Yuechiang Stephanie LuoProject 1: Classification and Source of Income

Facts: G, a professional golf player and South African national, currently lives in the UK. For the tax year in question, G played in at least 11 European Tournaments as a member of the European Tour. Previously, G rarely played in the US and was not a member of the Professional Golf Association (PGA). This year, G won the US Open, and his career and fame skyrocketed. He also automatically received a PGA Tour Card due to winning the US Open; the PGA Tour Card requires that G plays at least 13 tournaments a year in the US. For the year in question, G played 36 tournaments in the US. G also entered into endorsement agreements with several sponsors: A, B, C, D, E, and F. The endorsement agreements would pay G a base endorsement fee for using his name, face, image, and likeness in global marketing campaigns. Additionally, G agreed to perform some services for some of the sponsors. Sponsors A, B, and C provided a bonus should G achieve a certain place in specific tournament rankings, and the endorsement fees would be prorated if G did not meet the required number of tournaments he participated in.

G filed a US tax return as a nonresident alien. The IRS disagreed with some of G’s income allocation, asserting that 100% of the endorsement income and bonuses from sponsors A, B, and C is personal service income, rather than just 50%. The IRS also allocated a larger part of the endorsement income from sponsors D, E, and F to US source income, and issued a deficiency notice for $165,000 in taxes.

Issues: What part of G’s income is considered compensation from personal services and which portion is considered royalties? What portion of income is foreign source and what portion is US source?

Conclusions and Support: §861(a)(3) states that compensation for personal services performed in the US is considered to be income from US sources. Exceptions occur if the services are performed by a nonresident alien with temporary presence in the US that lasts at most 90 days of the tax year, the compensation is not greater than $3,000, and the compensation for services is performed by an employee who works for a nonresident alien or foreign entity. Royalty income from intangible property, such as patents, copy rights, and trade-marks, depend on the location in which the right to use intangible property is exercised. §861(a)(4). Personal service income from sources outside the United States must be performed outside the US. §862(a)(3). Similarly, royalties paid for the privilege of using intangible property in foreign countries is foreign source income. §862(a)(4). In some cases, the taxpayer has gross income from foreign and US sources that must be allocated accordingly. §863(b)(1) stipulates that income from services performed partly within and partly without the US should be apportioned.

G filed as a nonresident alien for the tax year in question. Following the substantial presence test, G cannot be considered a resident alien of the US because of his minimal presence in the US in the preceding two years.

For Sponsor A, which makes golf balls and golf clubs, G allowed A to use his name and likeness in connection with the promotion of A’s products for a fee of $375,000 and an agreement to play using A’s golf balls. Additionally, G must attend 4 days of public relations activities and play in at least 20 tournaments or the endorsement fee will be prorated accordingly. A bonus is offered if G reaches a certain position in a tournament. On the tax return, G characterized the endorsement fee and bonus from this contract as 50% personal service income and 50% royalty income. The IRS categorized 100% of the same income as personal services income. Personal service income occurs if G’s contractual obligation to play using A’s golf balls and attend public relations events result in A making sales of its products. Obviously, G earned compensation for personal services performed, but

as he also allowed A the right to use his likeness and name, he also earned royalty income. G should categorize the endorsement fee and bonuses from A as 50% personal service income and 50% royalty income.

G’s contract with Sponsor B, who makes golf clubs and accessories, allows the company to use G’s name and likeness on the golf products for $400,000 per year. G was required to wear clothing and use golf clubs made by B for golf tournaments, as well as attend 2 service days for TV and print advertising, and make 6 personal appearances to promote the products. If G does not participate in at least 31 tournaments, his fee is prorated. A bonus is offered should G obtain a specific place in a tournament. Here, the treatment of the income by G and the IRS is the same as for Sponsor A. Again, it makes more sense to categorize the income as half royalties, half personal services.

The agreement with C, which makes golf apparel, pays G $50,000 for using his name on the products. G must wear C’s apparel in tournaments and make 2 appearances. The endorsement fee is prorated provided G doesn’t meet a specific participation minimum, with a bonus for making a specific position in a tournament. The income treatment should be the same as for Sponsors A and B.

The determination of the sources of the endorsement income and bonuses from A, B, and C as foreign or US is different for personal services and royalties. Personal services income from A, B, and C is correctly allocated based on the number of days G played in the US over the total number of days G played golf in the year in question.

The IRS decided that there should be a larger allocation of the endorsement income from Sponsors D, E, and F to US sources.

G was paid $43,500 royalty income by D for the right to use G’s name and likeness in the business of selling and promoting D’s trading cards. 92% of the products are sold in the US. G allocated only 9.1% of the income to US sources. Obviously, as the majority of the products were sold and used in the US, the same portion, 92%, of the endorsement fee should be US source.

Similarly, E pays $34,000 for the right to use G’s name and likeness in the video game products. 70% of the video games are sold in the US, so 70% of the endorsement income should be apportioned to US source.

G also earns royalty income by agreeing to wear F’s watches in his public engagement appearances and letting F use his name and likeness with the marketing and sale of the watches. Assuming that G obeys the agreement to the letter, the income should be allocated based on the number of appearances in the US to the number of appearances in foreign countries.

Determining if the income is effectively connected to a US trade or business is based on a facts-and-circumstances analysis. If the income is from the performance of services in the United States, it is usually considered trade or business within the US. §864(b). Income from US sources is effectively connected with the conduct of a trade or business if such activity is a material factor in the realization of the income. §864(c)(2)(B). Thus, all of G’s personal service and royalty income allocated to US sources is effectively connected with a US trade or business. Effectively connected income from foreign sources, as determined in §864(c)(4)(B)(i), includes the royalty income derived from the conduct of trade or business. Personal service income from sources without the US is not treated as effectively connected with the conduct of a trade or business within the US. §864(c)(4)(A).