March 2007

RUNAWAY PRODUCTIONS: CLEARING UP THE CONFUSION

The American Jobs Creation Act (the “Act”) can provide significant tax relief to certain taxpayers who invest in qualifying film and television projects. After talking to and meeting with many people in the film and television industry, as well as heads of various State Film Offices, and after reading articles and listening to other enter-tainment attorneys, it has become evident that there is considerable confusion and misinformation about the tax benefits for independent film and television producers that are contained in the Act. This confusion remains even though the Act went into effect over two years ago.

The Act took effect in late 2004 and will expire at the end of 2008. Congress passed the Act to help the strug-gling film and television industry and reverse the trend of “runaway film productions.” Internal Revenue Code Section 181, added by the Act, provides tax incentives for film and television projects that meet certain criteria. Section 181 allows a taxpayer to deduct 100% of the taxpayer’s expenditures on film and television projects that have production budgets of $15 million or less. The budget can be expanded to $20 million if its aggregate costs are “significantly incurred” in a depressed or blighted area, a low income area, or a distressed county or isolated area of distress as established under various regulations. Television productions (but only the first 44 episodes of a series) also qualify. Relief under the Act is available to individuals and companies that own a production. Re-cently adopted IRS temporary regulations indicate that, if the taxpayer invests through a “pass-through” entity such as a partnership or LLC, the deduction is subject to the familiar active-passive limitations applicable to real estate and similar investments.

The Act requires that a minimum of 75% of any and all compensation for services paid to actors, directors, pro-ducers, and other relevant production personnel be paid to people or companies in the United States. This effec-tively means that compensation to the screenwriter for the screenplay and other rights is exempt from the 75%. Any other budget items that are not payment for services as defined above are also exempt. This reduces the amount that a filmmaker needs to spend in the United States. In addition, the service personnel do not need to be U.S. citizens. They simply need to provide their service in the U.S. and be paid in the U.S. This means that talent from abroad can be brought in and the tax benefits for the project will still be available. However, film and television projects that show sexually explicit scenes are ineligible for tax benefits under the Act.

After passage of the Act, many industry professionals and their legal and accounting advisors found the Act lack-ing in sufficient detail. This led to uncertainty and confusion. Rumors started to spread. Industry unions had concerns. Dealmakers and investors began to wonder: “Are investors allowed deductions under the Act only against passive income? Or, may investors’ deductions be written off against any income?” Many other questions arose because of the brevity of section 181 and the failure of Senate and House Reports to discuss many issues. Most questions have now been answered by a technical correction to Section 181 and temporary regulations re-leased by the I.R.S.

Section 181 was amended in December 2005 with a technical correction making it clear that Section 181 deduc-tions are subject to recapture under Section 1245 when the owner of a production sells it. This effectively pre-vented Section 181 deductions from converting ordinary income into capital gain. This change can easily be kept from disqualifying a domestic project for the Act’s benefits by reducing one’s budget to a “safe haven” amount that will reasonably prevent the production budget from going over the limits, even if deferrals and/or residuals kick in. If one’s budget is equal to or less than $10 million, then the risk is slight and one is, with careful review, probably within the “safe haven” zone. If one exceeds the permissible limit, then one will lose all benefits and be taxed without regard to Section 181. If the project turns out to produce so much revenue that residuals on a $10 million budget go over Section 181’s limit, presumably the loss of tax benefits will not be too painful.

In May, 2006, the I.R.S. released Notice 2006-47 specifying how taxpayers can elect to deduct production ex-penses of a qualifying production. After November 15, 2006, taxpayers may make the election by filing a Form 3115, Application for Change in Accounting Method, for the first or second taxable year ending on or after De-cember 31, 2005, in accordance applicable I.R.S. requirements. If a taxpayer made a section 181 election on a federal income tax return that was filed before June 15, 2006, but did not include with that return all of the in-formation specified in Notice 2006-47, the taxpayer must attach a statement containing the specified information to the taxpayer’s next-filed federal income tax return.

On February 9, 2007, the I.R.S. released temporary regulations applicable to Section 181. The regulations answer many questions that previously had divided advisors to investors in film projects. By specifying that the Section 181 deduction may be taken only by the “owner” of a production, including pass-through entities that received investments from investors, (rather than being taken by the investors themselves) the temporary regulations ef-fectively limit outside investors to taking Section 181 deductions only against passive income.

The temporary regulations also provide that any participations or residuals to those providing service to the pro-duction must be included in the budget limits, which many advisors to industry professionals thought needed clarification.

Many other questions are answered in the temporary regulations. For example, they explain when a project’s costs are “significantly incurred” in a depressed or blighted area so that the project qualifies for the higher $20 million budget limit. The temporary regulations allow the higher limit if the production meets either of two tests. Under the first test, 20% of first-unit principal photography (photography with the main actors) costs must be incurred in the distressed or blighted area. The first unit principal photography costs include such items as com-pensation to actors, directors and other production personnel, location costs, camera rental and insurance, and catering but exclude items such as preproduction, editing, and postproduction. The excluded items usually cost much more than the included items. Under the second test, 50% of the days of principal photography, both first unit and second unit, must take place in the designated area.

The temporary regulations specify that they apply to productions whose first day of principal photography oc-curs on or after February 9, 2007 and before January 1, 2009. Although the temporary regulations are not explic-itly retroactive, they may well represent the positions that the I.R.S. will take in auditing returns filed before tem-porary regulations were adopted. You should consult a tax advisor if you have any questions about previously-filed returns claiming a deduction under Section 181.

In addition to the tax reduction incentives under Section 181, the income received also has some tax reduction opportunities under the Act. Under the manufacturing sections of the Act, film production businesses are con-sidered “manufacturing businesses.” Manufacturing businesses can deduct 3% of the income they receive from the film project in the years 2005 until 2007. From 2007 until 2010 they can deduct 6% and from 2010 and be-yond they can deduct 9%. This deduction may also apply to television productions. If $100 is received from 2005 up to 2007, then the taxable income is $97. If $100 is received from 2007 up to 2010, then the taxable income is $94. If $100 is received after 2010, then the taxable income would be $91.

Additional good news for independent filmmakers is that the Act can be combined with any state film or televi-sion incentive programs. Currently, 38 states have incentive programs available to film and/or television projects, and in eight more states such programs are awaiting legislative approval. Producers and their tax advisers should evaluate projects to determine which state has the best incentives to add to those contained in the Act.

Despite some of the confusion surrounding the Act, it is a highly beneficial law for independent producers in film and television and can help put a serious dent into runaway productions.

This update is not intended or written to be used, and may not be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code. Funkhouser Vegosen Liebman & Dunn Ltd. has prepared this update for its clients and friends solely for general informational purposes. This update does not constitute legal or tax advice, nor is it intended as a substitute for obtaining legal or other professional advice based upon specific factual circumstances or issues. If we can be of assistance, please call or write Wilson Funkhouser, 312.701.6810, wfunkhouser@fvldlaw.com, Jon Vegosen, 312.701.6860, jvegosen@fvldlaw.com, Jim Groth, 312.701.6830, jgroth@fvldlaw.com, or consult with your regular FVLD contact.