THE 2004 FEDERAL TAX INCENTIVE FOR MOTION PICTURE PRODUCERS

 

 

 

SYNOPSIS: The American Jobs Creation Act of 2004 creates an extraordinary new tax incentive for film producers who make low- and medium budget films (under $15.0 or $20.0 million) in the U.S.  The new law allows producers of qualifying films to elect out of the uniform capitalization rules which mandate that film costs be deducted gradually over a film’s useful life or be matched to a film’s projected income.  Costs of qualifying films can now be deducted in full in the year they are incurred.  The purpose of the new tax law is to stimulate investment in domestic film production operations and make domestic film production more competitive with foreign production options.

 

 

DISCUSSION

 

On October 22, 2004 the American Jobs Creation Act of 2004,[1] which amends the Internal Revenue Code of 1986,[2] was signed into law.  The congressional committee statement indicates the purpose of the bill is to “remove impediments in [the Internal Revenue Code]…and make our manufacturing, service, and high-technology businesses and workers more competitive and productive both at home and abroad….”[3]  The Act creates three tax incentives[4] expressly applicable to motion pictures, one of which – § 181 of the Internal Revenue Code – is especially significant to independent film producers.

 

Overview of New IRC § 181.  Section 244 of the Act, entitled “Special Rules for Certain Film and Television Productions,”[5] adds a new section, Section 181,[6] to the Code subpart “Itemized Deductions for Individuals and Corporations.”[7]  Section 181, entitled “Treatment of Certain Qualified Film and Television Productions,” gives the taxpayer an election to deduct, in the year the expenses are incurred, the costs of any “qualified film or television production.”[8]  The new rules are in effect as of the date of enactment, October 22, 2004, and are applicable to qualified productions commencing before 2009.  Section 181 has three principal limitations on this incentive: a dollar limitation of $15.0 or $20.0 million; the production must be a “qualified film or TV production”; and an exclusivity of the deduction/amortization.[9]

 

Dollar Limitation.  The deduction election does not apply to any qualified film which has an aggregate cost greater than $15.0MM.[10]  The dollar limitation is $20.0 MM for any qualified film “the aggregate cost of which is significantly incurred in an area eligible for designation as “an IRC § 45D“ low income community”[11] or a Delta Regional Authority “distressed” county or areas.[12] 

 

Qualified Film or TV Production and Qualified Compensation.  The section 181 deduction election is only available to “qualified film or television productions,” defined as any production within the dollar limitations described above, in which 75 percent of the total compensation of the production is “qualified compensation.”[13] In addition, the new IRC section expressly indicates that, for television series, only the first 44 episodes may be taken into account and qualify for the deduction election.[14]  Sexually explicit productions subject to 18 U.S.C. 2257 are not eligible for the deduction.[15]

 

Qualified Compensation.  “Qualified compensation” means “compensation for services performed in the U.S. by actors, directors, producers, and other relevant production personnel.”[16]  It does not include residuals and participations as defined in 167(g)(7)(B) of the Code.[17]

 

Pre-§ 181 Film Production Tax Accounting.  In order to appreciate the impact of the newly allowed method of calculating deductions for film production operations, an overview of the pre-§ 181 law is helpful. In general, under the law prior to October 22, 2004, the costs associated with producing a film could not simply be fully deducted in the year they were incurred.[18]  Instead, like most costs associated with producing property, the costs (both direct and indirect) had to be capitalized,[19] with some exceptions.[20]  Under the tax rules prior to H.R.4520, the cost of producing the film was recovered by one of two depreciation/amortization methods: the income forecast method, and the straight-line method.[21]  Because H.R. 4520 effectively nullifies the law which mandates capitalization of the great majority of film production costs and prohibits their current-year deduction (i.e., IRC § 263A(b)[22]) an examination of the statutory framework and the authoritative interpretations regarding itemized business deductions is the logical starting place.

 

                General Rules for Itemized Business Deductions.  Section 161 of the Code states the general rule that, in computing taxable income, the deductions described in Part VI (i.e., §§ 161-191) are allowable, unless they are excluded by Part IX (§§ 261 et seq.).  Among the categories of allowable deductions in Part VI are: trade or business expenses (§ 162); and depreciation (§ 167).

