Using Tax Incentives to Mitigate Investment Risk in Film Projects

The tax laws and legislation of the United States, and of individual states is constantly changing. The information presented here is a general guideline on the structuring of projects for informational purposes only. Consult legal and tax professionals for specific advice related to individual projects.

The original version of this article posted on Medium in 2019 has been updated to reflect changes in the US Tax code. In December of 2020, Congress extended Section 181 through 2025.

There is no getting around it, in general films are a bad investment. According to Arthur De Vany, Professor Emeritus of Economics at the University of California, 78% of studio movies lose money. And that’s studio movies, not even independent films where the odds are even worse. And many filmmakers will say they don’t care about the profitability of films, that are in it for the art, not the business. But filmmaking is an expensive art and money is needed to pay for talent, crews, equipment, and all of the other things that go into production. So, even if the filmmaker doesn’t care about the profitability of the project, the people who are going to be asked to invest will care.

The project may have a great pitch and get an investor interested who shares the passion of the filmmakers, but at one point the investor or one of their financial advisors will ask about the risks and returns of the project. The filmmaker can try to point to small budget films that went on to make large sums of money, like Get Out and The Blair Witch Project. Most people know the chances of you having those same kinds of results is akin to buying the winning lottery ticket. While it is possible, it isn’t very likely.

Even if you can’t show that your film will be wildly successful and make your investor rich, they may still be interested. Again, they may share your passion for the project, or they may just be interested in having their name on IMDb to brag about at cocktail parties. But they will want to minimize what money they stand to lose. In financial circles, this is referred to as Value at Risk (VaR) and is a measurement often used to determine the extent and possibility of losses in an investment. By lowering the VaR of the project, it will be easier to raise investment into the film project.

How does one lower the risk of an investment without being able to guarantee that your film will be a hit? There are some possible paths to lock-in revenue such as pre-sales and minimum guarantees, but these are not available to most filmmakers, and even if they are, often fall short. So, instead, the focus can be on a path that is open to all filmmakers: tax incentives and credits offered at the federal and state government levels. These incentives and credits, when properly handled, can lower an investor’s exposure by as much as 72%

Before we get into the specifics, we need to take a step back and look at the way the tax code treats the creation of a film. The tax code generally treats the creation of a film the same as the creation of a building or any other asset; it is an asset that is capitalized until it is put into use and then depreciated over its useful life. This means that when money is invested and spent on the creation of the movie, no expense is recognized. The asset remains on the books until it is used or sold. Then when the asset is used or sold, it is depreciated, which means the value of the asset is lowered in a systematic and rational way and an expense is recognized. In 2004, the Jobs Creation Act included an incentive to invest in the entertainment industry, called Section 181. This section of the tax code changed the treatment of how costs were capitalized and/or expensed for certain qualified television and film productions. This change allows a production to expense all production costs as incurred instead of capitalizing and depreciating the costs over the life of the asset. This section had been allowed to expire, but was renewed in December 2019 and is now applicable to productions commencing before December 31, 2020.

Many film projects are created through the use of a single purpose entity, meaning a company that was created solely for the production and distribution of the film. These single-purpose entities are often set up as pass-through entities (S-Corporations or LLCs) meaning that any profit or loss that the company has is recognized by the owner/investor directly on their personal tax filings. So, if the pass-through entity experiences a loss of $1.00, that lowers the taxable income of the owner/investor by $1.00. Assuming the owner/investor is at the highest tax bracket of 37%, then that $1.00 loss offsets $1.00 of income, saving the owner/investor $0.37. By using the bonus depreciation, the company is able to increase the expenses of the company, passing those losses through to the owner/investor, helping them to offset other income and lowering their tax liability.

But the federal government isn’t the only level of government that incentivizes the film business. Approximately 40 states offer some form of tax or financial incentives to film production. Many of these incentives are in the form of tax credits. Many of these credits are rebateable, which means that the state government will issue you a check based on the money you spend. In others, there are markets created where other entities with state tax liabilities can purchase the tax credits from you. (For the purposes of this article, we will use Louisiana as our example state, although many other states would be similar.)

