We hear more and more of “non-profit” production companies popping up like toadstools after a spring rain. Since most of these seem to be micro-Independents, I thought it was about time to take a good hard look at what actually is a non-profit, and can a production company be one? Are these non-profit production companies just a tax swindle, or can a production company actually be one?
To many professional filmmakers, this term would seem an oxymoron. For a filmmaker to call themselves “non-profit” you’d ask why they don’t have faith in their ability to make a financially viable film that would make a profit at the box office.
Our major problem, it seems, is employing CPAs from outside the industry. These are the guys employed to stop companies from overspending or spending your hard-earned profit on undepriciable trinkets. Put one of these guys on a project with a $20 million budget and they will crash your project by trying to curb you spending over $5 million on “trinkets” like any actor whose fee is over SAG minimums and replacing a composer and orchestra with a music CD from Safeway.
At the same time, these outside-the-industry CPAs are notorious for getting you in trouble with the IRS. Jail-terms for you come about because they have convinced you to put your money in an offshore tax haven where up to a third of your money ends up in their pocket. They run away Scot-free while you languish in jail.
The same happened to a couple of well-known actors recently where their CPA had registered them as a non-profit organization… these poor actors are now in State “rehab” for tax evasion, while the CPA is driving around town in a Ferrari the actor didn’t know they bought as a gift to the CPA.
So, what is a non-profit?
According to the IRS, here are seven federal tax law attributes of five common types of tax-exempt organizations.
- Able to receive tax-deductible charitable contributions.
- Able to receive contributions or fees deductible as a business expense.
- Substantially related income exempt from federal income tax.
- Investment income exempt from federal income tax. (Private foundations are subject to tax on their net investment income).
- Engage in legislative advocacy.
- Engage in candidate election advocacy.
- Engage in public advocacy not related to legislation or election of candidates.
In addition to charities, churches and religious organizations, political organizations and private foundations, hospitals, and educational institutions, the following is a list of other types of tax-exempt organizations. For more information regarding these types of organizations, download Publication 557, Tax-Exempt Status for Your Organization, (http://www.irs.gov/pub/irs-pdf/p557.pdf) or contact IRS Customer Service.
Corporations Organized Under Act of Congress (including Federal Credit Unions).
- Title Holding Corporations for Exempt Organization
- Teachers’ Retirement Fund Associations
- Benevolent Life Insurance Associations, Mutual Ditch or Irrigation Companies, Mutual or Cooperative Telephone Companies, or Like Organizations (if 85 percent or more of the organization’s income consists of amounts collected from members for the sole purpose of meeting losses and expenses)
- Cemetery Companies (owned and operated exclusively for the benefit of their members or which are not operated for profit)
- State Chartered Credit Unions, Mutual Reserve Funds
- Mutual Insurance Companies or Associations
- Cooperative Organizations to Finance Crop Operations
- Employee Funded Pension Trusts (created before June 25, 1959)
- Black Lung Benefit Trusts
- Withdrawal Liability Payment Funds
- Title Holding Corporations or Trusts with Multiple Parents
- State-Sponsored High-Risk Health Coverage Organizations
- State-Sponsored Worker’s Compensation Reinsurance Organizations
- Religious and Apostolic Associations
- Cooperative Hospital Service Organizations
- Cooperative Service Organizations of Operating Educational Organizations
- Child Care Organizations
- Farmers’ Cooperative Associations
I can’t find production companies and actors listed here. Can you?
Okay, #2 in the above list (Able to receive contributions or fees deductible as a business expense), may seem to the untrained eye that ANY company or actor can be a non-profit. The trouble is, “fees deductable as a business expense” does not apply, because it’s part of standard tax deductions for any business. An actor would regard their agent’s commission or even their union dues as deductable as a business expense. That blows that out of the water.
Here’s the applicable regulation for allowable deductions (section 181) dated February 9, 2007:
Allowance of Deduction
The deduction under section 181 is allowed for the cost of producing qualified film and television productions for which principal photography begins after October 22, 2004, and before January 1, 2009. Production costs incurred before or after this period may be deducted so long as principal photography commences during the period.
Section 181 refers to “the taxpayer” who makes the election and takes the deduction. The temporary regulations provide that only the owner of the film or television production may elect to deduct production costs under section 181. Under the regulations, the owner of the production is deemed to be the person or persons otherwise required to capitalize production costs into the basis of the film or television production under section 263A (or the person or persons that would be required to capitalize production costs if subject to section 263A).
The production costs that must be taken into account (for both the amount of the deduction and for the production cost limit) are the amounts that, absent section 181, are required to be capitalized under section 263A (or the amounts that would be required to be capitalized if the taxpayer was subject to section 263A). Although a film’s budget might be evidence that the production costs will not exceed the production cost limit, the budget is not the same as production costs for purposes of section 181. All production costs eligible to be deducted under section 181 are subject to the production cost limit. Under the temporary regulations, distribution costs are specifically excluded from the definition of production costs under section 181, consistent with the exclusion of distribution costs under section 263A.