 

                Section 162 provides that an allowable expense deduction must meet a three part test.  First the expense must be incurred “in carrying on a trade or business.”  Second, it must be an “ordinary and necessary” expense.  Finally, it must be paid or incurred within the taxable year.  In addition, § 162 expressly excludes “capitalized costs” from allowable expense deductions.  Thus section 162 makes a distinction between currently deductible business expenses and expenses which must be capitalized.[23]  One provision in Part IX, IRC § 263A(b), expressly excludes deductions for both “direct” and “indirect” costs of producing a “film, sound recording, video tape, book, or similar property,” and provides that such costs must be capitalized.[24] 

 

                Depreciation Deductions for Film Production Costs Pre-§ 181.  Under the § 263A scheme, direct and indirect film production costs must be capitalized.  These costs include: direct material costs;[25] direct labor costs;[26] and indirect costs.[27] IRS Regulations provided exceptions for interest expenses under certain circumstances, state income taxes, and marketing and distribution costs.[28]   Production costs that were required to be capitalized can be depreciated under IRC § 167.[29]  Although the Code, caselaw and regulations have acknowledged numerous methods of recovering costs, only two methods have ever been approved by the IRS: the income forecast methods, and the straight-line method.

Income-Forecast Method.  Prior to § 181, the most common method used by independent producers to recover film production costs was the income forecast method.  Under this approach, the ratio of: a) the film’s total net revenues for the given tax year, to (b) its lifetime projected revenues, is calculated.  This fraction is then applied to the film’s total capitalized costs to determine the allowable depreciation deduction for the given tax year. 

 

Apart from the strict mathematical limitation on the deduction amount,[30] there is another important limitation on use of the income forecast method of depreciation: a taxpayer cannot depreciate the asset below its salvage value.  IRS regulations provide that “salvage value” means the “amount which it is estimated will be realizable upon sale or disposition…when [the film is]…no longer useful in the taxpayer’s business or in the production of income.”[31]

 

Both the income forecast method and the straight line method (below) required that the taxpayer own the film, and that the film must be “ready for service” or “ready for production of income.”[32]  Other troubling aspects to the income forecast method include: the difficulty of projecting a film’s total revenues; the IRS position that “net income” means net income to the producer (and not the distributor(s));[33] the “look-back” provisions which require the taxpayer to make complicated mathematical adjustments if estimates prove sufficiently incorrect;[34] and the difficulty of incorporating post-completion costs into the formula.[35]

 

Straight-Line Depreciation.  Under this less common method, the cost of the film is deducted in equal annual amounts over the film’s useful life.[36]   The meaning of “useful life” is a function of the taxpayer’s circumstances; relevant factors include wear and tear from natural causes, economic changes and current developments in the industry and the taxpayer’s business, and other matters peculiar to the taxpayer’s business.  Various cases have upheld useful lives of five to 12 years.[37] 

 

Effect of the § 181 Deduction Election: A Textual Analysis.  While nothing in the bill or the new statute expressly indicates that § 263A capitalization is no longer required for motion pictures, that conclusion is the only logically coherent interpretation.  A strict construction of § 263A and the new § 181 yields the following paradoxical result: first, per § 181 a taxpayer who produces a motion picture may now deduct all production costs in the year they are incurred, and treat such costs as expenses “not chargeable to capital account;” and two, per § 263A the same taxpayer must “capitalize” the same costs and must charge them to a “capital account.”  Inferentially, the drafters must mean that § 263A is no longer applicable to motion pictures with respect to which the taxpayer has made the § 181 election.  An amendment to § 263A to clarify capitalization is no longer required for § 181 film production costs is in order.  Fortunately, the Committee Report on H.R. 4520 speaks more clearly to the issue by expressly indicating that the § 181 deduction is “in lieu of capitalizing the cost and recovering it through depreciation allowances.”[38]  And while the meaning of “chargeable to capital account” in § 181(a)(1) is not embellished, the Regulations that explain § 263A are instructive in their definition of “capitalize.”[39]  Additional reassurance is found in § 181 itself, in paragraph (b), which provides that the § 181 deduction is mutually exclusive of all other depreciation and amortization deductions.[40] 

