'Participation' Payments Are Compensation

(1) Are the deferred contingent compensation arrangements providing for participation and residual payments covered by section 404(a) and (d) of the Code? If so, is the deductibility limited to the amount includible in income of the recipient?

(2) How does Transamerica Corp. v. United States, 999 F.2d 1362 (9th Cir. 1993) affect the analysis in (1)?

(3) Does section 404(d) of the Code apply to payments for participations that are made to a personal service corporation formed by an actor or director (a "loan out" corporation)?

(4) Does the "2 1/2 month rule" of Treasury Regulation section 1.404(b)-1T apply to each contract entered into with a producer, director, actor, or other service provider that provides for payments of participations?

(2) The Transamerica case did not address section 404 and the taxable years in issue in that case were prior to 1984. For years subsequent to the effective date of the 1986 amendments to section 404, section 404 applies to participations.

(3) The applicability of section 404(d) to participation payments made to a personal service corporation would depend upon the particular facts and circumstances surrounding the arrangement. Section 404(d) would apply to a "plain vanilla" personal service corporation -- i.e., a personal service corporation that acts in the nature of an agent for its principal, the individual service provider, in receiving the participation payments, but does not itself provide services apart from those of its principal.

(4) The "2 1/2 month rule" of Treasury Regulation section 1.404(b)-1T provides that section 404(a) applies to an arrangement under which compensation is received after the 15th day of the 3rd month after the end of the employer's taxable year in which the related services are rendered. For purposes of the 2 1/2 month rule, each participation payment is analyzed separately to determine whether it is received within the 2 1/2 month period. Whether the services provided by an actor, director, or other service provider in a particular taxable year were performed pursuant to contract or several different ones would not affect the application of that rule.

[4] Under the income forecast method, the taxpayer estimates the total net income a film will generate over its entire lifetime. Each year's depreciation deduction is then limited to a portion of the film's total cost that is determined by dividing that year's income by the total projected income of the film. This annual deduction limit may be expressed in a formula: the cost of the film multiplied by a fraction, the numerator of which is the income from the film for the taxable year and the denominator of which is the total forecasted income. Net income is defined as the gross receipts from the film, less distribution expenses. Durkin v. Commissioner, 87 T.C. 1329 (1986); see also Rev. Rul. 78-28, 1978-1 C.B. 61. Income and expenses from multiple films may be aggregated each year. Transamerica Corp. v. United States, 999 F.2d 1362 (9th Cir. 1993).

[5] The income forecast method of depreciating motion pictures and television films is described in Rev. Rul. 60-358, 1960-2 C.B. 68. Section 1604 of the Small Business Job Protection Act of 1996 (P.L. 104-108) added section 167(g) of the Code, which codifies many of the pronouncements of the Service regarding the income forecast method and is effective for property placed in service after 9/13/95.

PARTICIPATIONS AND RESIDUALS

[6] In the motion picture industry, the fees paid to producers, directors, actors, and others for their services are comprised of both a flat fee and a percentage of the film's future net profits or gross receipts. These percentage payments are known as "participations." Additionally, under various collective bargaining agreements, the producer is obligated to pay director and writer guilds (which represent writers, directors, actors and others) "residuals," which are a percentage of revenues received from the television exhibition of a product. Generally, the producers, directors, actors, and others receiving participations are not employees of the payor, but rather are independent contractors. often, a personal service corporation formed by a producer, director, actor or other service provider receives the participations on behalf of that service provider.

[7] In Transamerica, the Ninth Circuit considered whether the taxpayer, in computing the basis for each film produced, could include estimated participations and residuals. The Service, citing section 1012 of the Code, argued that the participations were contingent liabilities that could not be taken into account in determining depreciable basis until they became due and payable. The Ninth Circuit ruled that participations and residuals are "clearly costs of producing the film and not expenses incurred in the distribution," and that these items are properly included in the cost component of the income forecast formula. Transamerica did not consider the deferred compensation aspects of participations and residuals, and therefore did not address the application of section 404. The taxable years at issue in Transamerica were 1971-1973.

[8] Section 404 states, in pertinent part:

[10] There appear to be two reasons why section 404 was not raised in Transamerica. First, prior to the addition of section 404(d) by the Revenue Act of 1978, section 404 applied only to deferred compensation of employees. Second, prior to amendment of section 404 in 1986, section 404 was limited to "expenses which would be deductible under section 162 (relating to trade or business expenses) or 212 (relating to expenses for production of income) . . . ." Reg. section 1.404(a)-1(b). A motion picture is a capital asset, and the costs of its production are capital expenditures generally recovered under the income forecast method over the useful life of the film. Accordingly, production costs, including compensation paid to actors, directors, writers, etc., represent capital expenditures recoverable by depreciation deductions under section 167 rather than expenses deductible under section 162. Thus, prior to the 1986 amendment, it appears that section 404 was irrelevant to compensation included in film production costs for depreciation under the income forecast method.

[11] Participations are a form of compensation, because they are payment to the actor, director, or other service provider for rendering a service to the payor. Residuals, on the other hand, are not necessarily compensation for services performed. As we understand it, a collective bargaining agreement sets forth conditions under which residual payments will be made, and the residual payments are a pre-set percentage based upon film profits. The residual payments are made to the guild of which the individual who provided the service giving rise to the obligation to make payment is a member, and the guild does not turn any part of the residuals over to the member; nor does the recipient guild confer any benefit upon the member as a result of the residual payment. Thus, residual payments might not be compensation for services. However, we note that the determination of whether a residual payment is compensation would be based upon all facts and circumstances. ¹ Accordingly, for any particular case, we suggest that field personnel submit a request for technical advice to our office so that we can prepare a response based upon the particular facts of that case.

