Tax strategies available under income forecast method.

The income forecast method (IFM) of computing depreciation expense generally applies to businesses engaged in the production of filmed or recorded entertainment, including motion picture studios, independent film producers, syndicators of television programs or series, and recording companies. A review of the basic principles of the IFM formula and an analysis of the impact of certain refinements to the formula may enable taxpayers to accelerate depreciation deductions.

Rev. Rul. 60-358 (as amplified by Rev. Rul. 64-273) provides the methodology under which the IFM is to be used in depreciating costs incurred in producing or acquiring a television program or motion picture. In general, the depreciation expense for each show or movie in a given tax period is computed by multiplying a film's capitalized cost by a fraction, the numerator of which is the amount of gross income (on a tax basis) generated by the show in such year and the denominator of which is the amount of estimated total gross income to be derived from the show during its useful life:

Current year

Capitalized cost x gross income

                 Estimated future
                   gross income

The IFM allows a taxpayer to deduct depreciation expenses relating to a show's cost, based on the proportion of income generated from the show in the current year over the total anticipated revenue from the show. The Service recognizes that depreciation of these assets should not be determined based on the mere passage of time. Instead, the IRS has acknowledged that the usefulness of these assets depends largely on audience appeal. For example, a successful show will likely have income beyond the initial exhibition (e.g., reruns), while an unsuccessful show may have no prospects for future income, thus more rapidly exhausting its usefulness in the taxpayer's trade or business. Therefore, the objective of the IFM is to match depreciation expenses relating to capitalized film costs with the income generated by such films.

Capitalized costs

In general, capitalized costs include direct material and labor costs associated with producing a film, and certain indirect costs incurred in connection with the production activity, or the cost of acquiring a film's copyright. Certain expenses, such as marketing and advertising costs that are capitalized for financial reporting purposes, are generally not required to be capitalized for tax purposes. Accordingly, taxpayers seeking to accelerate deductions should carefully analyze the types of costs capitalized for book purposes and capitalize only those expenses required to be capitalized for tax purposes.

Although decreasing capitalized costs will generally accelerate expense deductions, capitalizing anticipated future costs will increase the depreciation expense computed under the IFM in earlier years. Recently, in Transamerica, 999 F2d 1362 (9th Cir. 1993), expenses relating to participations and residuals were properly included in capitalized film costs under the IFM. In general, participations and residuals are amounts paid by producers to those involved in the production of the film or to motion picture guilds, based on a percentage of the film's revenues or profits. In Transamerica, the taxpayer included in its capitalized film costs an amount relating to participations and residuals determined based on a percentage of the revenue estimates it used in the IFM denominator. The Service argued that because the amount of participations and residuals was uncertain, such amounts should not have been capitalized as depreciable film costs. Instead, the IRS contended that these expenses should have been deducted by the taxpayer in the year they became due and payable, when the all events test under Sec. 461 was satisfied. However, the taxpayer argued, and the court agreed, that participations and residuals were costs of production subject to capitalization; because the IFM formula provided by Rev. Rul. 60-358 was established to match depreciation expense of film costs with the flow of income, such expenses should be capitalized for IFM purposes. The court demonstrated the amount of participations and residuals to be capitalized could be determined in any given year based on the revenue estimate made in that year used by the taxpayer in the denominator of the IFM. As shown in Example 1, application of the IFM under the methodology accepted by the court in Transamerica results in the acceleration of expenses that would otherwise be deferred to a future year when economic performance is achieved.

Example 1: A business has production costs of $600, current year income of $300, and estimated future income of $1,200. Total expected profit would be $600 ($1,200 estimated income - $600 of production costs). In addition, 33.33% of profits are paid to participations and residuals, or a total of $200 ($600 of profit X 33.33%). Year 1 depreciation would be:

Participations and residuals included in cost (under Transamerica) ($600 + $200) x ($300 / $1,200) = $200 Participations and residuals excluded from cost* * $600 x (300 / $1,200) - $150

* Revisions to estimated income in subsequent years will require revision to capitalized costs for changes in the amount of participations and residuals.

* * Participations and residuals of $200 would be deductible in the year the liability is fixed and determinable under Sec. 461.

Current year income

This component of the formula is determined based on the taxpayer's method of accounting, and is equal to a show's gross income less distribution expenses (excluding depreciation). As applied in the IFM formula, the larger the amount of current year income of a show, the larger the depreciation expense for that year. Therefore, taxpayers have some flexibility in increasing or decreasing a show's current year depreciation expense, depending on the ability to accelerate future income to the current year or defer income to a later year.

Estimated future gross income

The future income estimate requires a taxpayer to exercise judgment based on available information and thus provides a degree of additional flexibility in computing depreciation of film costs. Under Rev. Rul. 60-358, there are certain parameters under which such judgment must be exercised. In general, future gross income estimates must include anticipated income from domestic and foreign sources, and must be determined based on the facts and circumstances at the end of each year for which a deduction is being claimed. In addition, the estimate should be modified each year to reflect increases or decreases to the amount of anticipated gross income from each show based on subsequent facts that become available. Thus, the estimates should be revised annually to reflect the most current information available on the future income of a show or movie.

Pursuant to Rev. Proc. 71-29, on examination of income tax returns, the Service will not require inclusion of estimates and forecasts of income from domestic television exhibition of motion pictures or television programs originally released after Dec. 31, 1970, unless the taxpayer has entered into an arrangement for such exhibition prior to the time the film is fully depreciated under the IFM. Although the revenue procedure does not address foreign television exhibition, exclusion of foreign income estimates from the IFM denominator until an agreement for exhibition or syndication in foreign markets is obtained appears to be a reasonable extension of the IRS's position. Therefore, it is not necessary for taxpayers to include such estimates in the IFM denominator until the year in which an agreement is obtained, regardless of the taxpayer's opinion as to the likelihood of obtaining an agreement in the future. In addition, the fact that an agreement is entered into before the taxpayer files its tax return for the preceding year is disregarded in computing depreciation under the IFM for such return, since the IFM computation should reflect the facts that existed only as of the end of the tax year.

Taxpayers basing their income estimates on amounts determined for financial reporting purposes might overlook the opportunity to accelerate depreciation expense by excluding revenue estimates from the IFM denominator not supported by contracts or agreements. As shown in Example 2, by excluding such estimates from the IFM denominator, the percentage of current year income over estimated future income increases, and depreciation expense for the current year also increases as a result of applying the IFM formula.

Example 2: Taxpayer T's estimated income from syndication is $1,400 based on facts and circumstances at the end of year 1. In addition, $200 of future income is expected from a contract entered into during year 2, before T files its tax return for year 1. The capitalized production costs are $700, and income from the film in year 1 is $400. Depreciation expense for year 1 is: Future income includes year 2 contract $700 X ($400 / $1,600) = $175 Future income excludes year 2 contract* $700 X ($400 / $1,400) = $200

*The IFM formula denominator will be revised in year 2 to include estimated future income from all contracts existing as of the end of year 2.

By using the guidelines prescribed by the Service and accepted by the courts, taxpayers may realize benefits from refining their methods of computing the components of the IFM formula. However, care should be exercised in determining whether it is necessary to obtain IRS approval for a change in accounting method prior to making any modifications to the way in which a taxpayer's IFM formula is currently determined.