 

Real World Effects of § 181: A Practical Analysis.  Films qualifying for § 181 treatment must meet the dollar limitation ($15/$20 million).  Generally speaking, films in this budget range are considered low- or medium-budget films, the average budget for a studio picture in 2003 being more than $59.0 million.   Additionally, qualifying films must meet the qualified compensation requirements; i.e., 75% of total compensation must be paid for service performed in the U.S.  Thus qualifying films will be “independently produced” American films.  The incentive to independent producers is that the great bulk of production costs for these qualifying films no longer need to be capitalized; thus, § 181 will grant independent producer/production company taxpayers 100% deductions for the costs of their film productions in the same year those costs are incurred.  In effect, the costs of qualifying films become “trade or business expenses” outside the purview of the uniform capitalization rules of § 263A.  The tax benefits of § 181 will likely stir great interest in film production investment by investors seeking to offset their passive income with passive losses from single-purpose production ventures.  Additionally, since the new section grants substantial new deductions for production company taxpayers who are already in the business of making low- and medium-budget films, it will dramatically lower such taxpayers’ tax liabilities.  The net effects will probably include more independently produced productions and a more robust if not more profitable independent sector.

 


[1]               H.R. 4520, THE AMERICAN JOBS CREATION ACT OF 2004, enacted as Pub. Law 108-357 (2004).  Hereafter, the “Act.”

[2]               26 U.S.C. §§ 1 et seq. (1986).  Hereafter, the “Code,” or “IRC.”

[3]               JOINT EXPLANATORY STATEMENT OF THE COMMITTEE OF CONFERENCE,

[4]               One, § 102 of the Act creates a deduction from income based upon a taxpayer’s “qualified production activities income,” limited, however, to 50% of the wages paid by the taxpayer.  For 2005 and 2006 the deduction is 3% of such income, for ’07, ’08 and ’09 it is 6%, and for 2010 onward, it is 9%.  Since this deduction is income-related and the great majority of films produce little or no income within twelve months of the start of production, its value to single-purpose production companies is extremely limited.  Another incentive, found in § 242 of the Act, modifies the calculation of the income forecast method of depreciating films (see “Pre-§ 181 Film Production Tax Accounting,” below) to allow for the inclusion of participations and residuals relating to ten-year post-service income.  While this is useful for taxpayers who find it economically advantageous to continue depreciating film production costs rather than simply deduct them the year they are incurred, to producers who seek the maximum deduction possible in year one, its value pales in significance to the tax incentive in § 244 of the Act.  Section 244 provides an election to deduct all costs of production in the year they are incurred for qualifying films, and it is the focus of this article.

[5]               H.R. 4520, Pub. Law 108-357 § 244 (2004). 

[6]               IRC § 181 (2004).

[7]               IRC §§161-198 (2004).

[8]               The section states:  “A taxpayer may elect to treat the cost of any qualified film or television production as an expense which is not chargeable to capital account.  Any cost so treated shall be allowed as a deduction.” IRC § 181(a)(1) (2004).

[9]               Other limitations include: only the first 44 episodes of a TV series may be taken into account; pornographic films are excluded (i.e., productions which have a performer with respect to whom records are required by 18 U.S.C. § 2257;  and rules similar to IRC § 194(b)(2) (relating to how dollar limitations apply in scenarios involving pass-through entities and “control groups”) and (c)(4) (relating to allocation of basis among two or more properties) shall apply for purposes of section 181.

[10]             IRC § 181(a)(2)(A) (2004).

[11]             IRC § 181(a)(2)(B) (2004).  IRC § 45D is known as the “New Markets Tax Credit,” and was enacted in 2000 as part of the Community Renewal Tax Relief Act of 2000.   The § 45D tax credit is available to investors who make “qualified equity investments” in “community development entities.”  Under the § 45D scheme, substantially all of the investment proceeds must be used by the CDE in “qualified low-income community investments.” “Low-income” communies are census tracts with a specified minimum poverty rate or maximum median family income.  See IRC § 45D(e)(1) (2000).  Additionally, the Treasury Secretary may designate lesser portions of census tracts as low-income communities under certain circumstances evidencing economic distress.  See IRC § 45D(e)(1) (2000).

