Vol. V, No.3 By Leader Publications/A division of The New York Law Publishing Company June 1989

IRS Bulletin 1989-24

Deduction Limits on

Recordings Announced

By Richard L Curtis

ON JUNE 12, the Internal Revenue Service published in Internal Revenue Bulletin 1989-24, originally released on May 23 as Notice 89-67, changes in the regulations under IRC Sec. 263A required as a result of the Technical and Miscellaneous Revenue Act of 1988. These changes will affect cash-basis recording artists who incur costs to produce a sound-recording master.(Record companies are subject to a slightly different set of rules with no statutory exemptions.)

The Tax Reform Ad of 1986 created the uniform capitalization rules under Sec. 263A. These rules generally provided that all direct and indirect costs associated with the production of tangible property must be capitalized and amortized under the income forecast method whereby an estimate is made of the total revenue to be generated from the property. Sound-recording master costs for demonstration or commercial exploitation were encompassed in the new law.

The 1988 Act, however, provided for an exemption from the uniform capitalization rules for "qualified creative expenses" incurred by writers, photographers and artists. The exemption was retroactive as if included in the 1986Ad. The exemption did not apply to expenses related to "printing, photo-graphic plates, motion picture films, video tapes, or similar items." But the exemption did apply to individuals whose personal efforts created the musical compositions and their personal service or loan-out corporations.

Still, it was not clear from the statute and related congressional committee Reports whether the term "similar items" would include soundrecording master tapes.The Treasury Department has now clarified its interpretation of the statute in Notice 89-67 by specifically citing "sound recordings" as an item not qualifying for the 1988 exemption. Thus, all direct and indirect costs (as provided in Sec. 263A) incurred by a recording artist and associated with producing sound recordings are capitalizable and not currently deductible. Rather, these costs must be amortized or expensed as the related revenue is recognized.

Amortization Alternatives

Several amortization alternatives are available, including a safe-harbor method outlined in Notice 88-62.The notice provides for a deduction of 50 percent of the cost in year one, and 25 percent in years two and three. However, the price for electing to use this simplified method is to capitalize in addition to masters produced and sold all costs associated with the business of producing creative properties - including marketing, advertising, distributing, office overhead and interest -even though these costs may not otherwise be capitalizable under the uniform capitalization rules.

Alternatively, a recording artist who produces a sound recording may amortize the costs on the income forecast method. Then the annual deduction for master costs is computed by taking the ratio of current-year revenue to total estimated revenue, times the master costs.

Record-Company-Owned Masters

The impact of the uniform capitalization rules on recording artists may in part by determined by the recording contract. The subcontractor rules of Sec.263A(g) may come into play if the record company owns the masters and advances recording costs to the artist for production of the master.

In fact, recording contracts many times provide for royalty advances to be made to an artist on each record. The artist may have the responsibility to pay for all recording costs out of the advance. Under these circumstances, the artist would be incurring the master-recording costs, such as studio rental, musician fees, travel costs and instrument rentals. The artist is then, in effect, a subcontractor producing an asset held for resale to the record company. Once in the record company 5 hands, the master should be a depreciable or amortizable asset.

The law states that if a person contracts with a third party to produce goods for it, the first person is treated as the producer to the extent of payments made to the third party. Therefore, to the extent a record company advances funds to an artist to produce a master, the record company is treated as producing the master and is subject to the capitalization rules

Notice 88-86 includes an example regarding prepublication expenditures of publishers. This notice concludes that advance royalties for the future sales of books should be capitalized and deducted as the future sales occur. However, it concludes that payments for the use of authors rights on literary works not based on particular sales is a publisher-depreciable asset. Similarly, record companies making production advances, although recoupable from artist royalties, are not based on particular sales. The advances are to pay for (at least in large part) the album production costs versus recording-artist compensation. (Literary royalties or commission advances are more akin to compensation for services.)

Therefore, to the extent master costs incurred by an artist have been advanced by a record company, the artist should not be subject to the capitalization rules. All costs up to advances received should be deductible in the period incurred. The advances on royalties would constitute taxable income in the year received.

The regulations under I .263A-IT(b)(2)(iv)(C) confirm that for purposes of interest expense as it relates to production activities, the capitalization rules don't apply to the subcontractor to the extent of advances received. Logically, the same concept should apply to capitalizable costs other than interest. The regulations don't make it clear, however, whether this principle is equally applicable to costs other than interest.

Year Master Is Completed

Provided the concepts in the interest section of the regulations apply, if the artist has not completed the master production in the same tax year as the advance is received, taxes will be incurred and payable on funds that will later be expended on production costs. If the production can be completed and these costs can be incurred prior to the end of the artist's tax year, the acceleration of income taxes could be avoided.

On the other hand, if production costs have been expended in excess of advances received, the uniform capitalization rules and income forecast method should prevent the current deduction of all these costs.

Alternatively, the IRS might take the position that recording artists are not relieved from the uniform capitalization rules to the extent of production advances. If so, the artist advances used for production costs and royalties earned on a record should be divided into the components of what they actually represent. First, where the artist is responsible as subcontractor for master production1 the production advance would represent payment for the master. Second, the royalties would represent payment for services.

There has been some precedence in prior law establishing that artist-royalty income is for the payment of services as opposed to payment for master costs where the artist retains no rights to the master. Likewise1the record company S artist-royalty expenses have not been connected to the production to property. (See IRC Sec. 48(s) and Boulez V. Commissioner, 83 TC 584.) Therefore, the separation of recording-contract income into its components is important when computing the amortization deduction. Deduction of costs capitalized under the uniform capitalization deduction rules must be taken as the income associated with that cost is earned and the property is used, sold or otherwise disposed of. Accordingly, if the income associated with the master sale is separated, once the full amount of the master costs is received and the master is delivered to the record company, any capitalized costs should be fully amortized. Additional royalties received should be for compensation for services. Typically, the cost of the master has been fully advanced by the release date. Therefore, the artist's cost should be at this time fully deducted. This result would be similar to the situation in which the record company pays the production cost directly. Consideration should be given to recognizing the two components of artist payments in contracts. A dollar amount established for master-production advances may facilitate limiting the impact of the adverse tax consequences on recording artists.

Artist-Owned Masters

If the recording contract provides for the artist to own the masters, different tax consequences may arise where title to the assets is not the controlling factor in regulations under Sec. 263A. However, the party at risk for the economic investment that accrues any economic benefit and controls the property should determine who has a depreciable master cost. In an artist-owned situation, the contract usually provides for an exclusive licensing agreement whereby the record company licenses the use of the master to produce records for sale. Two factors may impact the tax treatment of these arrangements. First, if the contract provides for the exclusive use of the master, the arrangement should be viewed as a lease for tax purposes. (See Revenue Ruling 84-4)Second, if the term of the license/lease extends over the entire economic life of the master, the lease should in fact be treated as a sale at a contingent price for tax purposes. Consequently, if there is exclusivity and a long-term lease, the application of the uniform capitalization rules should be similar to those where the record company retains the master. That is, the artist should be considered to have produced an item that has been sold to the record company. The total cost should then be deducted by the artist at that point. On the other hand, if there is no exclusivity and long-term lease, the artist should be treated as owning a self-constructed depreciable asset that was later licensed for use. The uniform capitalization rules would then be fully applicable and the master costs would be recoverable under the income forecast method as all royalty income and advances are received.

Mr. Curtis is a partner in the Nashville accounting firm of Curtis & Company, PLC

© 1991 Leader Publications, a division of The New York Law Publishing Company. A Price Communications Corporation Publication. All rights reserved. Reprinted by permission

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