[12] For years prior to the effective date of the 1986 amendments to section 404 of the Code, the language of section 404 appears to have precluded its application to participations. ² For years after the effective date of the 1986 amendments, it is clear that section 404 would apply. ³

[13] The Senate Committee Report on the 1986 amendment of section 404 states:

[14] Thus, for tax years after the effective date of the 1986 amendments, participations that are paid directly to employees would generally be governed by section 404(a)(5). Under section 404(a) and (b), a contribution paid or incurred with respect to a nonqualified plan, or method or arrangement, is deductible in the taxable year of the employer in which or with which ends the taxable year of the employee in which the amount attributable to the contribution is includible in the gross income of the employee (without regard to any applicable exclusion under chapter I, subtitle A, of the Code).

[15] Deduction for payment of participations to individual independent contractors would generally be governed by section 404(d), so the result is the same as for participations paid to employees.

[16] While we conclude that section 404 applies to participations, and that therefore participations are not deductible by the taxpayer prior to the year in which they are includible in the gross income of the recipient, we have not yet determined how section 404 might interact with section 167 in this context. One approach would be that participations and residuals are includible in the cost basis of films for purposes of the income forecast method of calculating depreciation deductions under section 167 at the time that they become deductible under section 404. However, we are not prepared at this time to say that such a conclusion is required. Rather, we will be happy to work with Passthroughs and Special Industries in resolving this issue.

PAYMENTS TO CORPORATE SERVICE PROVIDERS

[17] Whether participations paid to a corporate service provider are governed by section 404 is a more complex issue. In this regard, the legislative history of the addition of section 404(d) by the Revenue Act of 1978, P.L. 95-600, indicates that Congress did not intend to limit section 404(d) to compensation paid to individuals:

[18] In view of the scant authority, the applicability of section 404 to participation payments made to a corporate service provider would depend upon the particular facts and circumstances surrounding the arrangement, including the specific contract provisions relating to the participation payments, the nature of the services provided by the corporation and the individual workers, and the extent to which the corporation may be acting in the nature of an agent for the individuals in receiving the participation payments. Accordingly, for any particular case, we suggest that field personnel submit a request for technical advice to our office so that we can prepare a response based on the specific facts of that case. Generally, we believe that section 404(d) would apply to a "plain vanilla" personal service corporation -- i.e. a personal service corporation that acts in the nature of an agent for its principal, the individual service provider, in receiving the participation payments, but does not itself provide services apart from those of its principal.

APPLICATION OF THE "2 1/2 MONTH RULE"

[19] Pursuant to Regulation section 1.404(b)-1T, Q&A-2, section 404(a) applies to an arrangement under which COMPENSATION IS RECEIVED after the 15th day of the 3rd month after the end of the employer's taxable year IN WHICH THE RELATED SERVICES ARE RENDERED. (Emphasis added). Thus, the application of the "2 1/2 month rule" is based upon the taxable year in which the services giving rise to the payment of the compensation are rendered, and when the payment is received.

[20] You have asked whether the "2 1/2 month rule" of Treasury Regulation section 1.404(b)-1T applies to each contract entered into with a talent that provides for payments of participations. In conversations with Janet Laufer of this office, you have explained that your question relates to whether, when a series of participation payments are made based upon the same contract, all of those participation payments are considered deferred compensation if one of the payments is paid after the end of the 2 1/2 month period. For purposes of section 404, each participation payment would be analyzed separately to determine whether it is deferred compensation. The determinant factor is when the participation payment is received. For example, if a producer with a calendar taxable year made participation payments to an individual actor on February 28, March 31, and April 30, 1998, for work performed during 1997, the February 28 payment is not treated as deferred compensation and could be deducted as early as 1997, but the March 31 and April 30, 1998, payments are treated as deferred compensation and may not be deducted by the producer under section 404 until 1998. That result is the same regardless of whether each of the payments is made pursuant to a different contract, or whether all of the payments are made pursuant to the same contract.

[21] We hope that the above information will be helpful to you. If you have any questions, please call Janet Laufer at (202) 622- 6060.

Additionally, in discussions with Janet Laufer of this office, you asked that we address whether the payment of residuals may be considered a contribution to a welfare benefit fund, in which case the deduction would be governed by section 419 of the Code. In this regard, pursuant to section 419(e)(1) and section 419(g) of the Code, a "welfare benefit fund" is a fund (A) that is part of a plan of an employer (or other service recipient), and (B) through which the employer (or other service recipient) provides welfare benefits to employees (or other service providers) or their beneficiaries. For purposes of that definition, "welfare benefits" may include benefits such as supplemental unemployment benefits and medical and life insurance benefits (including postretirement medical and life insurance benefits), but would not include pension-type benefits. From the information we have about the residuals, it does not appear that residuals are contributions to a welfare benefit fund, because (a) it appears that the residuals are paid directly to a guild rather than into a fund as defined in section 419(e)(3) of the Code (e.g., an organization exempt from tax under section 501(c)(9), or a non-exempt trust); (b) the benefits provided by the guilds include retirement-type benefits that are not welfare benefits; and (c) the benefits provided by the guilds are provided to some persons who are not employees, independent contractor service-providers, or beneficiaries of either.

² GCM 36590 (February 12, 1976) states that participations are not deductible under Code section 404(a)(5), but rather are a capital cost that are included in basis for purposes of the income forecast method of computing depreciation under section 167.

³ We are not addressing here the effect of the 1986 amendments upon participation agreements that span years both prior to and subsequent to the effective date of the 1986 amendments.

⁴ It is not clear why the legislative history refers specifically to cash-basis corporations. Congress may have been less concerned with applying section 404(d) where corporate service providers use the accrual method, because generally the normal rules for accrual of their income would suffice to achieve the matching with service recipient deductions that is the goal of section 404(a)(5).