Yuechiang Stephanie Luo

Project 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 Gs 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 Gs 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 As products for a fee of $375,000 and an agreement to
play using As 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
Gs contractual obligation to play using As 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.
Gs contract with Sponsor B, who makes golf clubs and accessories, allows the company to
use Gs 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 Cs apparel in tournaments and make 2 appearances. The endorsement fee is
prorated provided G doesnt 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 Gs name and likeness in the
business of selling and promoting Ds 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 Gs 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 Fs 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 Gs 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).