Taxes for Writers
This article is written to do more than just give you a working knowledge of how to cope with your taxes. That basic information of how to file a sole proprietor (thatís how most writers are treated, being self-employed individuals) or partnership or corporate return is covered in great detail in a free publication printed by the IRS, the Tax Guide for a Small Business. This essay is designed to deal with the specific provisions written into the law that affect us. Recognizing that not everyone is into reading tax codes on a daily basis, let me explain first just what the law is and where it comes from.
The Internal Revenue Code is the actual law, which is written by Congress, those folks that were elected. They pass different Acts which may change or modify existing Code sections and also write Committee Reports, which, while not the actual law itself, are often useful in getting a perspective on what Congressí actual intent is.
The Regulations are direct applications of the law and are written by the Internal Revenue Service. Generally, IRS writes proposed or temporary regulations, invites comment on them when they are published in the Internal Revenue Bulletin (a sort of weekly reader of tax law) and later issues final regulations. Both the Code and the Regs are reliable sources of exact information.
However, if thereís one thing certain about the American taxpayer, itís that someone, somewhere, will come up with a question not specifically addressed in the Codes or the Regs. Further tax advice and information may come from IRS-issued Revenue Rulings or Revenue Procedures, or even from court cases or private letter rulings. But be aware that these establish precedent extremely specific to a particular case. A further point with the court cases is that IRS has the option to disagree with a court case (itís called "non-acquiescence") which means that while bound to follow the courtís ruling in the case involved, the IRS will not agree to apply this as a precedent in other cases.
If youíd like to see the actual code section or court cases, a law library is the best place to go for copies. Copies may also be requested by mail from the following address, but they will charge you a copying fee. That address is:
U.S.Government Printing Office
Washington, D.C. 20402-9371
An excellent free resource is the IRS Publications. I will refer to them frequently, as they are free for the asking by calling the IRS toll-free hotline in your area, and take about two weeks by mail when requested.
Rules That Apply To Authors, An Historical Perspective
That particular legislation that creates the tax laws we are bound to has been active where authors (and artists and film makers as well) are concerned. It isnít difficult to get tax advice regarding simple items such as what form to use and what records to keep. What is a lot harder to find is information about the particular legislation aimed directly at this industry. The law is easier to understand if you trace back the prior rules first.
Back in 1976, Congress enacted code section 280, adding it to the IRS Code in 1954. This provision stated that production costs of "a film, sound recording, book, or similar property" would be prorated over "the period during which the taxpayer reasonably may be expected to receive all of the income he will receive from any such film, sound recording, book, or similar property"
The practical application of this meant that if you wrote a book, you needed to capitalize your expenses, which means you saved them up, accumulated them until such time as you actually made money from the sale of your book. Once you started receiving income, you then amortized your expenses, which means you then wrote them off proportionally to your income. The current-year income, divided by your total income, times the total cost, equaled your deduction. This wasnít such a bad way to go, when you wrote a book and collected royalties. And if you were someone who wrote short stories, articles, or essays for magazines, receiving one-time payments like first North American Serial Rights (NASR), this really didnít affect you, since it was specific to books. A later court case, A.T. Hadley, established further that authors were not the intended targets of this legislation, as it was targeted more to curb tax shelter activities. This weakened the IRS case for a truly stringent application of this provision. Summarized, this was how a basic accounting principle, the matching principle, was applied. The concept is a simple one: make the expenses match up to the income. Remember this idea Ė weíll se a lot more of it.
The Tax Reform Act of 1986 (TRA í86) repealed section 280 and wrote a new code section into the new Internal Revenue Code of 1986 (which replaced the Code of 1954). The uniform capitalization rules (unicap) were in code section 263A, and were an attempt to apply the matching principle more stringently than before. Where previously you could use a standard formula based on total income to amortize expenses of books, and if you were an ongoing business you were able to write off expenses as incurred for short items, now unicap required you to establish how long you could expect to receive income from every manuscript, and to specifically match the expenses to the income from each item. Since itís nearly impossible to figure how long a particular book will remain in print, or how many times a short story will reprint, this was impractical. IRS responded to the outcry of the creative industry by issuing an elective ruling, contained in IRS Notice 88-62, called the "safe harbor rules." Simply put, the rules allowed you to capitalize your costs and write off 50% in the first year and 25% in the second and third year. This was elective, which meant you could choose to use it, or attempt to satisfy unicap instead. Not surprisingly, many people elected to go for the safe harbor rules. Although issued in June of 1988, it was retroactive to 1986, allowing authors to amend previous tax returns and use the safe harbor. Many did.
Then Congress reacted to this scenario by repealing unicap for authors, meaning that they struck down the law, made it as if it had never existed in the first place provided that you were an individual. The repeal did not (and still doesnít) apply to partnerships and corporations. A noteworthy angle of this is that you do not need a written contract to create a partnership. By definition, if you have two or more individuals each contributing to an enterprise and expecting to share equally in the profits, you have a partnership. (See IRS Publication 54I, Partnerships.) Collaboration will often fit that definition, and if youíve incorporated, then you are still bound by the rules for applying unicap. But where section 263A was repealed for individuals, the safe harbor rules were not repealed at all. This means that you may still, even if you are a partnership or corporation, choose to apply the safe harbor and write off your expenses over a three-year period, beginning with the year that the expenses are incurred, rather than waiting for income to be received.