Section 181 does not require the production to be placed in service in order for the producer to begin deducting production costs, and there is no requirement that the production ever be placed in service or completed. However, the temporary regulations require that, at the time the election is made and in any year that a deduction is claimed, a taxpayer must have a reasonable basis for believing that the production will be set for production (as defined in American Institute of Certified Public Accountants Statement of Position 00-2), will be a qualified film or television production upon completion, and will not exceed the production cost limit. For example, a taxpayer that has developed a shooting script, has a well-documented budget, and has obtained financing on the basis of these facts is in a good position to determine whether it has a reasonable basis to claim the deduction.
The temporary regulations treat the cost of acquiring a production as a production cost. This rule is premised upon the understanding that under section 1245, the seller would recapture upon the sale of the production any section 181 deduction that the seller had claimed. In the case of a sale between related parties, the purchaser must treat the greater of the acquisition cost or the seller’s production cost as the purchaser’s production cost for purposes of the production cost limit, notwithstanding that the purchaser’s deduction under section 181 is based on the purchaser’s actual acquisition cost.
In the film industry, once a prospective producer has determined the estimated budget for a production, it usually must obtain financing from a bank or other lender to cover at least part of the production cost. The producer may incur up-front costs in obtaining such financing. The producer’s pre-sale agreements with distributors may be used as collateral for this financing. Generally, the financier will be repaid directly by these distributors upon delivery of the finished production. In addition, the financier will usually require that the producer obtain a completion guarantee (often referred to as a completion bond) as a condition of the loan. The completion guarantee is a guarantee that, if the production costs exceed the budgeted costs or the loan proceeds are mishandled, the film will still be completed and/or the financier will be made whole. A completion guarantee can be satisfied in a number of ways. For example, the guarantor may loan funds to the producer to finish the production, may finish the production itself (although this is rare), or may reimburse the financier for the amount loaned to the producer (plus interest and other charges). Generally, the producer must pay an up-front amount in order to obtain a completion guarantee.
The temporary regulations provide that the costs of obtaining financing, including premium costs for completion guarantees, are production costs that are subject to the production cost limit and are deductible under section 181. In addition, if the completion guarantor loans additional funds to the producer and the funds are expended by the producer to complete the production, or if the completion guarantor incurs additional production costs on its own behalf, the additional funds are production costs under section 181.
Participations and residuals (P&R) are defined in section 167(g)(7)(B), as costs with respect to an item of property described in section 167(g)(6), the amount of which by contract varies with the amount of income earned in connection with the property. In the context of film and television production, participations are payments to actors, directors, and other talent based on a contractually-defined measure of future income from the production. Residuals are payments made pursuant to collective-bargaining agreements, such as those of the directors’ and actors’ guilds, based upon non-theatrical sales, under terms that differ between video, free television, and pay television sales. Participations are generally paid by the producer but may be assumed by a third-party distributor. On the other hand, residuals are generally paid by a distributor out of its gross receipts from the production. Industry accounting generally treats participation payments made by distributors as a reduction in the producer’s profit rather than a production cost, and generally treats residual payments made by distributors as a distribution cost.
Various comments were received with respect to the treatment of P&R under section 181. Some comments suggested that taxpayers be permitted to elect to deduct participation payments (rather than capitalizing those payments into the basis of the production) under the income forecast method rather than section 181. Other comments suggested that Congress, by specifically excluding P&R costs paid or incurred by the taxpayer from the definition of “qualified compensation” in section 181(d)(3), intended these costs to be excluded from the production cost limit in section 181(a)(2). Comments received also suggested that P&R costs should be excluded for purposes of determining whether the production cost limit is exceeded, but nonetheless should be deductible production costs under section 181.
In addition, various comments expressed concerns about productions being subsequently disqualified if P&R costs are included in determining if the production cost limit is exceeded. For example, a taxpayer forecasts its production costs (including a reasonable amount of P&R costs based upon projected income from the production) and based upon this forecast the taxpayer determines it has a reasonable basis for making an election under section 181. However, if an unexpectedly large amount of P&R is later paid as a result of production earnings being much greater than was initially expected, with the result that the total production cost exceeds the production cost limit, the production would become disqualified from treatment under section 181.
The temporary regulations provide that P&R costs are considered production costs for purposes of the production cost limit. The IRS and Treasury Department recognize that P&R costs are costs that are generally subject to capitalization under section 263A (see §1.263A-1(e)(2) and §1.263A-1(e)(3)). Nonetheless, an explicit reference to P&R costs is provided in the temporary regulations in order to avoid any uncertainty with respect to these costs.
