Taxation Of World Cup Players

 

I was reading a U.S. Representative criticizing the taxation of FIFA winnings:

We want to encourage these people to come over here and spend their money, and then we take a big chunk of it.”

I get it, but I would like to hear more about taking a big chunk of residents’ money before overly concerning ourselves with nonresidents.

Let’s take a (very) general walkthrough of the taxation of FIFA players.

Resident versus Nonresident

A resident of the U.S. is taxed on worldwide income. It doesn’t matter whether you work in the U.S.; in fact, it doesn’t matter if you live in the U.S. If you are a resident, you are subject to U.S. tax.

The easiest way to be a resident is to be born here - a citizen. There are special rules for U.S. births who did not grow up here, but we will leave that issue alone.

The next way is to obtain a green card, which requires one to go through the immigration system.

A third way is to spend too much time here – which the tax Code terms “substantial presence.” There is math involved, as follows:

·      Present in the US for at least 31 days during the calendar year, AND

·      Present in the US for at least 183 days during the current and preceding two years. Days in the preceding year count at a 1/3 rate; days in the second preceding year count at a 1/6 rate.

Have a German company send an employee to a U.S. office for two or three years and he/she will likely meet the substantial presence test. He or she is not a U.S. citizen but is a U.S. resident under the substantial presence test.

It is unlikely that a FIFA player is going to trip the substantial presence test.

Meaning the FIFA player is a nonresident.

And his/her income taxation changes. The player is now concerned only with U.S.-source income.

One can get mystical when talking about U.S. source.

Does a Swede receiving interest from loaning money to a U.S. business have U.S.-source income?

Does a Brazilian receiving dividends from a multinational corporation have U.S.-source income?

We leave the mystical and return to the concrete when discussing services: if you perform services here – say a player in the World Cup - you will have U.S.-source income.

Divide U.S.-Source Income into Categories

There are two main categories of U.S.-source income, and they are critical in understanding nonresident taxation.

Effectively Connected Income

There should be a trade or business as a first step if we want ECI. It can be humble – a restaurant, dry cleaner or liquor store – but there has to be enough regular and continuous activity to rise to the level of a trade or business. That trade or business activity in turn must take place within the U.S. Meet both criteria and you have ECI.

BTW compensation for the performance of services within the U.S. - like playing soccer - is normally considered ECI.

Fixed, Determinable, Annual, or Periodical (FDAP) Income

The easy definition is any income that is not ECI.

Examples would include interest, dividends and royalties.

Think of FDAP as investment income – not trade or business income – and you get the idea. In days past it would have been a check that arrived in your mailbox.

Allocating Compensation to the U.S.

Only compensation earned while in the U.S. will be subject to U.S. taxation. Sounds fair, but translating that concept to actual numbers can be tricky.

Here is one suggestion: divide the numbers of days in the U.S. by 365 days.

Problem: athletes have seasons. They are not office workers with 9 to 5s and two weeks annual vacation. Using 365 as a denominator does not seem to fit our FIFA discussion.

How about using the number of games as the denominator?

Better, but what about team meetings, practices, press conferences, mandatory league events? Should we include those days in the denominator?

Seems right.

How about bonuses?

There is a can of worms.

This concept BTW is sometimes referred to as “duty days.”

The point is to come up with a ratio, with U.S. duty days as the numerator and total duty days as the denominator.

Allocating Noncompensation to the U.S.

We are talking name/image/likeness, endorsements and things related. Chances are these payments are referred to as royalties.

How are we supposed to reasonably allocate this to the U.S.? Lionel Messi and Cristino Ronaldo are already famous and earning their NILs and endorsements without entering the U.S. I could argue that a reasonable allocation to the U.S. would be zero (-0-).

If there was a product endorsement, a reasonable allocation might include dividing the amount of product sold in the U.S. by total product sold worldwide.

I am not as sure what to do with indirect endorsements, such as wearing Nike products on a regular basis.

Yep, room here for disagreement.

Tax Deductions

There is a significant difference between the taxation of ECI and FDAP income:

You are allowed to deduct expenses against ECI.

You are not allowed to deduct expenses against FDAP.

And you can immediately see the tax planning: move income between ECI and FDAP as necessary and as possible.

Withholding

You may have read that the IRS was taking 30% off the top of FIFA winnings.

True but misleading.

The 30% was withholding.

The player still has to file a nonresident tax return.

Granted, the default rate for FDAP income is 30%, so that income bucket might be a push.

But ECI allows for deductions and graduated tax rates.

Depending upon the amount of deductions and his/her run through the tax rates, that 30% withholding might be excessive. The player might be entitled to a refund.

I doubt that FIFA players would have much in the way of deductions, however, as I expect the club to absorb team and travel expenses.