The alternative to using the safe harbor therefore depends on what you are. For individuals, the unicap provision of the law was repealed. This means that where you may choose to utilize the safe harbor, you donít have to. Since the repeal of unicap and the prior repeal of Section 280, there is at this time no provision in the law that treats individual writers differently than any other business activity. In other words, if you are an ongoing sole proprietorship incurring ordinary and necessary expenses relating to doing business during your tax year, you may simply write off your expenses in the year incurred exactly like any other small business. But donít be surprised if new legislation comes up in the future to change this. Keeping in mind how active law makers have been in this area, the old law is till something we all need to understand in order to make informed choices such as: Do you really want to incorporate? Or collaborate? Or buy that new word processor this year?
Now that weíve become current on the specific provisions directed at writers, artists, and film makers, letís move on to the more general topic of how to do a tax return for an author. We will use an individual whose business would be a sole proprietorship, as our example. (I specialize in individual returns).
What Forms to Use
Some people write for a living. Some write as a sideline. There are some differences in how taxes are filed for businesses compared to hobbies, so the first thing you need to establish for yourself is whether you are involved in this as a trade. Businesses have distinct characteristics, e.g. a profit motive. A tax court case in 1965, C. Lamont, disallowed losses claimed where the individual had pursued the activity of writing, teaching and lecturing because of an interest in literature, rather than a desire to make profits. "Art for artís sake" simply doesnít work as a business, but would be more in the nature of a hobby.
A key point here is the losses from hobbies are not allowed. When you receive income from a hobby, you must include the gross income (whatever you got, without deducting any expenses against it) on "other income" line of your tax return. (On 1994 forms, which are used to explain this, as theyíre the latest in print as I write, this would be line 21 of Form 1040. All further references given will be to 1994 forms as examples.) The expenses relating to this income may only be taken if you itemize deductions, in which case they are taken as miscellaneous deductions subject to the 2 percent limit. This means your hobby deductions, which may not exceed the amount of your hobby gross income, are taken on line 20 of the Form 1040 Schedule A, and they plus your other miscellaneous deductions will not produce a tax benefit for you unless the total exceeds 2 percent of your adjusted gross income, which is the figure on line 32 of the 1040 form. In other words, hobby deductions are sharply curtailed and never produce a loss.
On the other hand, if you have a profit motive (defined as a reasonable expectation of realizing a profit, which generally shoots down vanity presses), you still may not actually have active conduct of a trade or business. The amount of time you spend in pursuing this business activity is a factor. If you spend as much as 500 hours annual (this is not the only test for establishing a lack of passivity Ė see the instruction to Schedule C, line 1 for discussion, or order IRS Publication 925, Passive Activity and At-Risk Rules, from the IRS toll-free hotline in your area.) This is important since passive activities also have limitations on losses, and require a different form than an active business. For example, if you have a passive activity that generates royalty income, this income would not be subject to the self-employment tax, explained next.
Letís discuss royalties for a moment. One of the most common mistakes I see on the tax returns for authors is a tendency to try and separate out he royalty income and put it into Schedule E, Rents and Royalties, instead. This is appropriate if youíre an owner of say, oil royalties, or if youíve perhaps inherited the right to receive royalties from an estate. It is not appropriate if you are actually in the business of being a writer. Being in the actual business means you spend a certain amount of time and effort carrying on a business. Since itís a business and not a passive activity, it isnít subject to the limitations on passive losses. But the other side of the same coin is that the royalties become part of the gross income of your business, and are added in with whatever other income (e.g., first NASR, advances) on your Schedule C, Profit or Loss from Business, instead. Being part of your gross income from a trade or business, they are indeed subject to self-employment tax (a form of Social Security and Medicare taxes). Before you could avoid paying self-employment tax on this, you would have to be able to show that you are not in the trade or business of writing, which means that your expenses against writing income would not be deductible directly against your income, as with the Schedule C. Instead, youíd be putting yourself in the position of treating this as a hobby. If writing is simply a hobby, then your gross income from it would be included on your Form 1040, but your expenses could not produce a loss. If you continually produce income from such an activity over a significant period of time, itís likely that an auditor might question as to whether this is actually a hobby or actually a business. If this activity is a trade or business, then pay self-employment tax on your income from it.
An actual business, a sole proprietorship, involves filing a Schedule C for your starting point. The Schedule C, Profit or Loss from Business, is where you include your gross income and write off your ordinary and necessary expenses. This means youíll be able to write off your expenses without having to itemize deductions.
