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By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
In Goosen v. Comr., 136 T.C. No. 27 (6/9/11), the Tax Court determined that part of a nonresident alien professional golfer's endorsement income was compensation for services and part was royalties for the use of his name and likeness.1 Having bifurcated a contractual arrangement into two components for character and source purposes, the court went on to conclude that the taxpayer's "royalty" income was not effectively connected with what the court considered to be his separate "personal services" business.
The Goosen decision is incorrectly reasoned. But before getting into the analysis, I need to give the Tax Court a few strokes in recognition of the hazards it faced. The court had to negotiate between the IRS's completely unprincipled position that all of the taxpayer's income was for services and the taxpayer's truly horrible form. Based apparently on some bad advice from his advisors, the taxpayer had bifurcated the income into compensation and royalties, probably because this was the ways things worked in other countries where it mattered.2
Characterizing the Payments
So let's take a mulligan and ask, first, what the character of Goosen's income really was. At issue were worldwide endorsement agreements entered into between the taxpayer and three companies. Under these agreements, Goosen was paid a base fee, plus bonuses for tournament and ranking performances. The base fee was subject to pro-ration if he failed to play a set number of tournaments in a given period. In return for these fees, Goosen had to do the following:
So, basically, Goosen had to do nothing much more to earn these fees than what he would normally do, plus wear stuff with logos on it. Yet the IRS insisted that because everything Goosen was obliged to do under the agreements required his personal physical presence, they must be "services" and all of his income must be compensation for services. The Tax Court bought into this, stating:
Engaging in a U.S. trade or business includes any business activity in the United States that involved one's own physical presence. See §1.864-2, Income Tax Regs.
The cited regulations say nothing of the kind, of course. The regulations merely echo the statute and provide that the performance of personal services within the United States is, per se, engaging in a U.S. trade or business (ETB). Except in the context of an exception from ETB status not relevant here, the regulations never mention "physical presence," which is a sourcing, not a character, rule. Services can be, and often are, performed without the necessity of being physically present in any given place. Allowing someone to use one's name and likeness can similarly be done with or without physical presence.
The court expressed some frustration that the endorsement contracts did not make an "allocation" between Goosen's services and royalty income. What the court failed to consider was that the parties to the contract did not view the arrangements thereunder as two separate arrangements, but as a unitary whole. Thus, there was no reason for them to allocate the payments made to Goosen between payments for his "services" and payments for his name and likeness. For the following reasons, it should have been completely obvious to the Tax Court that all the sponsors were paying Goosen for was the use of his image and likeness, and not for his "services":
Not convinced? Try this simple §482 transfer pricing thought experiment: Imagine I walk into one of these sponsors' offices and offer to do exactly the same thing that Goosen did. I'll show up four times a year for photos, make appearances, and spend all my time putting and swinging.
Q: How much do you think the sponsor will pay me for my "services"?
A: Yeah, right. If I'm lucky, the sponsor will pay me to go away.
The point is, my image and likeness have no value to a sports audience, so no one would pay me a dime for these services. A professional athlete is not a walking sandwich board or a fairway model. Goosen was not being paid to wear apparel; he was asked to wear apparel as part of his contract so that the public would associate Goosen's likeness with the sponsor's product, resulting in more sales of the sponsor's product. One does not need to go to business school to figure this out.
In any case involving the character of income, a court needs to look to all of the relevant facts and circumstances, including evidence of the intent of the parties. It is therefore surprising that the Tax Court apparently failed to ask how the sponsors had accounted for the endorsement payments for tax purposes, which is clearly relevant to intent. If services were provided, the sponsors may have been required to give Goosen (or his incorporated talent company) a Form 1099 as an independent contractor. (He was clearly not an employee of any of them.) Royalties would require a different form, plus reporting under §1441 of the Code. Moreover, characterization of the payments as compensation or as royalties may have affected the sponsors' own tax returns.
