Entertainment Tax Issues For Dummies

Entertainment tax issues may not be sexy, but they sure are important. Here is a simplified summary of important tax issues that people in Hollywood should know:

1. Section 181. Fuhgeddaboudit for raising film financing. In theory, Section 181 permits a deduction of the first $15 million for the cost of producing a film in the U.S. However, the deduction is only deductible against a limited type of income that most individuals don’t have, and at best the benefit is a one year deferral of tax. And if you are pitched Section 181 as a leveraged tax shelter (“You can deduct four times your investment!!”), run – it is into the deep black (not grey) on the tax scale.

2. Section 168(k). Fuhgeddaboudit too. In theory, Section 168(k) permits a deduction for the cost of producing a film in the U.S. once it is released, with no cap. However, the deduction is being phased out by 20% a year, and only 60% of the cost is deductible in 2024. More importantly, Section 168(k) is subject to the same problems as Section 181, discussed above.

3. Employee vs. Independent Contractor. Almost without exception, every individual rendering services without a loan-out (discussed below) should be treated as an employee, particularly in California due to draconian legislation there. The risk to the payor of not withholding taxes on payments to an individual is extreme, as there is personal liability to all “responsible persons,” and the liability cannot be discharged in bankruptcy.

4. Loan-Outs. Loan-outs (where individuals provide services to third-parties through wholly-owned corporations) continue to be respected as independent contractors, but only if the individuals are above-the-line talent, such as a writers, directors, actors, or producers. Most film companies will not respect loan-outs for below the line crew, and loan-outs don’t work for film company executives. Loan-outs need to be corporations (not LLCs), and an S corporation is usually the best choice to minimize the 3.8% Medicare surtax and the risk of double tax.

5. Unreleased Films. There have been numerous articles in the last year about completed studio films that were put on a shelf and never released. The writer of the first article assumed it was for some nefarious tax reason, and all the other articles parroted that theory, even getting Congress riled up. But it just ain’t so. Unless the film is sold to a third party, the studios do not get a tax deduction by putting a film on a shelf, so they are doing it for some other reason.

6. Investment Contracts. For reasons that escape me, most investments in films are structured as some form of investment contract, as opposed to a contribution to an entity for an ownership interest in the entity (as is done for all other industries). The tax problem with this approach is (a) the production company is taxed on receipt of the investment (the transaction is treated as the sale of a profits interest) and (b) the investor may not be able to deduct the investment until termination of the investment, and even then the deduction may be a capital loss, which is only deductible against capital gains. Most people ignore these issues, and production companies typically treat the investment as a reduction of film costs.

7. Deposits on Pre-Sales. It is common for distributors to pay deposits during production. Such payments are generally taxable, just like payments under investment contracts, and once again, most people ignore it and treat the deposits as a reduction of film costs.

8. State Production Subsidies. Many states offer generous subsidies for film production, usually in the form of state tax credits that are then sold. Both the IRS and the courts have held that the proceeds of the sale of these tax credits are immediately taxable, and true to form, most people ignore it and treat the proceeds as a reduction of film costs. Notice a theme here?

9. Capital Gain on Sale of Film. A common issue is whether the gain on the sale of a film can qualify as capital gain. In general, the gain can be capital gain only if (a) the transaction involves the transfer of exclusive rights in at least one medium of exhibition in at least one country for the full term of copyright and (b) the rights have been owned for at least one year. It certainly helps to call the transaction a “sale,” and in all cases there will be “recapture” of prior deductions as ordinary income.

10. Choice of Entity. Here are my votes on the best entity to use for tax purposes depending on what the entity does:

a. Loan-outs: S corporation.

b. Film production or distribution: LLC.

c. Foreign individual or company doing business in the U.S. (including an investment in a U.S. LLC): Delaware C corporation. And while we’re at, a U.S. LLC should never accept a foreign individual or partner as a member, or the LLC becomes liable for the foreign member’s U.S. and state taxes.

11. California Source Rules. Did you know that California is a tax-haven for the studios? It’s true, since even if all their property and employees are here, only about 5% of their total income is taxed in California due to California sourcing rules, which allocates income to where the films are watched. An open question is whether non-California talent that work on a film in California can use the same rules to minimize California tax (my vote is yes).

For anyone brave enough to read it (or that needs help with insomnia), I have a tax treatise creatively titled Taxation of the Entertainment Industry that I am glad to send out for free; just email me at smoore@ggfirm.com with a subject line that says “tax.”