not use the publishing contracts to report the payments. Instead, the preparers:

used a calendar-based approach. They applied the percentage of the year which petitioner spent writing to the total payments she received for the year. … [T]he preparers relied on petitioner’s statement that it took her roughly 12 to 15 weeks to produce a manuscript for a publisher. The preparers applied a 12-week period and assumed a five-day workweek because petitioner told them she occasionally took time off from writing. For the 2011 tax year the percentage reported was higher than that for 2010 because petitioner spent more time writing.

This had the effect of subjecting only a portion of the payments to self-employment tax. The IRS did not agree with this determination, which resulted in the current court case.

Nexus for Self-Employment Tax

Only trade or business income is subject to self-employment tax. The law is clear in this regard. But what exactly counts as a trade or business? The law generally looks to whether there is a nexus between the income received and the business.

In the present case, the taxpayer was a self-employed author. She was compensated for writing books. She argued that she was also compensated for her personal brand. To the taxpayer, the payments for the service business was distinct from the payments for the non-business personal brand. As distinct revenue streams, only the revenue stream for services was subject to self-employment tax.

The court agreed that the taxpayer had developed a personal brand. It then considered whether the brand had sufficient nexus with the taxpayer’s book writing business. It doing so, the court concluded that there was sufficient nexus:

Petitioner’s readership is made up of those who enjoy petitioner’s writing, therefore providing a sufficient nexus. Without her writing there can be no books whose pages may be used for advertising. Further, the contracts include provisions that petitioner is, upon request, entitled to proceeds from the advertising in her books. If the contracts provide for additional and separate payment for that revenue, it follows that none of petitioner’s advances or royalties are allocable to it.

Thus, the court concluded that the royalties are subject to self-employment taxes.

Self-employed authors should revisit how they report their income given this case. Tax planning may be needed. It may be necessary to re-word their contracts or even use separate service and royalty contracts. It may also be useful to consider using a legal entity, such as an S corporation to deal with this issue.

Payments for Not Providing Services

While the court concluded that the royalties are subject to self-employment taxes, it also noted that payments for not providing services are not subject to self-employment taxes. It notes that payments to not compete with an employer avoid self-employment tax. But unfortunately for the taxpayer in this case, her contracts did not include what amounted to substantive non-complete clauses. This case leaves the door open to segregating services from non-services for self-employment taxes.

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