A SUMMARY OF THE “NEW TAX ASPECTS”

Deduction of the cost of Qualified Film or Television Productions.

Previously, some costs of film production were recoverable through depreciation deductions spread over a period of years. However, the 2004 Tax Act added a new Section 181 to the Internal Revenue Code that allows a current deduction for the cost of “qualified film or television productions” in the year of the expenditure.

For any qualified film or television production commenced after October 22, 2004, and before January 1, 2009, a taxpayer may elect to deduct expenses in an amount not to exceed an aggregate cost of $15,000,000. The limitation is increased to $20,000,000 if a significant amount of the production expenditures are incurred in areas eligible for designation as a low-income community or eligible for designation by the Delta Regional Authority as a distressed county or isolated area of distress. A production is treated as commencing on the first date of principal photography.

The “aggregate cost” of a qualified film or television production may include all costs previously required to be capitalized, such as (a) development costs, (b) general and administrative costs, (c) depreciation of property used in production, and, (d) financing costs.

A qualified film or television production may be a motion picture (whether released to theatres or directly to video, cassette or any other format), a miniseries, a scripted, dramatic television episode, or a movie of the week. In the case of a television series, only the first 44 episodes may qualify. Sexually explicit productions are excluded.

To qualify for the deduction, 75 percent of the total compensation of the production must be “qualified compensation”, meaning compensation for services performed in the United States by actors, directors, producers, and other relevant production personnel. There is no requirement that the individual be a U.S. citizen or resident. However, compensation does not include participations and residuals.

If the election to deduct the expenses is made, no other deduction for depreciation or amortization with respect to the qualified film or television production is allowed.

Only the owner of the qualified film or television production that pays the costs can take the Section 181 deduction. However, there is no requirement that the owner be the actual producer of the production. So even though the owner may subcontract production to another entity, as long as the owner retains the ownership rights over the production, the deduction should still be available. In addition, there can be multiple owners of the production. In that case, each owner would be allowed the deduction in proportion to the amount of his or her contributions.

Application of the Section 181 Deduction

The production activity should constitute a “trade or business”, therefore, the Section 181 deduction would be subject to the passive income/loss rules. Individuals and personal service corporations that do not "materially participate" in an activity (regular, continuous and substantial participation in the activity) can only deduct passive losses to the extent of "passive income." Passive income generally includes income from real estate and other passive investments, and will include the income from the film, television show, etc. produced. Any passive losses not used can be carried forward and offset against passive income in subsequent years, or may be deductible against ordinary income if the loss is "freed up" (i.e., by sale or disposition of the passive activity asset). This would apply even if the future gain were long-term capital gain.

Therefore, in the initial year of production, the production costs would be deductible to the taxpayer under Section 181, but only against passive income. Any excess of the deduction (or “loss”) would carry forward and could be used to offset any ongoing income stream from the produced material. Presumably, if the produced material were sold in the same year as the costs were incurred, the deduction amount could be offset against the passive income from the gain on sale. If the produced material were sold in a subsequent tax year, the taxpayer could apply the loss carry forward from the first year against ordinary income and also be entitled to capital gain treatment of the proceeds of the sale of the produced material.

If the produced material is held for more than 1 year from the date of completion, the capital gain will be a long-term capital gain. There are no preferential capital gains rates for corporations, but if the taxpayer were an individual, the long-term capital gain rate would be 15% under current laws.

Potential limitations on the application or effect of the Section 181 deduction under existing tax law may include the “At-Risk Rules” (under which a taxpayer may only take a deduction for direct investment and borrowed amounts for which the taxpayer has ultimate direct recourse liability), the Alternative Minimum Tax (though as long as the production activity constitutes a trade or business (for individuals) or is deductible for purposes of calculating "earnings and profits” (corporations) the deduction should not trigger the alternative minimum tax) and established case law relating to the Internal Revenue Service’s ability to recast a transaction based on the doctrine of substance over form in a manner that would eliminate the tax benefits.

Deducting Residuals and Participations

Effective for films placed in service after October 22, 2004, taxpayers may elect, on a film-by-film basis, to irrevocably adopt one of two approaches for the deduction of participations and residuals for the film. Participations and residuals are amounts that "by contract vary with the amount of income earned in connection with" the film (i.e., payables based on gross receipts, or box office bonuses). The taxpayer may elect to increase the adjusted tax basis of the film by the amount of participations and residuals that the taxpayer ultimately may owe based on an estimate of the income from the film during the first ten years after the film is placed in service. Alternatively, the taxpayer may elect to deduct the participations and residuals when paid.

Partial Exclusion of Income For Films Produced In The U.S.2004 Tax Act also provides for an exclusion of a percentage of worldwide net income attributable to audio-visual works if at least 50% of the total compensation relating to production of the audio-visual work is compensation for services performed in the United States. The exclusion is 3% in 2005 and 2006, 6% from 2007 through 2009, and 9% thereafter. In no event may the exclusion exceed 50% of the total W-2 wages paid by the taxpayer during the applicable tax year. The exclusion also applies for purposes of the alternative minimum tax.The exclusion applies regardless of the medium (i.e., theatrical, television, or DVD). Films will not qualify for this benefit if the film includes "visual depictions of actual sexually explicit conduct." Again, as with the Section 181 deduction, the income exclusion is limited to the owner of the film during production.

The foregoing is presented for informational purposes only and is not intended nor does it constitute a legal or tax opinion. This should in no way be relied upon or construed as an opinion or advice, and this is not intended nor does it imply, warrant or represent the suitability of the investment offered herein for any particular tax deduction, exemption, classification or planning strategy. State and federal tax laws, interpretations and applications can change at any time, without notice. You are strongly urged to consult with your own attorney, accountant, tax professional or other advisor concerning any of the foregoing information and/or the availability of any particular deduction, exemption, classification or planning strategy in connection with any entertainment investment.