On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the "Act"), which is the most significant revision to our nation's tax laws since 1986. Although the legislation is intended to simplify the tax laws, some of its provisions may leave clients with more questions than answers. Set forth below is a brief summary of some of the relevant provisions for entertainment companies and talent.
Production Cost Recovery
The following provisions will impact how production companies recover their production costs:
- Capitalization of Production Costs. Prior to the Act, a production company (or other taxpayer that creates a copyright) that was not eligible or able to deduct production costs immediately (i.e., by making a Code Section 181 election) was required to add its production costs to the tax basis of the resulting property (e.g., a copyright) and recover the cost over time using the income forecast method. Under the Act, if a taxpayer satisfies a $25 million gross receipts test, the taxpayer is not required to capitalize its production costs.
- Immediate Deduction of Production Costs. Prior to 2017, production companies generally were eligible to deduct, when incurred, qualified production costs for film, television, and live theatrical productions by making a Code Section 181 election, which limited the deduction to the first $15 million of certain U.S.-based qualified production costs ($20 million in certain circumstances). Although the Act did not renew Code Section 181, the Act added a bonus depreciation provision that generally allows taxpayers to deduct 100% of qualified production costs for film, television, and live theatrical performances in the tax year in which the production is placed in service. The key distinctions between Code Section 181 and bonus depreciation are (i) the timing of the deduction (bonus depreciation may not be claimed until the asset is "placed in service") and (ii) the removal of the deduction limit.
Deduction for Qualified Business Income
Under the Act, sole proprietors, partners in a partnership, and shareholders of an S-corporation (but not C-corporations) may be eligible to deduct up to 20% of such taxpayer's qualified business income with respect to a qualified trade or business. In other words, an owner of a qualified business may be eligible to pay taxes on only 80% of such pass-through business income. This benefit, however, may be reduced if the company does not pay sufficient W-2 wages (under the Act, the deduction is the lesser of 20% of the taxpayer's qualified business income or a W-2 wage limit that is calculated based on the amount of W-2 wages with respect to the qualified business).
Can a business using pass-through structures, such as loanouts, production companies, agencies, or other entertainment business, qualify for this deduction? Based on the statutory language of the Act, pure loanout companies, whether for "in-front-of-camera" or "behind-the-camera" talent, may not be eligible for the tax benefit unless the total taxable income of the entertainer is below a specified threshold amount.
Other types of entertainment businesses, however, may be eligible for the deduction if the principal asset of the business is not the reputation or skill of its employees or owners. This "principal asset" determination will be the subject of much analysis, especially for such clients as production companies, management companies, talent agencies, licensing companies, etc., which have substantial outside activities and assets (such as goodwill) other than the reputation or skill of their employee/owners. In order to be eligible for the qualified business income deduction, clients may need to restructure their existing companies to increase their chances of success (e.g., loanout companies may need to be rolled into the master production company). In addition, because of the W-2 wage limitation noted above, clients that are tax partnerships may be motivated to restructure their business to generate more or additional W-2 wage income. Consideration will need to be given to maximizing the deduction in the event that clients have multiple pass-through businesses with significant payrolls.
Limitation on Active Pass-Through Losses and Net Operating Losses
For taxable years beginning after December 31, 2017 and before January 1, 2026, use of active pass-through losses by a sole proprietor, partner, or S-corporation shareholder generally is limited to $250,000 (or $500,000 if married and filing jointly). Any disallowed loss is treated as a net operating loss, which, under the Act, may be carried forward indefinitely, but may no longer be carried back. The carryforward, however, generally may only offset up to 80% of taxable income in any given tax year. This new legislation generally will impact any entertainment business that generates losses in excess of the threshold. There are also questions regarding the full carryforward of NOLs from 2017 or earlier.
