IRS Examiners About to Zoom In on Hollywood : Taxes: The sweeping effort will focus on the practice of using ‘independent contractors.’ The industry is ‘very concerned.’

The Internal Revenue Service is launching a sweeping examination of the entertainment industry, which experts say could yield hundreds of millions of dollars in uncollected taxes.

The IRS will largely focus on the international film business and the widespread practice of actors, directors and technicians working as “independent contractors” instead of as employees.

Michael J. Quinn, Los Angeles district director for the IRS, said he is assigning 36 agents and auditors to a newly formed entertainment task force. Because of Hollywood’s notoriously complex accounting practices, many of the agents have been enrolled in entertainment business courses at UCLA.

Quinn said the IRS decided to form the unit six months ago and will have it fully staffed within six weeks. The prospect of IRS agents rifling through Hollywood’s balance sheets has sent chills through some industry quarters. But given the money at stake, Quinn said, “we’re probably a little late, when you think of it.”

Accountants and lawyers reached by The Times said the IRS effort could uncover hundreds of millions of dollars in delinquent taxes. In the last few months, the agency has already launched audits of some international transactions and independent contractors.

“We have many, many clients who are getting hit with this,” said David Wheeler Newman, a tax lawyer with the firm of Mitchell, Silberberg & Knupp. “I think it’s fair to say that throughout the industry, people are very concerned about the increased interest of the IRS.”

Newman said that at the IRS’ demand, one of his firm’s clients provided a list of about 500 people it had paid as independent contractors during production of a recent feature film. The IRS, Newman said, “ultimately did not accept 400 of those (people’s tax returns) as independent contractors.” Instead, the IRS ruled that the production company should have paid the 400 people as employees and withheld the necessary Social Security, unemployment and other payroll taxes.

As with many tax-related issues, determining who is and who is not a legitimate, independent contractor is fraught with complexity.

Unlike in decades past, when the IRS largely bowed to Hollywood custom, the service now is applying a list of 20 factors to decide whether a person is lawfully an independent contractor or an employee.

Those factors include whether an actor or other worker is required to follow instructions, or must work at hours specified by the employer. Some lawyers say this approach could cause unending uncertainty and disruption.

“There’s 50 years of case law. . . . That shouldn’t be changed without legislation,” said veteran Los Angeles entertainment-tax lawyer Bruce M. Stiglitz, a partner with the law firm of Loeb & Loeb.

What is not in dispute is that, for performers and others--including highly paid professional athletes--there are significant tax advantages to being compensated as independent contractors. For instance, independent contractors often claim far more deductions for work-related expenses and can avoid other liabilities, such as the alternative minimum tax.

“It’s definitely a loss to the (entertainer or athlete) taxpayer if they are an employee” instead of an independent contractor, said Pamela Christensen, an IRS exam manager who will help lead the new entertainment task force.

And for employers, IRS scrutiny of the independent contractor relationships “is a disaster,” according to Schuyler M. Moore, an entertainment tax law specialist. “If you don’t withhold (taxes from actors’ checks) and the IRS comes in and says you’re wrong, they impose personal liability on the officers and directors,” he said.

Another focal point of the probe is the lucrative international film business. Los Angeles-based Carolco Pictures, which has offshore subsidiaries, has told its shareholders that it is being audited.

One of the many international-related issues being eyed by the IRS is whether production companies are reporting adequate levels of income, or are unlawfully shielding revenue through affiliates in tax-haven countries such as the Netherlands Antilles. Many companies, for instance, produce films in the United States but place the distribution rights to those movies offshore.

“This is part of a huge push the IRS is making,” Moore said. “I’ve had two audits where I’ve won, with no change. But I’ve got a bunch pending.”

The tax advantages of placing film distribution rights offshore can be substantial. But for such deals to pass muster, Moore said, “there has to be real, bona fide, substantial activities offshore. You can’t just have a mail drop.”

The IRS contingent being deployed to examine the entertainment industry, first reported by the Hollywood Reporter trade publication, will work from separate offices in the Mid-Wilshire District and West Los Angeles. Christensen said the unit is being formed by reassigning people who were performing other functions in the Los Angeles district.

“This is an example of where we can really change the way IRS does business,” Christensen said.

