The IRS now has a new interest in sports and entertainment and not just as a spectator. At the start of October, Helio Castroneves, a two-time Indianapolis 500 winner and “Dancing With the Stars” champion, was indicted on six counts of tax evasion for allegedly failing to report to the IRS about $5.5 million of endorsement income between 1999 and 2004. Each count carries a maximum prison sentence of five years.
Criminal tax evasion is not the only breach of law commanding attention. Recently, an IRS official publicly confirmed that the IRS is concentrating on general U.S. income reporting and tax compliance of foreign athletes and entertainers who work in the United States.
Tax issues involving cross-border sports and entertainment are not new, nor are they unique. What is new, however, is the agency’s escalating focus and urgency regarding enforcement of U.S. tax law on global sports and entertainment. The IRS is particularly concerned that foreign athletes and entertainers are not paying their fair share of U.S. taxes on sponsorship income.
Why the spotlight on foreign athletes and entertainers? It is probably because athletes and entertainers are some of the most globally mobile individuals who can earn substantial amounts of money in many countries without establishing a fixed base in any country. Given their ability to move quickly through countries while earning high income, it is not surprising that the IRS is concerned over their compliance efforts. The bottom line is that the IRS now believes there is a “problem,” and they are watching.
Indeed, the IRS apparently has certain agents committed to monitoring certain high-profile sporting events. For example, IRS agents actually attend golf and tennis events to watch foreign athletes and their relationships with sponsors, and to document their business to learn if they are in compliance with IRS guidelines.
The agency’s focus on global sports and entertainment was first announced in October 2007 with the launching of a task force to concentrate on reporting and compliance of high-income golf and tennis players, high-income musicians, and their representatives. According to the recent public announcement, however, the scope of the agency’s focus has broadened with ripple effects on other groups, including directors, producers, technicians, managers, coaches, promoters, etc. Indeed, Castroneves’ sister and business manager are also facing charges!
There are several issues which have become the center of IRS scrutiny, including the determination of an athlete’s or entertainer’s residency for tax purposes (which is broader in scope than residency for immigration purposes), characterization of income, business structures established by or for foreign athletes and entertainers, and potential improper use of treaties and income allocations. Castroneves’ alleged tax evasion, in part, involves an abusive use of foreign shell companies to avoid U.S. taxes on his endorsement income from Penske.
Characterization of income is a crucially important issue. Under U.S. tax law, individuals who are neither citizens nor residents of the United States are subject to U.S. income tax on income they earn from performing services in the United States. This includes, among other items, prize money earned by foreign athletes from U.S. tournaments. Prize money is not an issue, however, because tournaments generally withhold the appropriate amount of U.S. tax before transferring the prize money to the athlete. The concern is whether the foreign athlete is properly reporting and paying taxes on his or her endorsement and sponsorship income attributable to the performance of services in the United States.
A significant number of foreign athletes competing in U.S. tournaments earn applicable endorsement income from sources all over the world. Where an athlete (or entertainer) receives a payment for the use of his or her name, likeness or signature, such payment is generally considered to be a “royalty” subject to tax, in principle, in the country of use but frequently exempt from source tax under tax treaties. However, if, pursuant to a contract, an athlete or entertainer is required to perform services in the United State on behalf of a sponsor, payments received on the contract generally are considered to be personal services income subject to tax by the United States. For example, where a contract requires a foreign golfer to appear at the U.S. Women’s Open wearing clothing bearing a sponsor’s logo or using a sponsor’s golf clubs, such athlete has performed a service on behalf of the sponsor in the United States. Further, if a foreign athlete appears in the United States to endorse a sponsor’s new product, the athlete has performed a service in the United States.
On this basis, the IRS believes that a portion of a foreign athlete’s worldwide sponsorship income may be subject to U.S. income tax. The IRS also justifies taxation on the basis that the foreign athlete is able to attract and secure sponsorships, in part, because of his or her performance in U.S. tournaments. This position may sound harsh, but the United States is not the only country taking this position (consider the U.K. tax authority’s taxation of Andre Agassi’s Nike endorsement income in 2006).
For U.S. tax purposes, the IRS has developed a formula for determining the appropriate portion of a foreign athlete’s sponsorship income taxable by the United States. This formula is based on tournaments played in the United States versus tournaments played worldwide, although the IRS appears to be generally open to other reasonable methods.
The IRS is not only reviewing the current reporting and compliance of foreign athletes. The Service also is examining the past records of both active and retired foreign athletes to determine whether they have accurately reported their U.S. taxable income, particularly whether they have properly reported a portion of their worldwide sponsorship income. The IRS is conducting audits and actively examining additional cases for potential audits. As a general rule, a tax return is subject to IRS scrutiny for 3 years (6 years, if there is substantial underreporting, and if there is an indicia of fraud or willful failure to file) from the date of filing--i.e., this means that the statute of limitations on a return never filed never starts to run. So, former foreign athletes could owe many years worth of back taxes, interest on back taxes and penalties (although the IRS rarely goes back more than 6 years).
In certain circumstances where the foreign athlete’s sponsorship income was earned through a foreign entity, the IRS is examining the entity’s structure against applicable internal tax laws and treaties to determine the proper characterization and source of income. In at least one case, the IRS has disregarded the existence of a foreign corporation which had received all of the athlete’s non-prize money income, and treated the foreign athlete as having directly received the non-prize money income. This treatment is consistent with most income tax treaties currently in effect.
Regarding past tax years, in addition to the burden of interest and penalties, another significant issue arises as to the applicability of deductions associated with income earned from sponsors or endorsers. Pursuant to internal law, the IRS can disallow deductions if a foreign person fails to file or amend a “true and accurate” return within the appropriate timeframe. A U.S. return which omits significant amounts income, such as sponsorship income, is not considered to be a “true and accurate” return. It appears to be the IRS’ general position is that if a foreign athlete fails to report or cure in a timely fashion, an allocable share of his or her sponsorship income will be denied the benefits of deductions to reduce the amount of taxable income.
A foreign athlete or entertainer caught in this situation is not without recourse—it may be possible to convince the IRS to grant deductions based on a “reasonable cause” standard (although it frequently is a difficult task to convince the IRS to concede a position they are entitled to take if significant taxes are at stake). Moreover, the foreign athlete or entertainer may have a good basis for claiming “reasonable cause” for abatement of penalties. Finally, and very importantly, a foreign athlete or entertainer may be entitled to foreign tax credits for foreign taxes already paid on the sponsorship income the United States seeks to tax, which would effectively reduce (or wholly eliminate) the foreign athlete’s U.S. tax on such income. However, under internal law, a taxpayer generally is not entitled to foreign tax credits with respect to U.S. source income.
Given the agency’s increased focus on global sports and entertainment, any professional performing in the United States should seek proper tax advice to not only comply with the income reporting and compliance requirements of U.S. law, but further, to be able to more effectively negotiate the terms of their performance. Ignorance is no defense.
A professional who has failed to report all of his or her income to U.S. tax authorities has the ability to approach the IRS in a “voluntary disclosure.” Correcting the “problem” before the IRS initiates an audit may produce a more favorable result. In all cases, it is advisable that athletes and entertainers, and their agents get appropriate legal advice to navigate the increasingly complicated morass of this stepped-up IRS enforcement.