Filing the Tax Return

Nonresident aliens have their own tax form:

If the athlete received a W-2, it would go on line 1a.

If the athlete was self-employed, the net business income would go first on Schedule 1 and then on line 8.

Line 9 is the sum of all income in the ECI bucket.

NOTE: Nonresident aliens are normally not subject to self-employment tax.

What about FDAP income?

It has its own schedule.

Tax Treaties

Treaties can override what we just discussed above.

Let’s look at an example.

Sergio Garcia was a professional golfer and party to a famous tax case involving services, FDAP and a treaty. It goes without saying that the IRS and Garcia did not agree on how to allocate U.S.-source income. The Tax Court finally decided that the NIL/endorsement/whatever-you-want-to-call-it was not so intertwined with his performance of services as to require it to be allocated the same as compensation for services. The Court said that 35% were for services and 65% were royalties.

So what, you ask.

Garcia was a resident of Switzerland.

Switzerland has a tax treaty with the U.S.

Which includes the following language:

Royalties derived and beneficially owned by a resident of a Contracting State shall be taxable only in that State.”

“Contracting State” is a common term in tax treaties.

Garcia was a resident of Switzerland which in turn was a Contracting State meaning that royalties received by Garcia were taxable only to Switzerland.

That 65% representing royalties was not taxable by the U.S.

You see the power of a treaty.

Central Withholding Agreement

This is a way to negotiate with the IRS to lower the 30% withholding rate for personal services (such as a nonresident athlete or performing artist).

The IRS has a specialized unit for this work, and - not surprisingly - there are fairly strict timelines for request and approval.

State and Local Income Taxes

We are talking about the jock tax.

Most states use some version of “duty days” that we discussed above. California famously counts every practice held at an opponent’s facilities during a game week. The point, of course, is to increase the numerator (that is, the duty days allocated to California).

Certain cities will also pile on, for example:

New York City                 3.8% tax rate

Philadelphia                     3.4% tax rate

Cleveland                         2.5% tax rate

Mind you, this is on top of the state tax.

And tax treaties do not apply to state and local taxes.

Spain

What is Spain’s equivalent to the U.S. tax regime?

Well, the automatic withholding is less: 24% (reduced further to 19% for a resident of another EU country).

The top tax rate will hurt, though. The maximum national rate tops out at 47%, with certain regional authorities increasing it to 54%.

The maximum U.S. tax rate by contrast is 37 percent.

The Sale of "American Pie"

Did you see where Don McLean sold his original manuscript for “American Pie” at Christie’s? He sold the work for $1.2 million, and it included his handwritten notes and deletions from the 1971-72 hit that – at 8 ½ minutes – was the longest song to ever top the U.S. charts.

The song of course is famous for its allusions. The “day the music died” refers to the death of Buddy Holly, whereas “the king” supposedly refers to Elvis Presley while “the jester on the sidelines” refers to Bob Dylan after his motorcycle accident. It became an anthem to disillusionment, to the sense of our best days being behind us and the ennui and hopelessness of a society being carted off in the wrong direction.

Sounds eerily contemporary.

He explained that he had forgotten he had the manuscript. He found it in the proverbial old box that had survived several moves. The sale allowed him to provide for his family, now and into the future.

Yes, $1.2 million will do that.

So what are the tax consequences from the sale of his manuscript?

We are talking about intellectual property and a subset we will call creative properties.

For the most part, self-created properties cannot be a capital asset in the hands of its creator. This causes a problem, as one requires a capital asset if one wants capital gains.

Take it a step further. If someone else owns the asset but its tax basis (that is, its cost for purposes of calculating gain or loss) is determined by reference to the creator’s basis, then it cannot be a capital asset.  How can this happen? Easy. You could gift the property, for example, or you could contribute the property to a family limited partnership. In either case the recipient will “take over” your basis in the creative property. Since the basis remains the same, it cannot be a capital asset.

The vocabulary gets tricky when discussing creative property. For example, an author (say Stephen King) may receive a “royalty.” Coincidently, find oil in your backyard and chances are an oil company will also pay you a royalty. Since the word “royalty” is the same, are the tax consequences the same?

The answer is no. If you write a book or score a movie soundtrack, that royalty is probably ordinary income to you. In fact, it is reported on Schedule C of your individual tax return, the same as your self-employment income from Uber. The oil royalty, on the other hand, is reported on Schedule E, along with rents. The Schedule C royalty will trigger self-employment tax. The Schedule E will not. 

OBSERVATION: We have discussed before that sometimes a word will have different meanings as it travels through the tax Code. Here is an example.

As always, there are exceptions. Let’s say you write one book and never write again. The IRS will likely consider that to be ordinary income but not self-employment income. Why? Supposedly it takes two or more books to establish that you are in the trade or business of writing books.

