Don’t Worry, Be Happy – And Keep Good Records!

I was assigned a case for a member who had been contacted by the New York State Department of Taxation and Finance (NYS DOTF). The agency had disallowed the member’s Schedule C losses because they believed the member did not conduct his business with a profit motive due to a five year history of losses. The member had a full-time job in the banking industry. At the same time, he was trying to establish himself as a Caribbean music producer.

In our response to the NYS DOTF, we addressed the nine factors listed in the IRC regulations that are used to determine the profit motive of a taxpayer.

First, we looked at “the manner in which the member carried on the activity.” We asked many questions about how he’d conducted his business, and we were able to document much of what he claimed. He provided copies of contracts he’d entered into with various musicians and a copy of a lease for his studio. He sent several e-mail chains between himself and recording artists, recording studio owners and other producers. He also submitted a discography of all of the songs he was listed on as a producer, along with the recording artist’s name and the recording label.

Next, we addressed “the expertise of the taxpayer and/or his advisors.” The member said that in previous years he had partnered with another songwriter with whom he’d had several hit records. Many of the artists that have performed their songs did so throughout the United States, Europe and the Caribbean. The member also produced the names of thirteen other musicians, vocal coaches, and music producers he’d collaborated with over the years.

The member had become educated on the legal side of the music business through an unfortunate chain of events leading to lawsuits for copyright violations. He said he was always looking to make his business profitable and he produced the names of sources from whom he’d been able to obtain ideas and creative concepts.

We then asked the member how much time he was devoting to his business. While he was working in a full time position, he was devoting 15 to 20 hours per week to his music business, which included writing music and the operational aspects of his venture.

Turning to the next factor, “the expectation that assets used in the activity may appreciate in value,” the member was very forthcoming about the possibility of success of any one individual in the music business. He provided the names and songs that had been produced by Caribbean immigrants such as himself. The member was well aware that many artists go through a barren spell before having a hit record. But much to his credit, he never seemed to give up. He was able to document several instances where he had sent demo tapes of his music to various record producers and other music licensing entities.

His music activity was the only activity ever undertaken by the member other than full–time employment.

The next two tests were to examine the member’s history of losses in the activity as well as his amount of occasional profits.

The member was able to demonstrate that before 2011, the music business had been characterized by sales of CD’s and vinyl records. Around 2011, the music business underwent a sea change where retail record stores closed and music became obtainable via Internet download. Many established record companies filed for bankruptcy.

From 2011 – 2012, the member’s business spent heavily on production and promotion costs related to one specific artist. During that period the artist’s career began to take off in the Caribbean music scene. In fact, the artist was selected to perform at the Caribbean Independence Ball held in New York City. Afterwards, the member attempted to formally sign this artist, but the singer refused to sign the recording contract and chose not to honor his side of the agreement. Given the member’s previous experience with the legal system, he decided not to pursue any legal remedies. In addition, during that time, the member stopped working with U.S. record promoters and video directors, and also stopped making CD’s.

The last factor in the IRC regulation, “elements of personal pleasure or recreation,” at first blush, was a difficult hurdle to overcome. The member said that while he actually enjoyed writing music, he did not like other elements of the music business. In particular, he cited the hype over substance of the business, difficulty of the independent producer to access the mainstream music, and the prevalence of many dishonest individuals who do not honor their agreements.

I was very much impressed with the amount of supporting documentation the member provided to us in defense of his case. He provided copies of emails he had sent to various artists, record producers, video directors and the like, demonstrating his hands-on involvement in his business. He was able to clearly illustrate where and why the losses in his business had occurred. The member was attempting to earn a profit in the music business, which has been marked by many changes ─ primarily due to the Internet. In addition, the product of the music industry, the songs and the artists that perform them, have a very short shelf life, often measured in weeks.

I assembled the response to the NYS DOTF and had it reviewed by colleagues to see if there was anything else we could add to bolster the member’s case. Most of my colleagues were equally impressed by the amount of documentation the member had provided.

We sent the response to the NYS DOTF and waited to hear from them. Several weeks later, they responded, allowing the member’s losses ─ not only for the current year, but also for all of the prior years as well.

A few months after the member’s New York case was closed with no changes, the member received an IRS audit notice for this Schedule C activity for the 2012, 2013 and 2014 tax years. We sent in the same response to the IRS that we had done for NYS DOTF. Not surprisingly, the IRS arrived at the same conclusion as the NYS DOTF and issued a “no change” as well.

What made this case different from many others I’ve seen with a history of Schedule C losses was the documentation and the records the member provided to substantiate his position. He took a very active role in his defense by producing documents and answering our questionnaires with very detailed explanations. With my audit defense strategy and his documents, we were a power duo with a hit.