Film Production Costs

https://www.accountingtools.com/articles/film-costs

I have a client who invested several hundred thousand dollars into a film project. For several reasons (including the pandemic and subject matter) the film is likely to be a huge loss. There were three partners but only one with the capital. The original operating agreement outlined a return of investment and a 1/3 split on profit and losses. As this movie will likely never recoup the original capital investment, the LLC operating agreement is being amended to assign 100% of the losses to the only partner that invested capital and has basis to claim the losses.

I intend to amortize the costs based on an estimate of earnings. There is no readily available source to estimate future earnings, but $10k over 10 years might be generous. If I amortize this out over 10 years (at straight line just for illustration), it will generate significant losses on 40-50k a year.

They attempted to push the film at the festivals (Cannes, etc) when it was first completed and it picked up very little traction. It now has a distribution agent for both US and worldwide audiences, but that agent is not able to come up with an earnings estimate. The total worldwide earnings for 2021 were not even enough to cover the agents out of pocket expenses.

1, does amending the LLC operating agreement to allow the only partner with basis to take the losses pass the sniff test?
2, does assigning a rather arbitrary estimate on lifetime earnings also pass the sniff test?
3, any exposure to hobby losses limitations here?

The whole project seems up and up, just happened to have some terrible timing and subject matter related to current events that unfolded over the last couple years.

Would you handle this any differently?

Partnership agreements can be amended up until the original due date of the return. And they can be amended annually as agreed to by the partners.

Would section 181 apply? Or 168(k)?

https://www.thetaxadviser.com/issues/20 ... ments.html

Sounds like you are doing the income forecast method by wanting to amortize over 10 years.

You don't have to use the income forecast method if 75% of the costs to make the film were in the USA.

YOu could elect Section 181; i would check and see if the state allows for Section 181.

Under income forecast method you just use your best estimate for what the income will be over 10 years.

One thing want to be careful of is you always want some revenue coming in b/c if one year there is 0 revenue
and let's say your expected income is 10k; then there is no depreciation as 0/10 * your film production costs = 0

Rather arbritrary estimate on lifetime earnings does pass teh snuff test....we're only talking about 10k anyway

Further, perhaps you want to use Section 181 if you can.

I don't see an issue with hobby loss...someone gave a sizable amount of money to make a film in the hopes of making a profit.

Predominance of independent films lose money; doesn't mean people aren't investing hoping to make a profit.

I'd only use the income forecast method if i had to...otherwise i would use Section 181

If you opt for Section 181; see the code for the election information you need to provide. You are electing Section 181;
it's just not given to you.

I hate to throw in anything negative, but is there a chance that this will be seen as an investment, rather than a trade or business, and the loss is capital?

someone made a capital contribution to a partnership.

if that person is not active in making the film; he/she has a passive loss

That’s even worse unless can sell the partnership because stuck with suspended loss! Most TPs don’t have any passive income.

If they are treating it like a business, etc, etc then the hobby loss rules don't necessarily apply. The original case is Storey v. Commission of Internal Revenue, but I think there was a follow up sometime that I can't find easily.

I would suggest making a 181 election. My experience with this situation the client decided not to, but they were a non-profit so it hardly mattered anyway. After a couple of disappointing years they just claimed remaining future income at 0 and wrote the asset off as useless.

mlauber...that's how it works if you make a passive investment...you could always sell or abandon your interest if you want to take the passive loss

z128, I think that’s what I said!

The 181 election has to be made in the first year of production, 181(c)(1).

Thank you for all the comments.

Section 181 is out, as the production actually started (entity formed) back in 2012.
All of the costs were capitalized for when the film was eventually sold. The film was never picked up by a major distributor so they went another route to try and salvage some of the money invested.

All partners were "active" in the entity. The main investor/partner is a videographer (by trade/day job), and the two other partners I would best describe (for this specific purpose) as actors who had parts in the film.

None of the partners would be described as "high income" by any means. If the total costs were written down in a single year it would generate a sizeable NOL, and my fear is the large loss and resulting refunds on the personal return would potentially trigger increased audit exposure.

