Taxwise strategies for models, athletes and entertainers.

Models, athletes and entertainers face a big problem in accumulating wealth. The extraordinary income from their careers lasts only a brief portion of their working lives. Meanwhile, they are taxed at high marginal tax rates on that income, so that the average tax rate over their total wage-earning years may be higher than for other taxpayers without such extremes in income.

Example: M works as a model in New York City for 10 years and thereafter works in a "normal" job in Westchester County for another 10 years. As a model, M earns $175,000 per year; afterward, she earns $40,000 per year. At current tax rates (assuming both Federal and New York State standard deductions, but no others), her tax in New York City would be $69,603.71 per year, and her tax in Westchester County would be $10,307.00 per year

Over the same period, S earns the same amount of money, but does so by earning $107,500 each year. S also lives the first 10 years in New York City and then lives the next 10 in Westchester County. S would pay $38,373.84 per year in taxes for the first 10 years and $34,091.38 per year in taxes for the second 10 years. M will have paid $799,107.10 in taxes over the 20-year period, 10.3% more than S, who paid only $724,652.26.

While this example highlights the importance of maximizing after-tax income for models, athletes and entertainers during their short-lived careers, it actually underestimates the problem by not taking into account the time value of money. Any money saved in the early years from reducing models', athletes' and entertainers' taxes will compound over time. However, there are many strategies (including the four explained below) that can be used to reduce their taxable income.

* Determining whether the business organization is the appropriate form for minimizing taxes: If the model, athlete or entertainer does not intend to spend his earnings immediately, incorporation as a C corporation may make sense. Since entertainers (definitely) and models and athletes (most likely) would be considered to be members of occupations classified as personal services for personal service corporation (PSC) purposes (so that their corporate income would be subject to a flat Federal tax rate of 35%), such taxpayers should consider starting a business or merging with an existing business that provides products or services not considered personal services. If the combined corporation's employees spend at least 5% of their time providing products or services not considered to be personal services, the corporation would not be considered a PSC.

* Planning for retirement: If the model, athlete or entertainer is self-employed, a simple employee pension (SEP), which allows a self-employed individual to contribute the lesser of 15% of earnings or $30,000 to a retirement account (and in so doing, post-pones the tax on the contribution until it is withdrawn), makes a lot of sense. If the model, athlete or entertainer has incorporated, other retirement plans are available. An intriguing new type of retirement plan is a savings incentive match plan for employees (SIMPLE). Companies with 100 or fewer employees may set up a SIMPLE, under which employees make voluntary pre-tax contributions of up to $6,000 per year to a retirement account; the employer then makes a dollar-for-dollar matching contribution up to 3% of the employee's compensation. Alternatively, the employer may make a blanket contribution of 2% of each employee's compensation for all plan participants. The intriguing aspect of SIMPLEs is that they are not subject to the complex nondiscrimination rules that apply to other qualified retirement plans, which limit benefits provided to "highly compensated employees."

* Setting up an expense reimbursement plan: If a model, athlete or entertainer has chosen to incorporate, he should also consider setting up a Sec. 105 employee medical expense reimbursement plan. A medical expense reimbursement plan allows an employer to pay and deduct employee-incurred medical expenses. There are two ways such a plan reduces taxes: First, the employer and the employee need not pay their portions of payroll taxes (i.e., Social Security and Medicare taxes) on the amounts reimbursed. Second, the employee avoids the 7.5%-of-income threshold that must be met before he can deduct itemized medical expenses. Similarly, a model, athlete or entertainer should consider setting up an employee expense reimbursement plan for miscellaneous business expenses.

* Setting up an MSA: A model, athlete or entertainer should also consider setting up a medical savings account (MSA) while it is still available. (In 1996, Congress decided to limit the number of MSA participants to 750,000 during the years 1997-2000. Once this cutoff is reached, no further MSAs will be allowed to be established.) An MSA contains financial assets held in trust by a fiduciary for use by an individual to pay for his, his spouse's and his dependents' medical; expenses; the individual can make annual tax-free contributions that compound tax-free until the individual withdraws the funds in the account. Employers with 50 or fewer employees (including self-employed individuals) that provide "high deductible" health insurance (see Rev. Rul. 97-20) may establish MSAs.

MSAs have several tax advantages. Contributions by an employee are deductible from his adjusted gross income (AGI). Contributions made by an employer are excluded from the employee's income, as long as they are not made through a Sec. 125 cafeteria plan. Distributions for the qualified medical expenses (i.e., unreimbursed medical expenses that would be eligible for the medical expense deduction) of the employee, his spouse and dependents are not taxable. If the employee makes the contributions, he can save the income taxes that would have been paid on the income that could not be offset by his Schedule A deduction (since a deduction is allowed only for medical expenses that exceed 7.5% of his AGI). If the employer makes the contributions, both the employee and employer save on the employee's payroll taxes, in addition to the employee's income tax savings, so that the best strategy might be to reduce the employee's wages by the amount to be contributed to the MSA and have the employer make the contribution.

All taxpayers should be interested in tax deductions and tax deferral. Models, athletes and entertainers can maximize their tax savings opportunities by reorganizing their businesses, setting up retirement plans, and creating employee expense reimbursement plans and MSAs.

From Jared King, President, New World Financial Group, Naugatuck, Conn. (not affiliated with AFAI)