[12]             IRC § 181(a)(2)(B) (2004) citing 7 U.S.C. 2009aa-1 – aa-13 (2000).  The Delta Regional Authority (DRA) is a federal-state partnership designed to remedy “severe and chronic economic distress by stimulating economic development and fostering partnerships that will have a positive impact on” a 240-county/parish area in an eight-state region (AL, AR, IL, KY, LA, MO,  MS, TN).  See “About the DRA,” www.dra.org.  The DRA was established by the Departments of Labor, Health and Human Services, and Education, and Related Agencies Appropriations Act, 2001 (12/15/00), as amended by H.R. 2646, The Farm Security And Rural Investment Act of 2002 (2002 Farm Bill).

[13]             H.R. 4520 § 244(a), new IRC § 181(d)(1).  See text below.

[14]             IRC § 181(d)(2)(A) (2004).

[15]             IRC § 181(d)(2)(B) (2004).  18 U.S.C. 2257 provides record keeping requirements for persons producing and distribution material containing “actual sexually explicit conduct,” defined as “actual but not simulated conduct as defined in” 18 U.S.C. 2256(2)(A)-(D). 

[16]             IRC § 181(d)(3)(A) (2004).

[17]             IRC § 181(d)(3)(B) (2004).

[18]             IRC § 161 states that the deductions contained in IRC Part VI (IRC §§ 161 – 191) are allowed, subject to the exclusions in Part IX (IRC §§ 261 et seq.).   Section 263A, in Part IX, sets forth the “Uniform Capitalization Rules,” which provide that the direct and indirect costs of property produced by the taxpayer must be capitalized.

[19]             IRC § 263A (1986).  Generally, “capitalization” is the assignment to a given cost or expenditure, of specific values over a specific period of time, for the purpose of gradually recovering the cost or expenditure through one of several accounting methods.  Accounting methods which can be used to recover capitalized expenses include: depreciation, amortization, and cost of goods sold.  Recovery of costs for producing independent films generally is accomplished by one of two common depreciation methods (see text following this note).

[20]             There are exceptions for interest expenses (see § 263A(f)(1)(B)), state income taxes (Reg. § 1.263A-12(c)(3)), and expenses for marketing, sales, advertising and distribution of films (see id, and the Form 1040 Audit Guidelines, Entertainment Market Segment Specialization Program, Jul. 28, 1995).

[21]             A third depreciation method existed under the former § 263A.  It allowed a taxpayer to rely on the "safe harbor" provisions provided in Notice 88-62.  Under that Notice, “qualified creative costs” can be deducted fifty-percent (50%) in the year paid or incurred; twenty-five percent (25%) the following year; and twenty-five percent (25%) the third year.  “Qualified creative costs” were defined as certain costs incurred by a self-employed individual in the production of creative properties where the personal efforts of that individual predominately created the creative properties.  Notice 88-62, 1988—1 CB 548 (May 31, 1988).

[22]             IRC § 263A(b) (1986).

[23]                 Essentially, capital expenses must be added to the basis of an asset or “charged to a capital account” (in the parlance of Regulation 1.263A-1(c )(3)) and, under specified circumstances, may be depreciated or amortized and then deducted from taxable income.  In the case of capital expenses for an asset for which no deductions are permitted over the useful life, capitalized expenses diminish the amount realized on disposition of the assert or may be taken as a loss upon abandonment or other disposition. 

[24]             IRC § 263A(b) (1986).

[25]             These include costs of materials that “become an integral part of specific property produced and those materials that are consumed in the ordinary course of production and that can be identified or associated with units or groups of units of property produced.”  Reg. § 1.263A-1(e)(2)(i)(A).

