By Marc Jacobson, Esq. and Jerome M. Hesch, Esq.
Marc Jacobson, Esq. of New York, New York is an entertainment lawyer practicing in the music, film and television industries. He is the Founding Chairman of the New York State Bar Association Section on Entertainment Arts and Sports Law, and is consistently listed in Chambers USA, Best Lawyers in America and Super Lawyers as a leading entertainment lawyer.
Jerome M. Hesch, Esq. of Miami, Florida serves as an income tax and estate planning consultant for lawyers and other tax planning professionals throughout the country. He is the Director of the Notre Dame Tax and Estate Planning Institute, is on the Tax Management Advisory Board, and a Fellow of both the American College of Trusts and Estates Council and the American College of Tax Council. He was elected to the NAEPC Estate Planning Hall of Fame. In the past, recording artists frequently entered into agreements with record labels through a loan out corporation, which two recent cases confirm had the effect of eliminating their ability to exercise the statutory termination right, as codified in the 1976 Copyright Act. This blog will address how a loan out corporation in a recording agreement can be used to allow the artist to maintain his/her/their rights (if any) to terminate copyrights granted to the record label, while simultaneously preserving the ability to use the loan out corporation to reduce the artist's income tax liability while avoiding certain income tax traps. Two recent court decisions in the Southern District of New York held that if an artist's loan out corporation ("Grantor") transfers a copyright to the record label, the artist does not have the right to terminate the grant of copyright to the record label, even in the face of the artist's simultaneous execution of inducement letters and covenants to execute assignments of copyright to the record label upon the record label's request. The court decisions may be used to guide artists in using a loan out corporation to achieve significant income tax benefits and to preserve their termination rights. What is Copyright Termination?
In recognition of the unequal bargaining power present when a new artist signs an agreement with a record label or other third party, the 1976 Copyright Act enacted provisions that permit an author (or the author's heirs) to terminate a prior grant of a copyright after a stated period of years. (17 USC §§ 203 and 304.) The termination will only be effective in the United States. The party exercising those rights must follow rigorous requirements to ensure that the termination is effective. As the termination does not happen automatically, the author or his/her/their heirs must take action to exercise those rights. Upon achieving an effective termination, the author or the author's heirs become the owners of the U.S. rights to the terminated works. Upon the effective date of termination, the author or author's heirs can enter into a new agreement with respect to those rights with any third party, including the original record label.
What is a Loan Out Corporation?
A loan out corporation is typically a corporation owned by an athlete, musician, entertainer, or another person in a similar business ("Artist") The loan out corporation enters into an employment agreement with the Artist. The loan out corporation then leases the Artist's services to others, such as a record label. Generally, the Artist is the sole shareholder of the loan out corporation. The loan out corporation enters into various agreements with third-party companies that want to engage the Artist. The Artist frequently signs an inducement letter, inducing the third party to enter into the agreement. In the inducement letter, the Artist agrees to provide services to the third party on behalf of the loan out corporation. Without the inducement letter, it is conceivable that the loan out corporation could engage another person to fulfill the obligations undertaken by the loan out corporation, and not the Artist, which would frustrate the purpose of the agreement.
A loan out corporation can accomplish several important objectives. One is to limit personal liability for the Artist. (But see NY Bus & Corp Law §630(a), which makes the top 10 shareholders of a private New York or foreign corporation qualified to do business in New York personally liable for unpaid wages to employees of the corporation.) It is worth noting that the corporation will not necessarily shield the Artist from liability for contributory or vicarious copyright infringement, because the Artist will often have the authority and ability to control the actions of the loan out corporation. The loan out corporation also provides certain financial benefits. Generally, a service provider such as an Artist, must report compensation in the year the compensation is paid, even if the right to collect the compensation is received by another. As an employee of the loan out corporation, a large portion of the compensation may not be immediately taxed if it is transferred to the Artist's retirement plan, thereby postponing the payment of income tax to that time when the person retires and withdraws funds from the pension plan. (An employee can postpone reporting the compensation income received by a retirement plan to age 72 and thereafter.) Another income tax advantage was created under the Tax Cuts and Jobs Act of 2017, where commissions paid by artists to agents, or managers, or legal fees paid in connection with securing employment are not tax-deductible. However, these expenses are tax-deductible if paid by a corporation.
What is the Assignment of Income Doctrine?
