Internal Revenue Code Section 181 (which permitted a 100% deduction for the first $15 million of the cost of producing a film shot in the U.S.) has expired, but Section 168(k) remains, and it permits a similar deduction but with no dollar limit, although the deduction is deferred until commercial release of the film.
While it sounds good on paper, Section 168(k) is worthless as a tax shelter to raise financing for films for the following reasons:
1. It is a deduction, not a credit. If you invest $100, your maximum savings is about $40, so it still costs you $60 to make the investment. That might soften the blow if you lose your investment, but no more so than donating $100 to charity.
2. If Lady Luck results in the film working and thus return of the investment, the return is fully taxable. Thus, all that Section 168(k) achieves is at best a relatively short deferral of tax, since in most cases the bulk of the film’s income is received in the year of release of the film.
3. For individuals, the Section 168(k) deduction can only offset a very narrow category of income, which generally consists of taxable income from real estate (and most real estate investments don’t generate taxable income due to favorable tax rules) and passive interests in businesses held by pass-through entities.
4. The deduction is permitted only to the “owner” of the film at the time of release, and the distributor will typically be the “owner” at that time unless it has only a “limited license” of rights.
In fact, the only time Section 168(k) “works” to raise financing is when it is used in connection with a tax shelter that is leveraged with debt to permit the investor to deduct a multiple of the investor’s actual investment, and these deals are almost always fraudulent. Indeed, the same structure was used extensively in Section 181 deals, many of which have resulted in the deductions being denied in IRS audits, criminal investigations, and investor lawsuits against the promoters, lawyers, and even the producers that received the investment. For those interested in the details, the deductions are denied because (a) the investors are not active producers (which requires at least 500 hours of active producing services per year, and not just reading reports at home), so the deductions are denied under the passive loss rules, (b) the “debt” is not deductible under the “at-risk” rules and is not true debt in any event, and (c) the deferred offsetting income is taxed up front under the constructive receipt rules. On top of those reasons, the investors will not be the “owner” of the film at the time of commercial release, which is required to take the deduction under Section 168(k).
Even aside from the risk of being sued by disgruntled investors, producers run three other risks from these tax-shelter transactions: The first is that since the deduction for film costs is allocated to the investor and the offsetting income is deferred, the producer ends up taxed on 100% of the gross income from the film with no offsetting deduction. The second is that the transactions require the producer to transfer the copyright to the film, and the documents are often so muddled that the producer does not get the copyright back. The third is that the IRS might pursue the producer for aiding and abetting tax fraud, although the IRS does not usually go after the counterparty to a tax shelter.
So when you hear about the purported wonders of a Section 168(k) tax shelter, please consider the risks.
