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August 23, 2012
Life in the Fast Lane: Tax Controversies of the Suddenly Wealthy and Globally Famous

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by William Hoffman

It seems hardly a month goes by without some movie star or musician getting entangled in a tax controversy, which prompts the question: How do multimillionaire global celebrities, their every whim catered to by acolytes and hirelings, get in trouble with the IRS over things the average wage earner avoids by income withholding and annual visits to her storefront tax return preparer?

"I've asked why this happens so many times I really don't ask anymore, because I don't get a good answer," said Jeffrey Davine, who in the early 1990s was a former special assistant U.S. attorney for the IRS, assigned for two years to the market segment specialization program in charge of athletes and entertainers. "I was surprised at the number of famous people who got themselves into tax trouble."

On August 12 the entertainment website TMZ reported that wall-clock-wearing rapper Flavor Flav had been hit with nearly $1 million in tax liens. In July R&B singer Rihanna sued her ex-accountants for failing to warn her about mounting tour losses and an ongoing audit by the IRS. And in June, hip-hop artist Lauryn Hill pleaded guilty to failing to file three years' of tax returns on more than $1.8 million of income. The celebrity tax hit parade includes Hollywood action figure Nicolas Cage, reality show Survivor winner Richard Hatch, and U.S.-born self-declared "nonresident alien" actor Wesley Snipes, who is serving three years in federal prison for failing to file federal tax returns.

If it is true (as Hemingway is said to have responded to Fitzgerald) that the rich are different from the rest because they have a lot more money, then perhaps some celebrities are unprepared for their sudden elevation into the economic stratosphere. More so than most wealthy, observers said, celebrities tend to come from working-class backgrounds and have little or no experience with money or taxes.

"A lot of celebrities acquire their wealth really quickly, some of them are very young, and then all of a sudden they realize that they are really rich," said Steve Henley, senior managing director and national tax practice leader at CBIZ Inc., a professional business services and consulting firm in Atlanta.

No celebrities volunteered to talk about their tax challenges for this article. But tax professionals familiar with famous entertainers' peculiar tax travails explained why otherwise smart-seeming, successful people fall prey to tax schemes, shoddy advice, and shady counselors; which traps most often befall them; and what tricks and tips they use -- and shouldn't use -- in dealing with the tax man.


Living in the Material World

Bill Hammer Jr., co-founder and president of Melville, N.Y.-based Hammer Wealth Group and author of The 7 Secrets of Extraordinary Investors, said there are some simple reasons why worldwide celebrities get in trouble over seemingly mundane tax issues.

They trust the wrong people. "My grandmother, I'd trust her with my life, but I wouldn't trust her with my savings," Hammer said. Stories are a dime a dozen about celebrities who relied on family or childhood friends to manage their business and money and got burned. "If nobody else is willing to pay that person to manage their money, what makes you think that they should manage your fortune?" Hammer asked.

They think they are above the law. "Celebrities are used to being surrounded by 'yes' people who agree to their every request," Hammer said. "Unfortunately, Uncle Sam is not a yes man."

They earn money in a 'lumpy' way. Most celebrities earn most of their money in the first five years of their careers, Hammer said; many earn a lot in a short time and then don't earn again for a while. "Income tax is more complicated for people who earn money in a 'lumpy' way," he said. For one thing, he noted, "when you get a lump sum you're more inclined, human nature being what it is, to do something silly" like not withholding for your taxes.

No withholding. "You make a lot of money, you spend 7 or 8 million for the huge house and lifestyle, and now you have to pay your taxes," Hammer said. "People live the lifestyle they can afford and don't think about when it will end. It's almost like your own personal Ponzi scheme."

Or perhaps it's simpler than that. "There's always some excuse," said Davine, now at Mitchell Silberberg & Knupp LLP in Los Angeles. Some celebrities "are spoiled, they're pampered, and perhaps they don't have the discipline of [managing their taxes]," he said. "They're accustomed to spending whatever money they make, if not more than what they make."

The new wealth, the yes men, the lump-sum earnings -- "it's a perfect storm for bad decisions," Hammer said.


Money Changes Everything

With the money rolling in, celebrities' tax challenges bear a lot of similarities to those of other high-income earners, the tax professionals said. But celebrities' particular style of work, along with the many tax jurisdictions in which they earn and live, require some special consideration.

For example, Henley observed, a star athlete working for a New York sports franchise may decide he doesn't want to live in the high-tax Empire State. To enjoy the tax benefits of living in, say, Nevada, it's not simply a matter of moving there. The wise tax adviser will tell his client to buy a home in the Sagebrush State, register his car(s) and register to vote there, get a Nevada drivers license, and spend a substantial portion of time there -- all to establish legal residency for tax purposes.

But the principle works on both ends, Henley said. The celebrity could maintain a residence in New York State, but tax authorities in Nevada will likely want to see that the individual has also withdrawn from full-time residency in New York.

Further, Henley said, the states where an athlete works will impute income based on how many games he played in the state or how long he worked there. States where a lot of celebrities work -- New York and California in particular -- are aggressive about such accountings, he said, because so much tax money is at stake.