The ability to use a retirement plan to receive the Artist's compensation can avoid immediate income taxation under the Assignment of Income Doctrine. In Commissioner v. Banks, 543 US 426 (2005), the U.S. Supreme Court described the assignment of income doctrine this way: "The Internal Revenue Code defines "gross income" for federal tax purposes as "all income from whatever source derived." The definition extends broadly to all economic gains not otherwise exempted. A taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party. The rationale for the so-called anticipatory assignment of income doctrine is the principle that gains should be taxed "to those who earn them," a maxim we have called "the first principle of income taxation," the anticipatory assignment doctrine is meant to prevent taxpayers from avoiding taxation through "arrangements and contracts however skillfully devised to prevent [income] when paid from vesting even for a second in the man who earned it." (Citations omitted).
The Southern District of New York Class Action Cases.
Last year, two putative class actions were filed by the same law firms, representing different plaintiffs, against Sony and Universal Music Group, comprising two of the three major record labels, (No similar claim was filed by these lawyers against Warner Music Group ("WMG") the third major record company.), (i) seeking a declaratory judgement that copyright termination notices served by the recording artists were effective (the record label's position was that such notices were not effective) and (ii) asserting that the record labels committed copyright infringement by continuing to exploit the works after the effective date of these termination notices. (Waite, et al v. UMG Recordings, et. al., Case number 1:19-cv-01091 (USDC SDNY Judge Kaplan) ("Waite") and Johansen, et. al. v. Sony Music Entertainment, Inc. et. al., Case number 1:19-cv-01094 (USDC SDNY Judge Ramos).) The defendants moved to dismiss in both cases. Sony's motion to dismiss the complaint against it was denied in its entirety. (Johansen v. Sony, Docket No. 61, Order, dated March 31, 2020.) UMG's motion to dismiss was granted, with respect to the plaintiffs' claims based on grants transferred by third parties (and in two other respects not relevant to this blog and denied in other respects.) (Waite v. UMG, Docket No. 68, Order with Memorandum Opinion dated March 31, 2020 ("Waite I").) A later decision in the same case denied the plaintiffs' motion to file a Second Amended Complaint, which sought to remedy the failures of the first complaint to properly allege that artists who relied on a loan out corporation to enter into the agreement with UMG still had the right to terminate the purported grant of copyright to the record label. (Waite v. UMG, Docket No. 89, Order with Memorandum Opinion dated August 10, 2020 ("Waite II").)
Who is the Grantor?
A threshold inquiry in any analysis of termination rights is who assigned the copyrights (i.e., who is the grantor of the copyright). The grantor may be an individual, several individuals as co-authors of a work, a partnership, a corporation, an LLC or a trust. In the first Waite court decision ("Waite I"), John Waite, a named plaintiff and the relevant recording artist, assigned his copyright to a loan out corporation. In turn the loan out corporation, as Grantor, assigned its copyright to UMG. In return, UMG agreed to pay the loan out corporation an advance and agreed to pay future royalties to the loan out corporation, earned from UMG's exploitation of the copyrights it acquired. In the complaint in Waite I, the plaintiff asserted that the loan out corporation was his alter ego and should be disregarded. The Waite I court refused to disregard the loan out corporation and respected the loan out corporation as the grantor of the copyrights. As the complaint in Waite I stated that Waite was the Grantor, and because only the Grantor can assert termination rights, the court in Waite I had to respect the form. Therefore, the complaint was dismissed.
In its papers, the plaintiffs asserted that "the loan out company was only a tax-planning device." The court held, however, "Even so, people cannot use a corporate structure for some purposes - e.g. taking advantage of tax benefits - and then disavow it for others. While Waite and his loan out companies...perhaps are distinct entities only in a formal legal sense, the statutory text is clear: termination rights exist only if the author executed the grant." (Waite I, Section V.)
The plaintiffs later moved to file a Proposed Second Amended Complaint, and the court in Waite II maintained its position that if the contracting party was a loan out corporation, then termination rights did not belong to individual artist plaintiffs, such as Waite. (Waite II, Section IV.) This Proposed Second Amended Complaint also made allegations that plaintiff Waite signed inducement letters in favor of the record label, and also alleged that the plaintiffs agreed to execute any assignments of copyright requested by the record label. The Waite II court held that "the agreements at issue were between the recording company and the third party. And therefore, it was the third party, not the artist that granted the transfer of copyright."
The inducement letters and agreements to execute an assignment, all common in recording agreements, did not save the plaintiff's assertion that the individual artist still could terminate these grants. The court denied the motion to permit filing a Second Amended Complaint with regard to terminations by artists who used loan out companies to contract with the record label on the artist's behalf. (Id.) These cases provide guidance on how to structure a recording agreement to achieve the Artist's objectives. However, this blog will not address the merits of these cases or prognosticate as to whether the claims will ultimately be successful. Since this is the second decision in the case in which the court held that the grantor was not the individual artist, but was the loan out corporation, the artist's lawyers should consider how to preserve the tax planning benefits of using a loan out corporation, while also preserving the right to terminate the grant of copyrights. However, the question of whether the termination right exists is also beyond the scope of this blog. (Many record companies provide in their agreements with artists that the recordings created are "works made for hire" for the record company. The gravamen of these cases is to challenge that position.) For purposes of this blog, we assume that the right does exist. The Problem.