It is also interesting to speculate how the IRS would react under these facts if a U.S. citizen treated payments like these as ordinary compensation income from services, perhaps to qualify for a retirement plan deduction or simply to claim business expenses on a Schedule C. Seems like a stretch, but as I wrote in the title …
To the extent the Tax Court found that a portion of Goosen's income was compensation for personal services, the effective connection issue was easy to decide, and the parties did not disagree on the point, because performing services is per se a trade or business. However, having erroneously bifurcated the character of Goosen's income, the court had to decide whether his royalty income from the use of his name and likeness was effectively connected with his conduct of a trade or business in the United States.
The first question the court should have asked, but did not, was what Goosen's trade or business(es) was (or were). Because both parties agreed that Goosen was in a trade or business, the court simply assumed that his trade or business was playing golf and that this was a "personal service" business in the same way that sitting at a desk 9 to 5 would be. But that assumed away the real issue in the case. There is no law that says a person cannot earn royalties as part of a business. What if one of Goosen's trades or businesses had been promoting his own likeness and name for profit? The question should at least have been asked.
Having assumed that Goosen's "business" was a personal service business, the court then asked whether the royalties he earned under the endorsement agreements were effectively connected with that business. The relevant regulations prescribe both an assets use test and a business activities test for finding an effective connection; the court correctly focused on the business activities test. Under the business activities test, one asks whether Goosen's assumed business of providing services was a material factor in producing the royalty income. When the question is framed in a way that assumes the existence of two separate businesses, as it was here, the answer is usually no, and so the court concluded. The court cited Example (2) from Regs. §1.864-4(c)(3)(ii), which involved a taxpayer that was in two separate lines of business.
The Tax Court's analysis of the effective connection issue was flawed because it assumed that Goosen's royalty stream was attributable to an activity separate from his business that generated the services income. But Goosen did not have two separate businesses; he had only one. Moreover, his endorsement fees were earned pursuant to the terms of contracts that did not attempt to separate his services from his granting of the right to use his name and likeness; indeed, as noted above, any services he provided were simply ancillary to the grant of that right. Goosen could not have earned the royalty income but for his business of being a golfer. Under any application of the material factor test, the royalty income should have been treated as effectively connected with his business of being a golfer and performing the "services" he was held to have performed under the endorsement agreements.
There are not many cases addressing the effectively-connected rules of §864(c). The most frequently cited case is InverWorld,3 where the court confused questions of character, source, and effective connection, and never clearly defined what business was being used to test the latter. The decision in Goosen is par for the course; the court conflated notions of character with notions of source and failed to address the scope of the taxpayer's business in any way that would enable it to apply effective connection rules properly.
Perhaps the moral is that our rules for taxing the income of foreign persons are simply too arcane for the courts (much less taxpayers) to grasp. But more fundamentally, Goosen illustrates how much can go wrong when a court fails to apply the common law to a tax case. If this had been a simple breach of contract case, there's little question that the court would have analyzed all the facts and circumstances and inquired into the parties' intentions in order to determine the true nature of their agreement. Here, the court skipped that step and went immediately to the tax regulations (misreading them to boot). So perhaps the real moral is that there is nothing magic about tax cases, and courts should not turn off their normal legal modes of analysis merely because they find themselves in the presence of a code and its regulations.
This commentary also will appear in the September 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blessing and Lubkin, 905 T.M., Source of Income Rules, and Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, and in Tax Practice Series, see ¶7120, Foreign Persons—Gross Basis Taxation, and ¶7130, Foreign Persons—Effectively Connected Income.
1 As the court noted, the law is fairly well-settled that payments for the use of an individual's name or likeness are treated as royalties.
2 The opinion notes that the U.K. tax authorities approved of Goosen's "incorporated talent" structure in which income from the endorsement contracts was arbitrarily divided between different entities and different countries. While such structures are commonly used outside the United States, even the taxpayer's advisors knew they wouldn't make the cut here, and so reported his income as if the companies they so carefully set up did not exist. In this sense, the case is an interesting example of a taxpayer being allowed to ignore his own form.
3 T.C. Memo 1997-226.
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