The IRS and Treasury Department believe that the statute requires P&R costs to be included in the production cost limit. For example, the statute specifically provides that participations and residuals are excluded from the definition of compensation for purposes of determining whether the production was a qualified film or television production, as defined in section 181(d)(1). This explicit exclusion is not found in the production cost limit of section 181(a) (2) or elsewhere in section 181.
In addition, the IRS and Treasury Department are concerned that if P&R costs were excluded from the definition of production costs under section 181, section 181(b) could cause them to be nondeductible under any provision of the Internal Revenue Code. Specifically, section 181(b) states that no depreciation or amortization deduction other than the deduction provided under section 181 is allowed for the basis of a qualified film or television production for which an election has been made. Therefore, if P&R costs were excluded from the definition of production costs under section 181, a taxpayer wishing to expense P&R costs under the holding of Associated Patentees, 4 T.C. 979 (1945), may be barred from doing so under section 181(b), as the holding in that case is explicit that a deduction under Associated Patentees is a depreciation deduction of basis.
Additionally, the IRS and Treasury Department are concerned that a blanket exclusion of participations from the definition of production costs would allow taxpayers to manipulate the total production cost (and avoid the production cost limit) by structuring compensation as participation payments. Commentators argued that this potential abuse could be mitigated with an anti-abuse rule that treats only those participations that are disguised non-contingent or guaranteed payments, where the talent incurs minimal risk of non-payment (for example, participations with a payment priority over distribution cost repayment and/or production financing cost repayment) as production costs subject to the production cost limit, but does not treat other participation costs as production costs.
The IRS and Treasury Department considered excluding from the amount to be taken into consideration as production costs any residuals (payments to actors’ or directors’ guilds based on gross income from exploitation in secondary markets) that are paid by the distributor or other third party, under the theory that these payments are costs of exploiting the finished production. However, the same argument could be advanced for participations contingent on income, notwithstanding that most participations are taken in lieu of compensation for services (normally a production cost). In addition, a payment of residuals by a third party is still made on the producer’s behalf, and the producer remains the party with ultimate liability for the payment. Thus, the temporary regulations provide that P&R costs are production costs that are deductible under section 181 and are included in the production cost limit.
Section 181(a)(2)(B) provides a higher production cost limit for a qualified film or television production “the aggregate cost of which is significantly incurred” in a designated area. Designated areas include areas eligible for designation as low-income communities or certain distressed counties and isolated areas. However, neither the statute nor its legislative history provides a definition for “significantly incurred”, nor do they explain how the standard should be applied. However, Congress’ stated intent in enacting section 181 was to encourage economic activity in these designated areas. Accordingly, the temporary regulations provide two different tests for establishing when production costs have been significantly incurred in a designated area. One test is based upon production costs while the other is based upon days of production. Under the first of these tests, the temporary regulations establish a 20 percent threshold for the “significantly incurred” standard (similar to the rules of §1.199-3(g)(3)). This test compares production costs incurred in first-unit principal photography that takes place in a designated area to all production costs incurred for first-unit principal photography. First-unit principal photography typically films the primary actors, whereas second-unit principal photography typically films shots that establish location or context (exteriors of buildings, crowds, cars passing). Production costs of principal photography include, for example, compensation to actors, directors and other production personnel, location costs, camera rental and insurance, and catering. This 20 percent test is based upon production costs incurred in first-unit principal photography and ignores all other production costs such as preproduction, editing, and postproduction costs for purposes of the “significantly incurred” requirement. These other production costs often greatly exceed principal photography costs, and must be incurred where adequate production facilities exist (and it is likely that few such facilities are available in the designated areas). The IRS and Treasury Department believe that if all production costs were taken into consideration in determining whether the 20 percent “significantly incurred” threshold had been met, very few films would qualify for the higher production cost limit, even if a substantial amount of principal photography occurred in a designated area. However, we request comments regarding whether the exclusion of preproduction, editing, and postproduction costs will unfairly impact taxpayers.
Comments were received requesting that consideration be given to developing a “significantly incurred” test based upon the number of days of principal photography. The temporary regulations adopt this suggestion and provide, as an alternative to the 20 percent cost-based test, a “significantly incurred” test based upon the total number of days of principal photography. Under this test, if at least 50 percent of the total days of principal photography take place in a designated area, the production will be deemed to have satisfied the “significantly incurred” requirement of section 181(a)(2)(B). This 50 percent test may provide a simpler computation than the 20 percent cost-based test and avoids issues such as the allocation of salaries to specific days of principal photography.
A taxpayer intending to utilize the $20 million production cost limit under section 181(a)(2)(B) must maintain records adequate to demonstrate that it has a reasonable basis under the “significantly incurred” standard to support reliance on the higher dollar limitation.
So, I leave the answer up to you, is calling a production company a “non-profit” legit, or a tax scam.
Trouble is, with the high amount of things we in the film industry can claim and charities can’t, is going non-profit really worth it?