An IRS spokesman said that the Los Angeles district has pioneered this approach, having already formed other specialized task forces to probe the operations of auto dealers, garment manufacturers, gasoline distributors, mortuaries, real estate companies and others.

“I would certainly like to see (in entertainment) the kind of success we’ve had with other industries, see our agents on an equal footing, understanding the practices of the industry,” said the IRS’ Quinn.

Specialized IRS scrutiny of other major industries has resulted in tax payments dwarfing those demanded by conventional audits, according to agency statistics provided to The Times. Quinn said he does not expect that trend to diminish with the entertainment industry.

Yet in Hollywood, the first challenge for the IRS is mastering the industry’s unique business practices, which can befuddle all but the most specialized accountants and lawyers.

“Knowledge is power,” said Jay Shapiro, an auditor who testified on behalf of columnist Art Buchwald in his lawsuit against Paramount Pictures, a trial that revealed many of the discretionary twists of studio accounting.

“It is a most complex industry, and baffling to someone who is first presented with it,” Moore said. “You wouldn’t even know the right questions to ask unless you were trained in it.”

The IRS decision to review the film industry’s tax practices comes at a time when the interests of Hollywood and Washington appear at odds.

In Hollywood, many independent production companies are either battling bankruptcy or struggling to secure scarce financing for film production. The major studios complain of flat or sagging profits.

Industry representatives, noting that sales of films, videotapes and television programming amount to one of the nation’s top exports, argue that the industry should be nurtured, not targeted.

Yet in Washington, there is the sobering certainty that the nation’s debt is surging toward $4 trillion, while the yearly federal budget deficit stands at $334 billion.

“I think the industry has to be constantly on its toes,” said Rep. Robert T. Matsui (D-Sacramento), a member of the tax-writing House Ways and Means Committee. “Because of the needs for revenue, there’s been an effort by (the U.S. Treasury Department) to tighten up much of the tax advantages that the movie industry has enjoyed.”

Matsui last February helped remove from a major tax bill a provision that would have narrowed an important film-production deduction for Hollywood’s major studios. If the proposed tightening had been left in the legislation, $50 million to $100 million of additional yearly taxes could have been generated, according to congressional staff analysts.

Noting the increased pressure in Washington and from IRS agents locally, tax lawyer Stiglitz said: “To what extent do you pluck the goose without making it fly away? They don’t have the entertainment industry behind bars.”

As for why the IRS is forming the entertainment task force, the agency’s Quinn rejected any notion that the Bush Administration is targeting Hollywood for partisan revenge.

“The (IRS) prides itself on being an independent agency,” Quinn said. “We are doing it purely from a tax compliance and revenue perspective. Believe me, we have no ax to grind at all.”

But it comes as little surprise to those who represent Hollywood interests that the IRS is now probing whether their clients--whose ranks include some of America’s highest-paid people--are paying their fair share of taxes.

“It’s absolutely, directly tied to the budget deficit,” said Moore, who, as a recent chairman of the entertainment tax committee of the Los Angeles County Bar Assn., has discussed industry tax issues with congressional staff members and officials of the Treasury Department and the IRS.

Moore said the IRS push is also traceable to a major overhaul by Congress in 1986 of the federal tax code.

“You had this army of IRS auditors who had been (examining) tax shelters,” the profit-offsetting ventures that were left largely obsolete by the 1986 overhaul, Moore said. “Now they’ve released a division of their army of retrained agents. And now it’s war.”

If war it is, the IRS appears determined to avoid being accused of a sneak attack. Quinn, for instance, met recently with a San Fernando Valley chapter of industry accountants, explaining what their clients can expect from the fledgling entertainment task force.

“The general reaction was, ‘We favor it; we think you need more consistency,’ ” Quinn said. IRS officials are also continuing to arrange similar meetings with entertainment tax attorneys.

And although this specialization costs money--officials are confident the expense will be more than offset by the extra revenue collected. Specialization does pay, according to IRS statistics drawn from audits performed from July, 1991, to February, 1992, in the Los Angeles area.

Conventional, non-specialized IRS audits of corporations during that period resulted in average additional proposed taxes of $15,699 per return, or $271 per IRS audit hour. Specialty-unit audits during the same period resulted in additional proposed taxes of $112,168 per return--or $1,110 per IRS audit hour.