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Written by: Alan T. Frankel, CPA, MST, CFP, Gregg Martorella, CPA, Isaiah Paul, J.D., CPA, and Evan Baken, CPA, EA

Entertainment assets, including copyrights for music compositions, films, and other creative works, are valuable intellectual properties that can generate significant income streams for artists and their heirs. As an entertainer, you want to ensure that your intellectual property is not only protected but accurately valued and transferred, to protect these assets and ensure their continued value after the creator’s death.

Owning entertainment assets typically provides legal title protection for creative works, allowing for future exploitation through selling or licensing. The income generated from these assets usually comes in the form of royalty payments subject to some of the highest federal tax rates.

One effective mechanism for protecting the earning potential for an artist’s family is placing assets like licenses, trademarks, and copyrights into a trust. Entertainment asset rights owned by a trust are controlled by the trustees and remain in trust until terminated or distributed under the terms of the trust. Some options for trust structures include revocable living trusts, intentionally defective grantor trusts, or grantor retained annuity trusts. These structures allow for specific allocation of royalties or shares of the catalog to designated heirs.

When it comes to selling or transferring entertainment assets, several factors need to be considered. Factors affecting the tax treatment include: the type of asset (copyright, patent, trademark), exclusivity of rights transferred, classification as a capital asset or trade/business property, and the nature of the transfer (sale vs license). The IRS has one main exception to the general rule for creators of musical works under IRC Section 1221(b)(3). If you are the creator of a musical work, you can elect to treat the related copyright as a capital asset, subject to capital gain treatment. Capital gains in the hands of an individual are taxed at 20,% whereas royalties, as mentioned earlier, can be taxed up to the current highest federal tax rate of 37%.

Another tool for asset protection is owning your catalog through an entity. You can place your musical assets into an entity and pay salary payments to your heirs, thereby reducing the taxable income brought in each year by the catalog. Entertainment asset rights owned through a corporate entity remain with the corporate entity post-death.

In a C Corp, capital gains are taxed the same as business income (currently at a rate of 21%) and the distribution of those gains to the shareholders are also taxed at the individual level, resulting in double taxation which is a major drawback of a C Corp.  There are strategies we can employ such as converting a C Corp to an S Corp which passes the gains from the entity to the shareholders at the 20% tax rate. Any unrealized gains in the C Corp carry to the S Corp and become Built-In Gains, which is a corporate-level tax on an S Corporation that disposes of assets that appreciate during the years when it was a C Corporation. The recognition period is the 5-year period beginning on the first day in which the corporation is an S Corporation. Thus, if assets can be held for more than 5 years, there would be no separate corporate-level tax on the C Corporation Built-In Gain once converted to an S Corp, and any further appreciation of the assets while held as an S Corp is not subject to the separate corporate-level tax.

S Corps have limitations on ownership and distribution structures, and do not receive a step-up in basis for the assets upon the death of the shareholder. This means that if those assets transfer to a beneficiary, they inherit the basis of the shareholder, thereby creating a larger capital gain upon the sale of the composition. We can mitigate this with a Section 754 Election in an LLC treated as a partnership, the result of which gives the beneficiary a FMV basis in the LLC or partnership assets held at the date of death of the member or partner.

The LLC treated as a partnership is generally the most favorable entity as it allows for: unlimited shareholders and investors, special allocations of partnership items, varying distributions among members, and has uniformity between the partnership step-up in basis of the partnership interest and the asset step-up in basis upon the death of a partner.

The complexities of the trust structures, entity structures and deal structures are far too complicated for one article. It is critical that any artist who hasn’t taken the steps to establish an estate plan or is considering changes to their current plan work with a tax advisory firm that has experience and expertise for entertainers and the various intellectual property assets and rights, to mitigate the risk and tax liabilities that occur.