Some celebrities think they can avoid U.S. taxes simply by depositing money in a foreign bank account -- "It never ceases to amaze me what they come up with," said Henley -- because they've seen a peer do it and not immediately end up in prison. Some simply neglect (or perhaps more precisely, their inexperienced tax advisers neglect) to declare those accounts, both with U.S. and relevant foreign tax authorities. "Unless you're an attorney or a CPA, most people don't realize there are stringent rules about foreign bank account reporting," Henley said.

Some celebrities also buy the accoutrements of great wealth, such as yachts and aircraft, without fully considering the tax consequences. Depending on whether and how they are used for personal or business purposes -- a balance that can be particularly complex for celebrities who frequently mix the two -- the item may or may not be a deductible expense.


Grab That Cash With Both Hands and Make a Stash

At some point in a successful entertainer's career, income becomes wealth. That brings with it a whole new set of tax and estate planning and asset protection issues -- some of which could be changing before our eyes.

K. Eli Akhavan of Moses & Singer LLP in New York said film producers, investors, and stars may transfer their interest in movies to grantor retained annuity trusts. GRATs allow chancy investments (such as films) that could generate income from movie distribution and film-related franchises to be frozen at a low value so that later appreciations in value can be passed along to the celebrity-investor's children or other family members free of gift tax. The Obama administration in its fiscal 2013 budget proposal would require a 10-year minimum term for GRATs, up from as little as two years, making them less appealing for tax purposes. (For Treasury's green book explanation of fiscal 2013 revenue proposals, see Doc 2012-2947 or 2012 TNT 30-32.)

If the Obama proposal is enacted, Akhavan said, the use of GRATs could be "diminished or eliminated" for some investors in film and TV. "They should think about that before 2013," he said.

As outlined in Akhavan's article "Legal Gaga: Tax Planning and Asset Protection Strategies for Celebrities" in Trusts & Estates magazine (Feb. 2012), celebrities and their tax advisers also face a bewildering array of income tax planning options. Celebrity clients may earn "participations" (compensation contingent on net profits or gross receipts from film and TV), "residuals" (payments for subsequent showings of TV shows and films), and "deferments" (future fixed payments), not to mention personal appearance and product endorsement revenue.

Celebrity tax advisers may also need to be conversant in such relatively arcane tax strategies as "loan-out entities" (basically, a personal service company structured as a C or S corporation or limited liability company that can also serve as the celebrity's retirement plan); "transmutation agreements" (which allow divorcing couples in many community property states to mutually change separate property to community property or vice versa, although the tax consequences are not for everybody); and "forced heirship" rules (which may complicate a celebrity testator's intentions for any copyrights).


Takin' Care of Business

Most important for celebrities devoted to staying out of trouble with the IRS on these and other tricky issues, the practitioners agreed, are trustworthy, competent, experienced, and independent advisers.

"If you can't or won't do it yourself, you've got to make sure you have someone trustworthy, not just in your mind, but who is independent, not necessarily your friend, but experienced and knows what they are doing to take care of that stuff for you," Davine said. "Otherwise you are rolling the dice."

Henley said, "It's not a cure-all, but if an adviser is with a large, reputable firm, then that firm has gone through a certain vetting process before they made that person a partner, and I think that will speak volumes about the person's capabilities and competencies if he's been with a reputable firm for a long time." He added: "I would steer away from one- or two-men shops."

Celebrities too frequently get poorly served by their own gatekeepers, Henley added. "The [gatekeeper] is the intermediary that doesn't have the breadth of experience, and really may not know the change in the paradigm shift that is occurring with that particular tax authority or that particular regulator" over time, he said. Tax advisers need direct access to their celebrity clients for whom it is the gatekeeper's job to control, he said.

Conversely, Hammer said, some tax advisers and attorneys are too awed or intimidated by their celebrity client (or the gatekeeper) to be independent and convey the hard truths and difficult tax choices their client may face. "If you're worried about losing that fee, I'm not sure you're in the right business anyway," he said.


When the Whip Comes Down

"One thing I always recommend when the IRS comes to the door is: cooperate, cooperate, cooperate," said Akhavan. "If the economics warrant it," he added, the IRS will work out a payment plan with a famous celebrity the same way it will with an average taxpayer. "If [a celebrity has] millions in the bank and they just don't want to pay it, of course, the IRS is not going to take kindly to that," he said. "And the IRS does not want, especially from them, to hear a sob story."

The tax professionals agreed that the IRS doesn't target celebrities for examinations or audits. But Davine said, "I don't think the IRS will do a lot to keep it quiet if it hits the papers." And famous people who adhere to controversial theories, such as the section 861 argument (that U.S. citizens' domestic income is not taxable, and which helped snag Snipes), or make inane public declarations, such as "only the little people pay taxes" (real estate "Queen of Mean" Leona Helmsley, who subsequently served 19 months in prison for tax evasion), "are just asking for it," Henley said.

One of the most basic things celebrities get wrong about taxes is the filing requirement, said Davine. "A lot of people equate filing your return with paying your taxes," he said. "That is 100 percent wrong." Penalties for not filing are more severe than for not paying, he noted, adding, "Even if you can't pay, you should still file."

"You can't delegate away your obligation to file tax returns and pay taxes," Davine said. "You can't delegate that obligation away to an adviser or to someone who is part of your entourage. That ultimately is your responsibility. You can't say, 'Well, I didn't know,' or, 'I gave all of my records to my accountant or my friend or anyone, and I thought it was taken care of.' That excuse doesn't fly."

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