Increase in Gross Receipts Threshold for C-Corporations Required to Be on the Accrual Method
Prior to the Act, a C-corporation loanout (not generally applicable to loanouts for actors, athletes, or performing artists) was forced to convert from the cash method to the accrual method of accounting if the C-corporation's average annual gross receipts over the immediately preceding three years exceeded $5 million. Under the Act, this $5 million average gross receipts threshold has been increased to $25 million for tax years beginning after December 31, 2017, subject to adjustments for inflation over time. This is good news, as the $5 million threshold was often inadvertently crossed and loanouts did not know that they had been forced to the accrual method of accounting. If a C-corporation loanout or other entertainment company was previously forced to convert to the accrual method of accounting under the $5 million gross receipts test, but has not exceeded the $25 million gross receipts test, the loanout may want to consider converting back to the cash method of accounting.
Choice of Entity Considerations
Does the reduction of the corporate tax rate from a 35% maximum rate to a 21% flat rate justify converting an S-corporation loanout company to a C-corporation, after taking into account the entity-level federal deduction for state income taxes paid and assuming that a preferential qualified dividend rate applies? Although there may be other reasons for using a C-corporation, based on the new rates, it appears that individual taxpayers in the highest tax brackets who are residents of California for income tax purposes should still have a better overall effective tax rate when using a structure other than a C-corporation. Should the talent use an LLC or S-corporation separate from his/her loanout company for endorsement deals? This will depend on whether the talent can avail him/herself of the deduction for qualified business income described above.
Meals and Entertainment Expenses
For tax years beginning prior to December 31, 2017, taxpayers generally were able to deduct 50% of the cost of meals and entertainment directly related to the active conduct of such taxpayer's business. Under the Act, for tax years beginning after December 31, 2017, taxpayers may continue to deduct 50% of meal business expenses through 2025, but may no longer deduct entertainment expenses (such as sports season tickets or premier parties) related to the active conduct of the taxpayer's business.
Limit on State and Local Income Taxes
Under the Act, individuals generally are limited to a $10,000 deduction for state and local taxes. This change makes state income taxes much more expensive (because of the lack of a meaningful federal tax subsidy) and may motivate certain entertainers/talent to migrate to lower state-tax jurisdictions.
Disallowance of Employee Business Expenses
Under the Act, employee business expenses can no longer be claimed as a tax deduction. For the unincorporated entertainer/talent, this can be a huge loss, because of the very substantial level of professional fees (e.g., agents, personal manager, business manager, entertainment attorney, etc.) that are typically incurred. Loanout companies generally are permitted to deduct these costs "off the top," and, for that reason, we expect that more entertainers/talent will form loanout companies, even at lower income levels. We also expect that there will be a renewed emphasis on the possible use of "executive loanouts" for executives who are also producers.
Prior to the Act, accrual method taxpayers generally could defer advance payments for entertainment services until the next taxable year pursuant to IRS Revenue Procedure 2004-34. This technique is particularly beneficial for production companies that receive up-front overhead payments or distribution advances from an unrelated party, allowing the production company to defer the recognition of such payments to the next tax year to line up with the production expense. Prior to the Act, it was clear how to change to this accounting method for advance payments, but it was not entirely clear how a taxpayer would adopt this method. The Act generally codifies IRS Revenue Procedure 2004-34 and tasks Treasury with the authority to issue guidance on how to make the election to defer advance payments, which we expect will clarify how a taxpayer should go about adopting the deferral method election.
International Tax Implications
There are a number of international tax provisions included in the Act that may change how talent should engage in outbound international tax planning through their loanout companies (e.g., determination of foreign tax credits under the new tax regime). There are several international tax provisions affecting non-loanout U.S. entertainment companies that operate as C-corporations. These include an exemption for non-subpart F dividends paid by certain foreign corporations to U.S. C-corporations, which is coupled with a one-time deemed repatriation of earnings of certain foreign corporations. Also of note is a deduction available to U.S. C-corporations for certain intangible income derived from foreign markets. This provision provides an incentive for U.S. entertainment companies to maintain IP ownership in the United States and conduct foreign operations through corporate subsidiaries rather than pass-through entities. For more details on these and other relevant provisions, read Venable's Tax Reform Update.
Changes Considered, but Not Passed
During the legislative process, various proposals were made that ultimately were not included in the Act—for better or worse. For example, Code Section 409A, the alternative minimum tax (AMT), and the election to achieve capital gain from the sale of self-created music copyrights were each proposed to be repealed under prior versions of the bill, but were both retained in the Act.