In Louisiana, if the investment in the film project is greater than $300,000 then up to 40% of the spend is eligible to be returned in the form of a tax credit. (25% base credit, 10% increase for Louisiana screenplay, and 5% increase if outside of the New Orleans metro area). The State of Louisiana will also offer to buy back the credit at 90% of face value, with a 2% transfer fee charged. This means that for every $1.00 of the tax credit, you get $0.88. Taking it a step further, that means that for every $1.00 you spend in Louisiana, you get a $0.40 tax credit that turns into $0.352 cash. Now, there are limitations on exactly what costs qualify for the credit, but for the purposes of our example, we will assume we smartly plan our spending so that all $1,000,000 of costs qualify.

By means of an example let’s assume that we are looking to raise funds to produce a film that will cost $1,000,000.

In Tax year 1, a single-purpose entity is created for this project that is set up to be taxed as a pass-through entity and raise $1,000,000 of equity investment from an investor who has a large amount of passive income to offset. The $1,000,000 is spent to create the film.

As we spend money to create the film we are allowed to treat those expenditures as expenses. Assuming the film makes no other material revenue or incurs any other material expenses in Tax Year 1, our single purpose entity has a $1,000,000 loss that passes through to our investor. This loss offsets $1,000,000 of passive income that the investor earned from other investments, effectively saving him $370,000 in taxes.

In addition, the $1,000,000 spent on qualified costs in Louisiana in Tax Year 1, resulting in a $400,000 tax credit that we then sell back to the state for $352,000 (after transfer fee). This money is received based on the fact that money was spent in the state, and the quality of the film and potential future sales do not impact this number.

So, how does this all look to the investor?

In Tax Year 1 he gave us $1,000,000, meaning he is at an exposure of $1,000,000, having written a check for that amount. The money spent to create the film is able to be expensed as incurred and the investor gets to show a $1,000,000 loss on their tax returns, saving $370,000 of tax liability. The company also earns and sells the tax credit, receiving $352,000* that passes through to the investor, leaving his exposure now at $278,000 before a single unit is sold. This means that if the film never makes another dollar, the investor will lose at most $278,000

In Tax Year 2 (or future tax years), The film may sell and the company will earn revenue. If the film sells for $1,000,000 (the original cost of the film, meaning the film is not profitable), then the investor receives $1,000,000 of taxable income. Assuming he pays the full 37% tax rate on this income, he gets a net of $630,000. But, it is possible for the investment to be treated as a long-term capital gain, either through qualifying the film itself as a long-term capital investment or the sale of the company as a whole. In this case, the tax rate would only be 20%, so the $1,000,000 income would net $800,000. The investor’s exposure of $278,000 results in receipt of $630,000 or $800,000.

But what if the film is a dud. After all, Arthur De Vany said that 78% of studio films lose money so chances are that our independent film will lose money too. Let’s assume the film sells for $500,000, half of what was spent to create it. This $500,000 is given to the investor as taxable income, which at the full tax rate of 37% results in him having $315,000 to spend. This $315,000 plus the Louisiana tax credit of $352,000 plus the original tax savings of $370,000 means the investor is receiving value of $1,037,000 on a $1,000,000 investment.

So, if the film never makes any revenue, the investor loses at most $278,000, their Value at Risk (VaR). Using tax incentives and credits to lower the VaR of the project, the filmmakers are able to show investors that they are only risking a few hundred thousand dollars in order to make a few hundred thousand dollars if the film just covers costs, while there is still the huge upside potential of the film being the next runaway hit.

And no matter how well or poorly the film has done, they will still be able to have the benefits of having supported a project they were passionate about (and have the IMDb credit to brag about to their friends).

*There may be a tax liability associated with the receipt of the state tax credit for the investor.