Asymmetrical Information - Megan McArdle

04.30.13

The Taxman Cometh

Art may be valuable. But it's not deductible unless it turns a profit.

Maria at Crooked Timber wonders why the Minnesota Department of Taxation is hassling artists: 

One of the days, I’ll get around to reading the copy of Sandel’s ‘What Money Can’t Buy; The Moral Limits of Markets’. It’s even made the exquisitely painful cut of being one of only two dozen books brought on our three-month sojourn on the south coast of England. When I do read Sandel, I hope to acquire a greater appreciation for exactly how market thinking has permeated and corrupted so many aspects of human life.

One surprising place a weirdly attenuated and manically zealous form of market thinking has popped up is in the Minnesota tax office. (via BoingBoing) They’re running a quite unhinged vendetta against Lynette Reini-Grandell and Venus DeMars, a married couple who make music, art, poetry and teach English. The taxman running their audit says Reini-Grandell and DeMars’ creative activities don’t make enough money, and haven’t for years, thus proving the artists are mere hobbyists who shouldn’t get a tax break. Either they should turn a consistent profit by now, or have given up already and gone back to being good little consumers.

Fascinated, I clicked through the link she provides, and I think I can tell her: the couple in question are not actually making any money.  

At the second meeting, I really felt as if Venus might still have problems, but my case was totally solid. I’d made a profit as a poet in one of the three years they were auditing, so I didn’t even fit their definition of what might flag concern. I had just had a poem nominated for a Pushcart Prize.

Business expenses are not supposed to be subsidies for doing something we think is important or valuable. (We do have some of those items in the tax code, too, but Schedule C is not where they normally go.)  Business expenses are supposed to be the expenses necessary to generate the profit upon which you pay taxes to the government.  

The tax department will disallow your expenses if the auditor deems that 1) the expenses are unnecessary to making a profit or 2) there is no profit.  It has nothing to do with whether you are a "real" artist or not; from the taxman's perspective, the relevant question is whether your art is a "real" business, i.e. one that generates substantial taxable income in excess of expenses.  It sounds like the couple in question flunk this criteria.

And in fact, this is fair.  Otherwise, there's a tendency for people with small businesses to inflate the expenses of the business to match the income.  Do you really need to go to that conference at a nice spa in Arizona?  Well, no, but hey, it's tax deductible, and you could use a vacation . . . or maybe the spa vacation you were already becomes "research".  

This temptation is particularly big for writers and artists, who can claim that virtually any nice thing you'd like to do is research.  (I once met a novelist who claimed to have legitimately deducted a bed and breakfast excursion with his wife because he had a scene set in a bed and breakfast in the relevant area.)  Also, most writers and artists have day jobs, which enables them to pay expenses that the IRS would never allow (rent, groceries) off of their taxable income, while piling potentially allowable expenses onto their business income, and declaring the most minimal possible profit.  

I am not saying that this is what Lynette and Venus are doing.  I am saying that this is why the tax department frequently audits writers and artists who declare lots of expenses and very little profit.  And once they've started auditing you, they're pretty much going to demand that you prove you have a business which has some hope of making a consistent profit at some point in the future.  It sounds like our Minnesota couple can't do this; they've had exactly one year of profit in six years of working.  Auditors usually give some leeway to new businesses which take a few years to ramp up to profitability, but it doesn't look like these guys are just starting out.

They also really don’t like that I tour. They say I tour way too much and that really, my name is already out there enough, after all this time in the business, there is now no need to do any promotional touring. I have this statement in writing. I attempted to show them, and tell them that this was the industry standard, approved, well-documented, way to build one’s fan base, to expand on it, to inspire interest in one’s work because of the direct contact one has with an audience. They replied that there’s no reason to return to the same cities and venues, and that I’m wrong, that I’m really touring only for pleasure and recreational reasons.

Touring is hard [bleeping] work, and I think they know it. They’re just trying to misrepresent me, so they can dissolve my business and collect back taxes which they can say I deducted wrongly because if they win, they can say I was never running a business. And I’m an easy target. I’m an artist. Artists are easy targets.

I’ve spent a lot on my career, I’ve financed it with credit cards because I was transgender and out in the early days, and way too controversial for others to feel comfortable in investing in me. I invested a great deal, and I still owe a large amount of credit debt. We’re not rich people who pretend to run a vanity business, finance it out of their large savings resources, and claim deductions on everything so they can avoid paying taxes. I’ve sweat blood to keep my art going because people tell me how important it is to them. And because, yes, it’s my calling.

They’re trying to go after the easiest targets, the ones who can’t afford to fight, the ones who have had a hard struggle and which is reflected on their tax returns. So they can build an easy case. So they can win. So they can claim money. So they can maybe then say, "Look at all these artists, these government freeloaders. Why are we supporting these tax abusers?" That’s why they’re making an example of me by this audit.

At root is a conflicting definition over "work".  The artists say that they are working hard at their art, which they undoubtedly are, and that these are the necessary expenses to doing their work.  They view the tax people as disputing whether what they're doing is real work.  

But it sounds to me like the tax people are disputing whether what they're doing is a real business for the purpose of the tax code--which is to say, one that generates tax revenue.  And while some of the things the auditor is saying are a little bizarre--for instance, demanding to know why Venus, the musician, hasn't tried to get a contract with a major record label--reading between the lines, I infer that this is part of an escalating dispute where the auditor points out that his/her "business" has made no money for three years running, and the musician effectively defends by saying that well, being an indie musician isn't actually isn't a very good business model.

This doesn't sound like an unhinged vendetta.  It sounds like this couple has been taking deductions for decades on a business that isn't profitable, and doesn't have any reasonable prospects of becoming.  Once the tax department has discovered this, they can hardly just say, "well, you're clearly very passionate about your art" and drop it.

Of course, you can make an argument that doing art should be tax deductible--that it offers enormous benefits to society, and so forth.  But under current law, it isn't tax deductible unless it's a business, and the tax department can't simply ignore the law because these nice, well meaning people who clearly don't understand the tax code have been breaking it.

Frankly, I'm surprised that their accountant sounds so surprised.  It's pretty standard conventional wisdom among both the writers and the accountants I know that you do not want to declare a business loss more than very occasionally.  Sending in years of returns with virtually no profits is a pretty big red flag, and their accountant should have warned them that this would be the case.  

Especially when their state government, like so many, is under heavy fiscal pressure and looking for revenue under every couch cushion.  The broader lesson from this is that a deep recession is the worst possible time to be pushing the boundaries on your deductions.