Waite I and Waite II make clear that if the loan out corporation is the party to the agreement with the record label, the Artist who owns the loan out corporation loses his/her/their right to terminate any grant of copyrights to the record label. Therefore, in order to preserve termination rights, the Artist must be in direct privity with the record label. Yet without the loan out corporation, (i) the individual cannot deduct currently any agent and manager's commissions, or legal fees in connection with the Artist's work in the industry and (ii) the individual loses the ability to create and fund defined benefit or defined contribution retirement plans, which significantly enhance the income tax benefits available to the Artist upon retirement. Simply keeping the loan out corporation on the sidelines and assigning income to the loan out corporation will not work under the Assignment of Income Doctrine.
The Solution.
Prior to executing the agreement with the record label, the Artist should form a corporation, establish himself/herself/themselves as the sole shareholder (and director) and enter into an employment agreement with the corporation by which the Artist agrees to provide services to the corporation. The Corporation should timely elect Sub-Chapter S status. (Internal Revenue Code §1363 (a) "...an S corporation shall not be subject to the taxes imposed by this chapter.") If the election is filed within 75 days of the formation of the corporation, then the corporation is not subject to Federal income tax for so long as the corporation complies with the statutory requirements. New York State also recognizes Subchapter S corporations, and does not tax their net incomes, either, provided that election for New York State is also made timely. (NY Tax Law §208 1-A, and NY Tax Law §1450(f). Note, however, that while New York State recognizes a single level of taxation for Federal S. corporations, New York City does not recognize that single level of taxation, thus creating "double income tax" for New York City based S. Corporations.)
Separately, the Artist should enter into the agreement with the record label directly. Thus, to the extent that any termination rights exist, the Artist will have such rights and will be in direct privity with the record label.
With the record label's permission, the Artist should assign all of his/her/their rights to receive income to his/her/their loan out corporation. As an accommodation to the Artist, labels frequently accept letters of direction, which instruct the label to pay third parties to which the Artist may have an obligation. This proposed assignment typically does not generate an objection from the record label. The loan out corporation will pay the Artist a salary, engage agents, lawyers, and managers on the artist's behalf, and can defer the taxation of current income by funding a pension or retirement plan in addition to those plans that might be available from any applicable guilds to which the Artist may belong. The Potential Hiccup.
What about the Assignment of Income doctrine? Since the Subchapter S corporation is a pass-through entity for Federal income tax purposes, and in our example is wholly owned by the Artist, any net income in the corporation is not taxed at the corporation level but is reported by the Artist and he/she/they pays tax on that income. That has the same effect of having the Artist receive the income directly. This solves the assignment of income problem, permits all termination rights to be preserved and all tax benefits to be realized.
Here is a simple example: Artist forms a loan out corporation that elects to be an S corporation for Federal and NY State income tax purposes. Artist owns all the shares in the loan out corporation and is its sole employee. The loan out corporation leases its employee to the unrelated record label. During the first year, the record label pays the loan out corporation $135,000, which the loan out corporation reports as revenues. The corporation pays $10,000 of operating expenses, e.g., commissions, legal fees and makes a $25,000 pension contribution to the Artist's qualified retirement plan. With $35,000 of business expenses, the corporation's net income before deducting the Artist's $100,000 salary is $100,000. The S corporation's taxable income is therefore zero. As an employee, Artist reports all $100,000 of compensation income.
Here is another example: Let us assume that the loan out corporation does not elect Subchapter S status and remains as a C corporation. In the assignment of income court decisions, the service provider received a salary far less than the income the C Corporation generated from leasing its employee to third parties. The IRS attacked these arrangements because the corporate income tax rates were far less than the individual income tax rates, and it alleged that this was an assignment of income from a high tax bracket taxpayer to a lower income tax bracket taxpayer. If the Artist pays the same operating expenses as in the prior example, and makes the same contribution to the pension plan, and receives a salary for all of the C corporation's income after deduction of pension contributions and operating expenses, there is no net income in the corporation (on which income tax would be due), and therefore, no assignment of income to a taxpayer in a lower income tax bracket. (See, Johnson v. Comm'r. 78 T.C. 882 (1982) (IRS Win) and Laughton v. Comm'r., 40 B.T.A. 101 (1939) (taxpayer win).)