[26]             “Direct labor costs” include the costs of labor that can be identified or associated with particular units or groups of units of specific property produced.” Reg. § 1.263A-1(e)(2)(i)(B).  The definition expressly encompasses full-time employees, part-time employees, contract employees and independent contractors.  Components of direct labor costs include: basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay (with certain exceptions), shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan.  Id.

[27]             “Indirect costs” mean “all costs other than direct material costs and direct labor costs….” Reg. § 1.263A-1(e)(3).  The Regulations require the taxpayer to “capitalize all indirect costs properly allocable to property produced….”  Id.  Such indirect costs are “properly allocable to property produced…when the costs directly benefit or are incurred by reason of the performance of production or resale activities,” and may be allocable to production activities as well as “other activities that are not subject to section 263A.  Id.  The Regulations provide a laundry list of examples of indirect costs, which include: indirect labor costs, officers’ compensation, employee benefit expenses, indirect material costs, purchasing costs, handling costs, storage recovery, cost recovery, rent, taxes, insurance, utilities, repairs and maintenance, tools and equipment, licensing and franchise costs, interest, et al.  Reg. § 1.263A-1(e)(3)(ii).  Excluded from indirect costs are: selling and distribution costs (including costs of marketing, selling, advertising, and distribution); research and experimental expenditures per § 174 and the Regulations thereunder; and income-based taxes (i.e., state, local, and foreign taxes, and income-related franchise taxes).  Reg. § 1.263A-1(e)(3)(ii).

[28]             Reg. § 1.263A-1.  See preceding note 27, above.

[29]             IRC § 167 (1996).

[30]             Observe that the income forecast method completely precludes a deduction for the taxpayer in any year in which net revenues are zero.  I.e., when net revenues equal zero, then the numerator of the fraction is zero, and thus the percentage of capitalized costs which can be deducted is also zero.

[31]             Revenue Ruling 60-358, 1960-2 CB 68.

[32]                 Gilmartin v. Commissioner, 47 TCM 1532, 1548 (1984).

[33]             Some taxpayers have argued that the numerator portion of the income forecast ratio should actually be gross income (not net), and/or should mean the revenues flowing to the film’s distributor(s) rather than producers.  The IRS, the Tax Court and the 7th Circuit have all disagreed.  Gordon v. Comm’r, 85-2 USTC ¶9483 (7th Cir. 1985), Siegel v. Comm’r, 78 TC 659 (1982), and Rev. Rul. 78-28.

[34]             IRC § 167(g) (1996).  Essentially, the “look-back” provision requires the taxpayer to check the accuracy of his annual estimates with actual performance and make adjustments which may include paying interest on previous year’s under-reported/unpaid tax liabilities.

[35]             Costs of production which are incurred or accrued after the film is placed “in service” and not accounted for in a prior year’s (or years’) return(s), may be discounted to then-present value in order to recompute the allowable deduction(s).  IRC § 167(g) (1996). 

[36]             There is an exception for films which are acquired as part of the acquisition of at least a substantial portion of a trade or business.  IRC § 197 (1986).  Section 197 requires a fifteen-year straight line amortization for such films.

[37]             See Cathedral Films, Inc, v. Comm’r (5 TCM 112, 113 (1946); Leisure Dynamics v. Comm’r, 32 TCM 159, 169 (1973); Walt Disney Prods. V. United States, 480 F.2d 66 (9th Cir. 1973), cert denied 415 U.S. 934 (1974), and Inter-City Television Film Corp. v. Comm’r, 43 TCM 270 (1964).

[38]             See Committee Report on H.R. 4520, p.128.

[39]                 Regulation § 1.263A-1(c)(3) defines “capitalize” to mean “to charge to a capital account.”  Thus, the costs of § 263A property must be “charged to capital account”; and § 181 costs need not be charged to capital account.  Because § 181 directly contradicts §263A, the only reasonable inference is that the legislature intended the § 181 deduction election to supersede the provisions of § 263A which by their terms still apply to § 181 costs.

[40]             IRC § 181(b) 2004.  Logically, if the taxpayer validly elects to deduct costs under § 181, then even if § 263A were applicable to the same costs, the taxpayer would be unable to deduct any amounts that were capitalized per § 263A by the express terms of § 181(b).