Michael is a producer for the largest record label east of the Mississippi. He rose from humble beginnings to become the most famous record producer of the last decade, working 50-70-hour weeks at the label. He has come to your office to seek confidential tax advice regarding the following situations:

1. Five years ago, Michael decided to anonymously open a recording studio in his old neighborhood, funding operational losses with his own money. It is a place where anyone can come and record a demo of their music for a very reasonable price. It is his way of giving back to the community and secretly searching for new, fresh talent (likely his prime motive). This year (year 5) the studio took in $60,000 and had the following expenses:

1. 1. 1. Rent - $36,000
      2. Recording equipment- $120,000
      3. Paint- $800
      4. Advertising - $600
      5. Salaries - $50,000
   2. Office Supplies - $2500
   3. A famous artist (MJ) gold record that hangs in the waiting room which he purchased for $2 million at auction
2. Michael proceeds to tell you that his attorney set up the studio as a single member LLC. His prior accountant told him the income from the studio would be reported on his personal tax return Form 1040, on Schedule C. He also tells you that his former accountant was not certain that ANY of the above expenses could be used to offset the $60,000 income from the studio, believing they may be personal expenses. The accountant told Michael that if any of the expenses could be deducted, they would be miscellaneous itemized deductions reflected on Schedule A, Form 1040. As a result, JJ was told the expenses would provide zero tax benefit to him and all $60,000 of gross income generated by the studio would be taxed at his tax rate.

3. Michael is infuriated by that advice and wants your views. He tells you he has not only contributed significant amounts of money to fund this endeavor ($150,000) but has also contributed “countless” hours during his spare time to make the studio viable.

Please discuss the following:

1. Do you agree that none of the expenses are deductible? If you believe some, but not all, of the expenses can be deducted, explain which are deductible, which are not, and why. Support your answers with legal cites.

2. For the expenses you believe to be nondeductible, is that lost benefit permanent, or will there be future tax benefits available, such as when the studio is sold.

3. Is there tax planning, alternative positions, entity structuring, or documentation surrounding the studio that you can suggest providing the best tax outcome for Michael?

Question 2:

In addition to the facts/questions listed in number 1 above, Michael provides the following historical information. Michael put $150,000 cash into the recording studio business in year one. An old friend runs the business for Michael and contacts him when he thinks there is a demo Michael should hear. Michael makes all management type decisions, attends weekly status meetings, and visits local venues scouting for talent. If he finds an artist he believes has a future, but is not ready for a major label, he refers them to the studio. The recording studio had a loss of $90,000 in year 1, a $5000 profit in year 2, and a $20,000 loss in year 3. In year 4, however, Michael discovers a very talented singing group that generates significant local, though not yet national, demand. As a result, Michael does not sign them to his major label, instead they are promoted through the local studio. In year 4, the studio had $220,000 of revenue, $95,000 of cash expenses and $24,000 of depreciation expense.

1. Assuming returns were filed NOT deducting any of the economic losses against other income (producer salary and capital gains) and assuming some earlier years are still open for amended returns, please explain what advice you would give Michael regarding the proper reporting of the studios operating results for the 4 previous years. Please discuss and document the technical issues associated with your advice.