Letís look a moment at gross income. When youíre in the business of being a writer, that means that your gross income will include such items as first NASR, royalties and royalty advances. A 1961 court case, Holbrook, established that royalty advances were considered fully taxable, despite the contention by the taxpayer that he might have to give them back and therefore shouldnít be taxed until the advances was paid off by the book royalties. The U.S. Tax Court disagreed, stating that royalty was taxable when received. On the other hand, if you were in the situation where you properly included a royalty in your income and then had to give it back, you could then take a deduction for the repayment. The deduction is taken on the same form as you previously included the income on, e.g., the Schedule C.
A note about expenses, and particularly word processors. Thereís a common tendency to think when you buy an asset, you can write off the expense that same year, and most of the time itís true. But remember the matching principle Ė if you buy a computer that youíre going to use for maybe five or ten years, you wontí generally be able to write it all off in one year. When you have a tangible asset with a useful life over a year thatís used to produce income, thatís a depreciable asset. This means that youíll use Form 4562, Depreciation and Amortization Schedule, to write it off over a standard period. In many cases, you can make an election, a choice, to write off up to $17,500 worth of otherwise depreciable property in a single year, but it has to be the same year that you bought it and started using it in your trade. Itís called the section 179 deduction and has limits deriving from how much income you made and how much you spent on business assets. The whole (and rather complex) information on this is printed in two separate publications, number 534, Depreciation, and number 946, How to Begin Depreciating Your Property. Note that a computer used in your home is a "listed property", which has more restrictive rules than most.
The bottom line on our Schedule C will be your net income, and that goes in two places Ė it carries over to line 12 of the 1040 form, where it will add to your other income (such as wages or interest) and be figured in for your federal income tax, and that net income also carries over onto line 2 of the Schedule SE, Self-Employment Tax. Self-Employment Tax is actually your Social Security and Medicare tax, and if you made a net income of over $433, you must pay it. This is the tax that most beginning sole proprietors tend to overlook. Unlike income tax, there is no standard deduction and exemptions you can take against it, and the tax is 15.3 percent of 92.35 percent of your net from the Schedule C, except that if you make over $61,200 (1995 figures) youíll hit a limit where the greater part of it stops then. See IRS Publication 533, Self-Employment Tax, for more information.
The reason Iím bringing this up is that the tax law system has been on a pay-as-you-go basis since July 1, 1943. The key here is that if you donít pay enough of your tax as you go during the year, you can be hit with a penalty. The vehicle for paying as you go, yourself, is Form 1040ES, Declaration of Estimated Tax. If youíre going to owe as much as $500 when you file your tax return, including the self-employment tax, then you should look into estimated taxes. The minimum required payment to avoid penalty is 90 percent of your current year taxes or 100 percent of the last yearís taxes, but if you had a gross income over $150,000 (or $75,000 if you were married filing separately) in the previous year, you may not be able to use that 100 percent of prior year option. The IRS publishes a free booklet, Publication 505, Tax Withholding and Estimated Taxes, with detailed information and filled-in examples, available at the toll-free hotline.
The best overall publication for a new business is IRS Publication 334, Tax Guide for a Small Business. Itís a large, free reference. For example, Chapter 38 contains a comprehensive example of the tax return for a sole proprietorship, and the next three chapters illustrate tax returns for partnerships, corporations and S corporations. Itís also indexed, so that when you have a specific question regarding a subject, such as start-up expenses, or how to depreciate equipment, you can find it in the index, read that page listed, and at a bare minimum youíll get a handle on the right question to ask. Calling the hotline to ask for it, you might also want to ask if any of the Small Business Workshops given by the IRS are scheduled to be presented in your area. The reason I havenít gotten further into how youíll do your tax return and take your ordinary and necessary expenses in more detail is that the publication does a better job than I could given the space considerations here. Other publications you might want to order are:
Pub. 463, Travel and Entertainment
Pub. 542, Corporations
Pub. 552, Recordkeeping
Pub. 587, Business Use of Your Home
Pub. 917, Business Use of a Vehicle
Pub. 910, Guide to Information Publications
Hereís a final note that effects only those of us successful enough to sell to other countries and collect foreign royalties. Frequently, the foreign country will send you a request for certification that you file a U.S. tax return. Itís because there are tax treaties between countries and, if the IRS property certifies that you file a U.S. tax return, they wonít withhold as much foreign tax from their payments to you.
In lieu of using a foreign certification form for this purpose, you may request that the IRS issue a Form 6166, Certification of Filing a Tax Return, by contacting:
Internal Revenue Service
Philadelphia Service Center
Philadelphia, PA 19114-0447
Form 6166 is not accepted in Italy, however, so you will have to obtain the Italian version of the form and send it to the Philadelphia Service Center for certification. For further information, Publication 686, Certification for Reduced Tax Rates in Tax Treaty Country, explains the process succinctly.
© 1993, 1996 Cyn Mason
Reprinted with Authorís Permission *
*This article was handed out as part of a presentation at a recent science fiction convention. The Author told the audience it was OK to reprint this. It is presumed that this includes the web as well. If this is incorrect, this document will be removed immediately.