High net worth athletes and entertainers traditionally have been at risk for increased audits, due to the combination of high income offset by high itemized deductions. In June 2020, the IRS announced that its Global High Wealth Program would be focusing on this class of individuals, generally defined as those with adjusted gross income exceeding $1 million. The increased audit focus now looks to the individual’s related entities, in addition to the Form 1040, with a particular eye on pass-through entities such as limited liability companies, partnerships and S corporations.
What led to this focus?
Three factors generally led to this increased focus: tax reform, the coronavirus pandemic and increased scrutiny on the IRS’ audits of high net worth individuals. Consider the details below:
- The Tax Cuts and Jobs Act (TCJA), passed in December 2017, drastically changed the tax landscape for salaried athletes by eliminating or substantially reducing popular deductions. Starting with the 2018 tax year, many athletes were shocked to find that they now file with the standard deduction. As explained below, this class of individuals may be more tempted to move otherwise nondeductible expenses to their pass-through entities and claim such deductions there.
- The pandemic has led to the loss of billions of dollars in tax revenue, so state and local governments, as well as the federal government, are looking to various measures, including enforcement actions, to replace this lost revenue. In fact, under the People First Initiative, the IRS agreed to suspend enforcement and certain collection activities from April 1 to July 1, 2020, due to the pandemic.
- The IRS has received recent criticism for failure to audit high net worth individuals. A study by Syracuse University revealed that only about 3% of the approximately 504,000 people who earned at least $1 million in 2018 were audited. (TRAC study, March 7, 2019). Funding cuts are partly to blame, leading to reduced staffing and increased workload. (The number of IRS examiners has been reduced by 38% since 2010, and the 2019 budget of $11.3 billion is down from $14 billion in 2010, according to research by Indiana University.) Thus, playing audit roulette has generally been in the athletes and entertainers’ favor—until now.
As background, athletes are either salaried employees on professional teams that comprise leagues, or they are self-employed individuals earning prize money (e.g., golfers and boxers) and endorsement income. Before 2018, salaried employees would report their deductions on Schedule A, including potentially hundreds of thousands of dollars in state income taxes and such unreimbursed expenses as agent, trainer and advisor fees. Self-employed individuals report their income on Schedule C, where it is subject to self-employment tax but offset by related business deductions. However, the TJCA changed this by enacting a combined limit of only $10,000 permitted for state, local and property taxes, and eliminating the deduction previously permitted for unreimbursed employee expenses. Consequently, athletes who either do not own homes (for the mortgage interest deduction) or are not charitably inclined (for the charitable contributions deduction) see their former itemized deductions of several hundred thousand dollars whittled down to just $12,200 (the 2019 standard deduction for a single filer).
What should an athlete or entertainer to do?
As mentioned above, many try to move their now nondeductible expenses over to either their Schedule C, claiming such expenses are tied to their self-employment income, or to their related pass-through entities. Athletes do not like to hear that their $200,000 agent fees, for example, are now nondeductible. Unfortunately, some CPAs who cater to athletes try to justify the continued deduction of such fees on Schedule C or on the athlete’s S corporation return.
This shifting of expenses to the pass-through entities will now be scrutinized by the IRS Global High Wealth (GHW) Program. The program, formed in 2009, is part of the Large Business and International Division, within the Pass-Through Entities Practice Area. Its stated goal is to “identify and examine high wealth taxpayers with the highest compliance risk in a consistent and efficient manner.”
So what exactly will GHW examinations cover? The IRS explains that an examination under this program “consists of a key case, generally an individual income tax return, and related income tax returns where the individual has a controlling interest, and significant compliance risk is deemed to exist.”
This approach contrasts with the typical IRS audit of a Form 1040 by expanding the examination to the taxpayer’s interest in partnerships, trusts, S and C corporations, private foundations and even gift reporting.
For example, assume a professional basketball player has a lucrative shoe deal worth millions annually. He forms an S corporation to hold this endorsement income. Separately, he is passionate about specific issues and forms a foundation to support his philanthropic interests. His financial advisor diversifies his account with investments in several real estate partnerships. Finally, the athlete has several business involvements, including rental commercial property, a restaurant, music label and a clothing company, each housed in its own entity. If this player is examined by the GHW Program, he may be contacted by the Tax Exempt and Government Entities division and Small Business/Self-Employed Division. Additionally, the exam may expand beyond income tax to include gift and transfer taxes.
The term “global” in the program’s name is not by accident. International sharing of information has increased over the years. Cooperation between Australia, Canada, England, France, Germany, Ireland, Japan, the United States and others led the Organisation for Economic Co-operation and Development (OECD) to publish a report titled “Engaging with High Net Worth Individuals on Tax Compliance” in September 2009. The OECD touts the report as a detailed examination of the high net worth segment, including the group’s usage of aggressive tax planning schemes. It proposes prevention, detection and response strategies that tax administrators can use to respond to these challenges. The publication offers several suggestions to improve compliance, including the creation of a dedicated high net worth unit, and engaging more in international cooperation.
That international component raises questions about enforcement for athletes who reside in one country and play in others. For example, should the GHW Program examine a German citizen who now qualifies as a U.S. resident playing professional basketball in America? Would the GHW Program reach out to Germany and coordinate efforts to expand its examination of the athlete’s foreign holdings and activities? Imagine managing such an audit!
5 key steps in creating good habits
How should an athlete or an athlete’s advisor put this information to use? The following basic steps should be reinforced as good habits:
- Maintain good records and be able to substantiate the business purpose of every deduction
- Be meticulous about proper entity formation and registration, and keep separate ledgers to easily segregate business activities
- Do not misuse business credit cards for personal uses
- Do not try to move expenses around and play the audit game
- Be wary of tax “promoters” who promise large refunds by amending past returns
While it might not be much consolation to some, as we advise our athletes, you owe money because you make money. Work with CPAs and tax firms who have proven experience with athletes and entertainers, and stay away from firms that promise high refunds but offer little details. Otherwise, a GHW Program examination could quickly transform those dubious refunds into interest and large penalties.