On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (“TCJA”) into law. The TCJA is one of the most sweeping pieces of tax reform in recent history.

It revamped and reduced individual and corporate tax rates, eliminated or limited many familiar itemized deductions, and introduced new business-friendly tax provisions designed to benefit corporate and non-corporate businesses.

The entertainment industry is among the businesses that will realize immediate and significant tax savings from TCJA. Two of the most entertainment industry-friendly tax breaks will be addressed in this article.

100% Deduction For Production Costs

One of the most striking changes introduced by the TCJA is the tax treatment of production costs for film, television and live theatrical productions.

Prior to the TCJA, a production company that produced a motion picture or television show could not immediately deduct such costs, but rather was required to include production expenses in the “tax basis” of the property and amortize them over the projected period the film or TV show would generate revenue (known as the “income forecast method”).

This was at best an imprecise way of computing the annual deduction for production costs, and required restating based on the actual revenue stream over a period of years.

A major – and now repealed - exception to income forecast enabled production companies under Internal Revenue Code (“IRC”) Section 181 to elect to deduct, when incurred, up to the first $15 million for U.S.-based qualified production costs ($20 million for production costs incurred in certain low-income or distressed areas). Any production costs not eligible for Section 181 treatment remained subject to the income forecast method of cost recovery.

In a huge tax break for the entertainment industry, the TCJA introduced revised IRC Section 168(k), a new bonus depreciation for new or used “qualified property” acquired after September 27, 2017 that is placed in service after that date.

The term “qualified property” includes most tangible personal property, computer software and property which is a “qualified film or television production” or “qualified live theatrical production.”

The new IRC Section 168(k) incorporates the definitions of the old IRC Section 181 as to what constitutes a “qualified production.”

Specifically, a “qualified film or television production” requires that 75% of the total production compensation be for services performed in the U.S. by actors, production personnel, directors and producers (“qualified compensation”).

A “qualified live theatrical production” is a live stage production of a play (including a musical) by a taxable entity in a venue or series of venues with audience capacity not exceeding 3,000, provided 75% of the total compensation is “qualified compensation.”

The key differences between old IRC Section 181 and new IRC Section 168(k) are:

  • the Section 181 election was subject to the $15/$20 million limitation, while qualified production costs under Section 168(k) are 100% deductible (without any other ceiling); and
  • costs were deductible under old Section 181 when incurred, while bonus depreciation under Section 168(k) requires “qualified property” be placed “in service,” which for a qualified film or television production is the time of initial release or broadcast.

But the ability of production companies and studios to deduct 100% of production costs for films and television programs that are qualified property should generate considerable tax savings, particularly for the larger studios where film budgets frequently exceed the old Section 181 limits.

For smaller independent production companies that are frequently limited liability companies which pass through income and deductions to their members, any losses generated by the expensing of production costs under Section 168(k) would typically be “passive,” and are generally deductible when either such production companies generated “passive income” or the individual members had “passive income” from other activities to absorb such losses.

The 100% allowance under Section 167(k) is subject to a 20% per calendar year phase out, beginning for property placed in service after 2022. But new Section 168(k) nonetheless affords many production companies and studios an immediate and substantial tax-saving ability to recover their production costs.

Deduction For Pass-Through Income

A much-ballyhooed provision of the TCJA introduced a flat tax rate of 21% for C corporations for taxable years after 2017.

In an effort to provide some tax relief for businesses not operating as C corporations, which include sole proprietors, partnerships, most limited liability companies and S-corporations, the TCJA lets such taxpayers deduct up to 20% of certain domestic “qualified business income” (“QBI”) under new IRC Section 199A.

A qualified trade or business’s deductible amount is generally the lesser of (i) 20% of the taxpayer’s QBI from the trade or business; or (ii) a W-2 wages/qualified property limit. That limit is the greater of (a) 50% of the W-2 wages of the trade or business; or (b) 25% of the W-2 wages of the trade or business plus 2.5% of the unadjusted basis of all qualified property (depreciable property used in the qualified trade or business).

This W-2 wages/qualified property limit does not apply to married taxpayers filing jointly whose taxable income doesn’t exceed $315,000 or other taxpayers whose taxable income doesn’t exceed $157,500 (adjusted for inflation after 2018). These limitations get phased in for taxpayers whose taxable income exceeds these thresholds but is not more than $415,000 for a joint return or $207,000 for other returns.

Taxpayers falling within this phase-in range are not subject to the W-2 wages/qualified property limit, but the amount of such taxpayer’s QBI eligible for the 20% deduction gets reduced by a “reduction amount” determined under a rather complicated formula.

Under IRC Section 199A, for each “qualified trade or business,” QBI equals the net amount of a business’s “qualified items” of income, gain, deduction and loss. To be “qualified,” such items must be included or allowed in the determining taxable income for the tax year and be effectively connected with a trade or business conducted in the United States.

The new IRC Section 199A deduction cannot exceed a taxpayer’s taxable income (reduced by net capital gain). In addition, the QBI deduction gets phased out for “specified service businesses” based on taxable income computed without the IRC Section 199A deduction. This phase-out range is $315,000 - $415,000 for married taxpayers filing jointly and $157,000 - $207,500 for all other filing statuses.

The effect of this phase-out is to reduce and ultimately preclude the IRC Section 199A deduction based on taxable income for a service business owner which is within the phase-out range.

The term “specified service trade or business” includes services rendered in the performing arts and any trade or business where the principal assets of such trade or business is the reputation or skill of one or more of its employers.

Accordingly, the QBI deduction will be limited or not available for talent whose income is within or exceeds the phase-out range. So most successful actresses and actors, who typically use a loan-out “S” corporation to provide their services to production companies, won’t get the IRC Section 199A deduction.

However, the “performing arts” exclusion should not preclude production companies producing their own content or distribution companies distributing such content from availing themselves of the QBI deduction.

Since the QBI deduction is also a function of W-2 wages paid to employees and the unadjusted basis of depreciable property held by the business, production companies may be motivated to increase W-2 wages and treat service providers previously classified as independent contractors as W-2 employees in order to maximize the allowable IRC Section 199A deduction.

Is It Oscar Time for the IRS?

The ability to fully expense film, television, live theatrical and production costs and for many businesses to take the QBI deduction should generate significant tax savings for the entertainment industry.

Perhaps the Academy of Motion Picture Arts and Sciences should consider creating a special Oscar for the IRS based on the TCJA tax benefits that will put a smile on the face of Hollywood!

By Michael R. Morris