OBSERVATION: I am curious how the IRS would apply this standard to Harper Lee. She published, you will recall, To Kill a Mockingbird in 1960. It was only this year that she published her second work (Go Set a Watchman) – 55 years later. What do you think: is this self-employment income or not?

Remember when Michael Jackson bought the catalog of Beatles music? He bought it as a non-alternative investment, akin to stocks and bonds. Like a stock or bond, Michael Jackson would have had capital gains had he sold the catalog.

This created a fuss among songwriters. If they sold their own compositions, they would have ordinary and self-employment income. Introduce Michael Jackson and the tax result transmuted to capital gains.

So Congress passed Section 1221(b)(3), which incorporated a provision from the Songwriter’s Capital Gains Equity Act, promoted by the Nashville Songwriters Association International (NASI). It extended capital gains to self-created music owned for more than one year. It requires an election, and the songwriter/creative can elect for one musical composition and not for another. It does require the transfer of a musical composition or a copyright in the same; transfer something less and the result defaults to ordinary income.

NASI argued that the industry had changed. By the 1990s many music artists were acting as their own publishers or co-publishers, meaning they had some control over the exploitation of their songs. Gone were the days of Hank Williams and Bill Monroe, when songwriters sold their songs outright to music publishers with no right to ongoing income.

Congress listened.

Don McLean now has a tax option that he did not have years ago when he recorded “American Pie.” I suppose that there could be a scenario where it would be more advantageous to recognize the $1.2 million as ordinary income rather than as capital gains, but I cannot easily think of any that do not require low-probability tax considerations.

I would say he is making the election.

Reviewing Two ObamaCare Taxes Springing Up in 2013

We are beginning over here to re-review the tax aspects of ObamaCare after the Supreme Court’s decision last week. There are several tax changes, but today we will revisit the new investment income tax and the new earned income tax. These will happen in 2013, so let’s go over them.

Investment Income

If you are single, you will owe a new investment tax if your adjusted gross income (AGI) is over $200,000. If you are married, you will owe the new tax if your AGI is over $250,000. (I know, twice $200,000 is considerably more than $250,000. I did not write the law). If this is you, will owe a brand-new 3.8% tax on your investment income.

Let’s be clear: it is not necessarily ALL your investment income. Rather it will be on investment income over $200,000 or $250,000, as the case may be. If you are married and retired and your entire adjusted gross income of $250,000 is interest and dividends, you will owe no NEW tax. You will owe plenty of OLD tax, though.

What is investment income? Let’s go with the easy examples: dividends, interest, capital gains (short-term and long-term), royalties and annuities outside retirement plans

NOTE:  Net investment income is also defined to include income from a passive activity. This concerns me, as the rental of a duplex is a passive activity, as is passthrough income to a “passive” member in an LLC. Under Section 469, these activities were considered “trades or businesses,” although the activity could be further tagged as “passive” or “nonpassive.” They were not however tagged as “investment.” This new tax appears to use the language differently from Section 469 and equates “passive” with “investment.” The IRS unfortunately has yet to issue formal guidance in this area.

How can this tax surprise you? Here are a few ways:

(1)   You sell your business.

(2)   You get married.

(3)   You sell your principal residence, and the gain exceeds the $250,000/$500,000 exclusion.

(4)   You inherit and sell stock from a parent’s estate.

Earned Income

If you are single, you will pay an extra 0.9% Medicare tax on your earned income over $200,000. If married, that threshold changes to $250,000.

What is earned income? The easiest way is to ask whether you paid or will pay social security or self-employment tax on the income. If the answer is “yes”, you have earned income. Note that this definition excludes your pension, 401(k) and IRA distributions.

Let’s go over a few examples.

EXAMPLE 1: A married couple filing jointly has $360,000 of adjusted gross income—$240,000 of wages plus $120,000 of interest, dividends and capital gains. They have $110,000 of investment income` over the $250,000 threshold. They will owe an extra 3.8% of that $110,000, or $4,180, in tax.

EXAMPLE 2: In the following year, the same couple has $400,000 of income, the difference being a $40,000 bonus. All their investment income is now above the threshold amount. Their new investment income tax will be $4,560. In addition, since their earned income is now above $250,000 they will owe the new earned income tax of $270 ((280,000- 250,000) times 0.9%).

EXAMPLE 3:  After many years, you move from Purchase, New York. You sell your house for $920,000 and are single.  Your exclusion amount on the sale is $250,000 so the taxable gain is 670,000. Assuming that you earned income is over $200,000, the new investment income tax will be $25,460 ((920,000 – 250,000) times 3.8%).

We will discuss other tax changes in a future blog. Some are delayed (such as the employer penalty) and others are already in place but are somewhat esoteric (the prescription drug fee).