The IRS Offers a Road Map to Entertainment Tax Audits

In 1992, the Internal Revenue Service announced the formation of industry specific audit groups designed to provide guidance for auditors on tax return questions unique to these industries. Not surprisingly, the industry audit unit garnering by far the most press coverage was the entertainment task force.1 In conjunction with this audit specialization program, the IRS also began issuing a number of Market Segment Specialization Program (MSSP) guides, including an MSSP guide entitled Entertainment: Important 1040 Issues,2 which was based upon the research and experience of Office Exam Group 2321 of the Los Angeles District of the IRS.

This MSSP guide is designed to provide auditors with an overview of activities in the entertainment industry, familiarize auditors with terminology and tax-related issues in the industry, and to provide them with suitable audit techniques. Reading between the lines, the guide also represents the latest IRS campaign against perceived abusive tax practices in the show business world.

As a starting point, the MSSP guide informs auditors that considerable crossover now exists among entertainment job titles, and individuals may function in different job titles on different entertainment projects. This makes the determination of a taxpayer's duties critical, since only ordinary and necessary expenses that are incurred in connection with the taxpayer's trade or business are deductible. For example, acting expenses incurred by a lighting director would not be deductible, since they are not incurred in that taxpayer's trade or business.3

In planning an entertainment audit, the IRS auditor is instructed to develop a solid background on the individual's activities and responsibilities. Thus, it should be anticipated that the IRS auditors will request copies of documents such as contracts, project agreements, deal memos, resumes, and/or working proposals, since these documents frequently provide fundamental information about the nature of a creative person's income, expenses, and reimbursements.4 The IRS candidly acknowledges that a taxpayer's reputation and standing in the entertainment business is relevant in ascertaining the nature and extent of expenses that ordinarily would be incurred to maintain such standing.5 For example, the MSSP entertainment industry guide states that an unknown actor would usually not send gifts to a prominent producer, and a well-known singer would not need to entertain a cameraman. The guide, however, offers no pro-taxpayer examples, such as an established director entertaining a high-level producer.

Business Expenses

Given Hollywood s reputation - deservedly or not - for lavish lifestyles, it is hardly surprising that the MSSP guide devotes substantial attention to personal expense issues and the related topic of recordkeeping requirements. Business expenses in the entertainment industry are perceived by the IRS as one of the areas most subject to both abuse and misunderstanding, as well as differences of opinion.6

Generally, personal expenses are not deductible, even if required as a condition of employment,7 and the allocation of a personal expense to a business purpose hinges on a specific correlation between expenditure and income source. Consequently, IRS auditors will request all logs and records of travel, meals, and entertainment, and may also request background information explaining each Form W-2 or Form 1099, such as dates worked, job requirements, and specific activities. The IRS believes that most job-related expenses in the entertainment industry are reimbursed by the employer, especially for union signatory productions.8 Hence, actors who pay for their own travel or buy costumes must demonstrate that such expenses are not reimbursable. Moreover, no deduction is allowed for an expense that could have been reimbursed had the taxpayer sought reimbursement.9

Even in the presence of adequate proof, the IRS can be expected to challenge vigorously certain items, such as clothing. To be deductible as a business expense, clothing must: 1) be required by the employer or be essential to a taxpayer's employment; 2) be unsuitable for general wear or use away from work; and 3) not, in fact, be worn while away from work.10 Although courts were formerly much more lenient in allowing wardrobe deductions,11 denial of clothing expenses is now commonplace.12 However, the IRS does acknowledge that certain specialized, protective clothing in the entertainment industry, like a stuntperson's asbestos clothing used in a fire scene or a makeup artist's smock, is deductible, as are true costumes and period clothing (provided no union contract provides for reimbursement).13

Practitioners should expect IRS agents to be especially thorough in their auditing of entertainment-type deductions due to the perception within the IRS that show business folk splurge.14 The Internal Revenue Code specifically prohibits the deduction of lavish or extravagant food and beverage expenses.15

For meals and entertainment to be validly claimed as business deductions, a taxpayer must first establish the ordinary and necessary nexus to his or her trade or business and also meet stringent substantiation requirements. Thus, an expense considered to be of a type generally constituting entertainment, amusement, or recreation is only deductible if the taxpayer establishes that such item was directly related to, or, in the case of an item directly preceding or following a substantial business discussion, that such item was associated with, a taxpayer's trade or business.16 Assuming this hurdle is overcome, a taxpayer must also satisfy the following recordkeeping criteria (by adequate records or sufficient corroborative evidence): 1) the amount of each expenditure; 2) the time and place of each expenditure; 3) the specific business purpose for the expense; and 4) occupation or other information relating to the person entertained in order to establish the business relationship.17

The IRS's cynicism and suspicion of entertainment industry deductions is also illustrated by the devotion of an entire chapter in the MSSP entertainment industry guide to personal expense issues.18 For example, expenses incurred to maintain an image or appearance will generally be regarded as inherently personal in nature. Likewise, general makeup or hairstyling for auditions will not be allowed, although stage makeup bought for a live performance or audition may be allowed (if not a general over-the-counter product).19

The IRS can be expected to take an equally tough stance in connection with keeping-current expenses, such as cable TV subscriptions and movie and theater tickets. The taxpayer must demonstrate that these items specifically benefit the employment of a taxpayer in the entertainment industry, since items of general amusement, entertainment, or recreation are ordinarily not deductible.20 Consequently, an actor must identify how a movie or play directly applied to his or her career through appropriate substantiation.21

Other items that the IRS will routinely characterize as personal and nondeductible include deductions for general physical fitness and security (e.g., bodyguards and home security). However, if a...