Excellent point about receiving no income for a given year in relation to the estimate.

Pub 964 - page 10
Films, videotapes, and recordings. You cannot use MACRS for motion picture films, videotapes, and sound recordings. For this purpose, sound recordings are discs, tapes, or other phonorecordings resulting from the fixation of a series of sounds. You can depreciate this property using either the straight line method or the income forecast method.

Now I'm just having trouble narrowing down the "useful life" of a film that is now available in a "pay-per-view" type streaming environment.

It would be no longer than copyright, but that's not really a useful answer.

With income forecasting I believe you have to right to change the total forecasted earnings, so after 2 years you could just plot a straight line decline to arrive at total earnings for the film.

I am thinking of classifying the film production asset as a 10 year asset and taking straight line depreciation.
This will generate a depreciation expense in the 45-50k/year for the next 10 years, and we would have to file entity tax returns for that whole time.

A 5 year life is likely more plausible, as far as any income expectations, but this would generate a sizeable depreciation expense, and almost completely offset actual earnings in any given year, and result in large refunds.

Any opinions either way on actual life of a move that costs half a million but only produces a couple thousand in income?

Is there a debt restoration obligation in the OA? Can the partnership even allocate any loss to the zero basis partners with economic effect?

Operating agreement has been amended to allow the money partner to claim 100% of the losses.

The other 2 partners have historically received K-1s showing trivial losses that were non-deductible because of the basis limitations.

Is using a 10 year life an option? I thought that film was depreciated either over 5 years or using income forecast method.

I was able to determine that income forecast or straight line were the only acceptable methods, but for the life of me cannot find any resource on the useful life when using straight line.

If you have a source showing 5 year is the acceptable useful life for film costs, I will happily use that.

Nothing authoritative. I did a quick Google search while reading this thread and found the link below. The discussion is not necessarily consistent with my understanding, which is that the choice is straight-line (over some life) or income forecast. The second option discussed below for writing off the cost seems to be for film that is treated as inventory (i.e., held for sale at Blockbuster). Of course, inventory and a depreciable asset are two different things.

Also, I just reread #1, and am now more suspicious of the reliability of this article. It seems to suggest depreciating first year costs before the film is placed in service.

http://www.chucksloan.com/filmmaking.html

The essential lesson is that there are two ways to write off any film making expenses:


1) You can amortize (depreciate) the expenses during the years they are created over a five year period. In other words you are supposed to take the entire year’s expenses and equally distribute the costs over five years. If you spent $10,000 then you can write off $2,000 a year over the next five years. If you incur additional expenses in the following year, then that amount must be written off in a similar manner.

EXAMPLE:

Let’s say you spent $10,000 in the first year and then $5,000 in the second year to complete and market the film. The amount you can write off in each year is as follows.

· Year 1: $2,000 (20% of the original $10,000).

· Year 2: $3,000 (another 20% of the original $10,000 and $1,000 of the $5,000).

· Year 3: $3,000 (same as year two)

· Year 4: $3,000 (same as year two and three)

· Year 5: $3,000 (same as years 2,3 and 4)

· Year 6: $1,000 (The entire original expense is now gone and all that remains is the final amount from year 2 expenses.)

For most small filmmakers this is a fairly unusable manner to make use of the expenses because they need to re-coup their total costs as quickly as possible.
Therefore most small filmmakers use the following scenario:

2) You are allowed to write off the TOTAL of the film’s expenses in the year that the film is available for sale, assuming you have made attempts to get it distributed. Bear in mind, if you don’t make any attempt to actually sell the film then the IRS has the right to argue that the film was not a profit making expense and it is not acceptable as a business write-off. Understandably you may not actually sell the film, but you have to be able to prove you made the attempt. Showcasing the film at competitions and in other mediums would be justification of your attempts to sell the project.

Using a two year scenario, assuming you finished and marketed the film by the end of the second year, you could then write off the FULL $15,000 on your return in that year. In other words, by holding onto all the expenses until the film is completed, you will gain the full rewards of those deductions in a shorter period of time (versus a five year depreciation).