Originally published on Forbes.com. Oct 30th, 2013
The Gallery is a band with roots in New England. Their music by their account consists of:
Hook-laden rock songs that combine a mix of mainstream appeal and professionalism with indie cred and likeability. Their brand of guitar-driven, southern-infused pop rock blurs the lines between authenticity and commerciality, producing songs that are refined and disarmingly catchy. A subtly biting guitar sound, simple, road-worn lyricism and consistently sharp musicianship transform their tracks into instantly memorable pop gems you don’t want out of your head.
They seem to be doing OK with three albums and bookings going into next February.
That was not enough to help their backers, Dr. Patrick and Shirley Schlievert, prevail in their recent Tax Court appearance. The case was about Section 183 (Hobby Loss).
So You Want To Be A Record Producer
Doctor Schlievert is a professor of microbiology at the University of Iowa and Mrs. Schlievert is a homemaker. Doctor Schlievert founded two biotechnology companies. Backing an indie rock band seems like a natural diversification move to me, but the IRS and the Tax Court see it differently.
It was the Schlieverts’ daughter, Sara, who influenced them to get into the music business. Sara Schlievert majored in Music Industry at the University of Southern California. While an intern at Atlantic Records she discovered The Gallery. Atlantic Records did not sign The Gallery. I’m guessing that being discovered by an intern might be less than optimal for a band looking for a record deal. Sara became the band’s manager in 2009 (still is according to the website ). She convinced her parents to produce the band’s album.
The decision does not say which album, but from the date, it would appear to be Come Alive. It includes a cut titled appropriately for litigation – “Who’s In The Right
Not Worth The Paper It’s Written On
Rather than invest directly in the band, the taxpayers decided to start their own record label. They called it Shlievert’s Ultimate Record Facility (SURF) (Dr. Schlievert likes to surf.)
Petitioners entered into an oral agreement (agreement) with the band to fund the band’s expenses. The agreement provided that petitioners would be repaid for all expenses from any money the band received from a future record label advance or 50% of the money from record sales. Petitioners would also receive 10% of the amount over $200,000 that the band earned. The agreement also required that Sara continue to serve as the band’s manager for a 15% fee.
Here, of course, I must pay homage to Samuel Goldwyn who is supposed to have said “A verbal contract isn’t worth the paper it’s written on.” Actually, my years of business experience do not totally support that viewpoint. I had a client who was rather upset about the small book that passed for an engagement letter from the national firm that employed me. I explained to my Tax Practice Leader that there was no question in my mind that the correct business decision would be to say “You are right Mr. _____, we’ve done business with you long enough that we don’t need an engagement letter.” (The relationship went back decades beginning with a large local firm that merged into a regional and was acquired by the national.) Of course saying things like that was not the right political move in that context, which, in part, accounts for my less than stellar national career.
That’s business, though, not an IRS audit or Tax Court. If you are going to be writing off losses, have solid looking contracts. Assuming the band was trustworthy enough to merit a handshake deal, I would have left the part about continuing Sara as the manager as an informal understanding.
Form An Entity And Open A Checking Account – Or Not
The way SURF executed was less than ideal
… Sara paid all of the band’s expenses through her personal checking account or her personal credit card. Petitioners would then reimburse Sara. Petitioners provided a list of itemized expenses but provided no evidence of Sara’s giving petitioners receipts or invoices of the band’s expenses. Such commingling of funds indicates that an activity is more closely related to a hobby than a business.
Petitioners represent only one band and have made no effort to develop or find other talent. Petitioners have no Internet presence for their music activity, no active presence in the recording or producing industry and have not sought methods to increase their exposure to the industry. Unlike others in the music industry, petitioners do not represent any other bands, nor do they have any employees. Due to the risky nature of the music industry, it is imprudent to work with only one band.
Petitioners never advertised as a record label. Petitioners’ activity is not even recognized as a record label on the only album they purportedly produced. Save for petitioners’ being “thanked” on the CD jacket along with 32 other people, nowhere on the band’s record is the label SURF or anything indicating petitioners’ professional relationship with the band. Rather, the copyright on the CD belongs to the band, and the production credits go to Warren Huart.
There is more, but that was probably enough to sink them.
Was There A Better Way?
I think trying to get a current deduction for backing their daughter’s music management career was probably a bridge too far. I would have gone for a more conservative approach that would have likely stood up and assured an ultimate ordinary deduction. Have the band, itself, organize as an LLC with Sara as one of the managing members. Give the Schlieverts a preferred interest with losses allocated based on positive capital accounts. There would be no Section 183 issue then. The passive activity rules would defer any deductions, but that is a lot better than having them entirely blown away.
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