At Filmmaker we have covered Section 181, the United States’ film tax credit incentive, quite extensively, but this article by entertainment attorney Daniel J. Coplan, Esq. is both a great overview of how the incentive actually works for individual investors as well as an explanation of one underknown element. The latter concerns the ability of some investors to deduct against ordinary income, not passive income. In short, if you’re raising private equity for a U.S. film this year, read on. (This piece was originally published on LinkedIn and is reprinted with permission.)

The purpose of this short article is to explain how IRC Section 181 works. It is not intended to be legal advice or tax advice. Readers are urged to consult with their own tax professionals regarding their tax decisions.

The Jobs Creation Act of 2004 (the “Act”) included this incentive to investors in the entertainment industry. Section 181 deals with the tax treatment of certain qualified television and film productions. While the incentives, described below, were scheduled to expire at the end of 2009, the recent tax bill “Protecting Americans from Tax Hikes Act” signed into law by President Obama on December 18, 2015, extended Section 181 to apply to the cost of any qualifying film and television production commencing before December 31, 2016.

Previously, the incentives offered under Section 181 only applied to films costing $15 million or less to produce. Under the revised Code, up to $15 million of production costs for qualified films may be immediately expensed under Section 181 regardless of the aggregate cost of the film. This $15 million can be increased to $20 million if a significant amount of the production expenditures are incurred in areas eligible for designation as a low-income community or eligible for designation as a distressed county or isolated area of distress. With respect to a television series, only the first 44 episodes of the series may be taken into account. The remaining cost of the film or television series would be recovered under customary amortization methods (e.g., income forecasting).

Thus, in order to understand the full impact of this option it is necessary for rudimentary understanding of how motion pictures, which are depreciable assets, are treated under the Internal Revenue Code. Normally when a capital asset is created, accounting practices and the revenue code require that the cost of the asset be amortized/depreciated over a period of time. Normally motion pictures are amortized/’depreciated using either the “income forecast” method or straight line depreciation. Under either method the cost of producing the film cannot be deducted in the year in which it is incurred. Typically depreciation does not begin until the capital asset is placed in service. For a motion picture this usually means when it is sold for exploitation, and that event usually occurs 12 to 18 months after production begins. So during that 12 to 18 month period the producing entity cannot depreciate or deduct the cost of the motion picture.

The principal benefit of IRC Section 181 is to allow the producing entity to immediately expense, i.e. write off, the entire cost of the production, in the year in which the money is actually spent.

Assuming that the production entity is structured to allow pass-through of the income or loss to its individual members, it is the individual shareholder or member who will have the deduction available to them when they file their tax return that year.

For taxpayers who meet the “material participation” test, i.e., a) who work more than 500 hours in the business; or b) do most of the work of the business; or c) work 100 hours in the business when nobody works more than 100 hours, such taxpayers can use the IRC Section 181 deduction against ordinary income.

The limitation on the Section181 expense deduction for taxpayers who do not materially participate in the business or trade of producing motion pictures is that it can only be used to offset passive income, i.e., rental income from real estate property and the like.

The analysis discussed below assumes that it relates to taxpayers who have passive income that they wish to defer and/or recharacterized.

So how does this benefit prospective investor?

The ability to expense the entire cost of a motion picture in the year that the money is spent can be used to advantage by certain taxpayers to defer or shelter income in a current tax year to a later tax year.

To illustrate, let’s assume that Joe/Jane Taxpayer (JT) in Tax Year One (TY1) has passive income and the amount of $1 million.

Let’s also assume that JT is in the highest US tax rate, i.e. 39.6%.

If JT does nothing they will be required to pay approximately $400,000 in tax on their $1 million of passive income.

Along comes independent film producer (IP), a single purpose pass through entity, who offers JT the opportunity to invest the $1 million of passive income in a motion picture. JT agrees, and invests $1 million to produce the film. JT becomes a member of an LLC which allows the profits or losses to pass through to JT individually. The money is spent and the film is completed in TY1.

When IP files its tax return for TY1 it makes an election under IRC Section 181 to expense the film. Since IP is a single purpose entity that has no other income, for TY1 it shows a one million dollar loss. This loss is passed through to JT via a K-1, and now JT is a deduction of $1 million to apply against the $1 million of passive income that JT received in TY1. The net effect of this transaction is that for TY1 JT pays no tax on the $1 million of passive income. An immediate savings of about $400,000 for JT.

In TY2 the motion picture is sold and begins to generate income for IP.

At least one commentator, (“Film Related Provisions of the 2004 Tax Act,” Schuyler M. Moore, Esq., Entertainment Law Reporter, Vol. 26. No. 5, Page 4, 6-7 (2004)), has concluded that it is possible for the film to qualify for long term capital gain treatment. Assuming the long-term capital gains holding period is met for this asset, the film is not treated as inventory, and the film is sold outright, the income from the sale of the motion picture will be taxed at 15%. The effect is to transform Ordinary Income into Long Term Capital Gains Income.

Assuming that the sale of the motion picture generates $1 million in revenue in TY2, that amount will be reported by IP when it files its tax return and on the K-1 given to JT.

Further assuming it will be taxed at the long term capital gains rate of 15%, or $150,000, (Plus Affordable Care Act Tax of 3.8%.). The net benefit to JT is as follows:

If JT had done nothing, they would’ve had a net of $600,000, i.e., $1 million – the $400,000 tax.

By investing in the movie, JT now has a net of $850,000, i.e., no tax was paid on the $1 million of passive income for TY1 since JT had deducted the $1 million expense of making the film in TY1. In TY2 the film generates $1 million of long term capital gains income which is taxed at 15%; $1 million -15%; ($150,000) equals $850,000.

The net gain to JT as a result of IRC Section 181 is $250,000.

Now let’s assume the same as the foregoing but with only $500,000 in revenue to IP.

In TY2 the film generates $500,000 of long term capital gains income which is taxed at 15%; i.e., $75,000, equals $425,000

The net loss to JT as a result of IRC Section 181 is $175,000, i.e., $600,000 the net if JT had not invested in the film, minus $425,000 sum from TY2 revenue, equals $175,000.

Here is should be noted that most films continue to generate revenue for many years. Even more so now since new delivery platforms, like Netflix, Hulu, Amazon and others have an insatiable need for content. Thus while under the $500,000 scenario JT is in a negative position inTY2, the film will continue to generate revenue and move JT towards break even and/or profit.

When this scenario is combined with a state/local production incentive, (tax credits/rebates) in the amount of 20%, or $200,000 JT has profit of $25,000, in TY2 and the promise of future revenue during the life of the film.

Additionally, if the requirements are met 9% of the future gross revenues from each Section 181 qualified film is non-taxable under IRC Section 199.

The foregoing illustration assumes that the revenue from the film in TY2 qualifies for long term capital gains. However, not all films are sold in a manner that will qualify for such tax treatment of the revenue. Assuming that JT is still in highest tax bracket when the film starts to generate revenue, JT will be taxed at that rate on the income as it is received by JT. However, in such an event, JT could again use IRC Section 181 (assuming it is available) to offset such tax liability or it is possible that JT may be in a lower tax bracket in TY2 and beyond. Under this scenario JT will have successfully shifted the income to a later year(s).

Moreover, JT will be a hit on the cocktail party circuit because they have their name up on the screen as a producer.

Daniel J. Coplan is a veteran litigator and transactional attorney with more than 30 years’ experience in intellectual property and entertainment related issues, having represented a range of clients from industry trade associations to individual content creators.