December 1992 Entertainment Law & Finance 3

 Rent Versus Royalties Dilemma

Figuring Tax Status of Record Masters

By Richard L Curtis

This article is the second of a two-part series.

TYPICALLY, THE Internal Revenue Service has held that royalties arise from the license of intangible property and rent arises from the use of tangible property. In recording industry contracts, income from record and video masters is often deemed as royalties. It is clear that the IRS considers income derived from the license, rather than the sale, of song copyrights to be royalty income for all purposes of the tax code. For tax purposes, the nature of income arising from record masters is less clear.

In most cases, such as for deductions, the IRS has treated masters as tangible, rather than intangible property. (See Internal Revenue Code Sec. 38 and Revenue Ruling 84-4). Information released by the IRS regarding the application of the uniform capitalization rules also deems record masters as tangible property.

Implications of Nonexclusivity

However, when it comes to in come, the IRS has sometimes taken inconsistent approaches. Revenue Ruling 84-4 and General Counselís Memorandum (GCM) 37710 held that a contract for less than exclusive rights to use of the property was not a lease yielding rent income, but rather a license yielding royalties. Ruling 84-4 was determining whether a "lessee" was eligible to claim in vestment tax credit under prior law. Since the user did not have exclusive use of the masters (the owner could license the masters contemporaneously in foreign markets), the arrangement was held to be a license, rather than a lease. Thus, no investment tax credit was available to the domestic user.

In GCM 39111, the IRS held that the lack of exclusivity for the use of


Unless the con-

tract is exclusive for the life of the copyright, the IRS says that

royalty income is generated


masters indicated that the property was intangible, rather than tangible. This seems to reflect the IRSí lack of understanding of the record business. How can they conclude in some contexts that a record master is tangible property, and in others, intangible, based upon contract terms?

What if the facts analyzed by the IRS provided that the lease was for a record master copy to be used by the lessee in a defined territory? Under these facts, the lease could have been for exclusive use, that is the asset leased would be used only by the lessee during the term of the lease. Another master copy could have been leased to another party in a different territory. Nonetheless, based upon IRS guidance, if a lease/ rent treatment Is desired by the income recipient, the arrangement should provide for an exclusive worldwide use. If sale treatment is desired, the arrangement should also be for a term equal to the record masterís life.

Although in times past the distinction between royalty and rent has included whether the payments are fixed in amount for a term (i.e., rent) or variable with use (i.e., based on sales), this distinction has been blurred by the courts and is currently not of much significance.

The difference between rent and royalties is important in the personal holding company area since rent can escape personal holding company income classification, whereas royalties cannot unless they are copy right royalties meeting certain IRC tests. Likewise in the S corporation area, if the income is classified as rent, it can escape the passive in come taint if significant services are also provided.

GCM 37710 states that the definition of royalty income under the personal holding company rules of IRC Sec. 542 and under the S corporation rules of Sec. 1362 (passive in come) are not the same. This GCM gives great weight to whether the income recipient owns a copyright In the product giving rise to the in come. If an item is subject to copyright, apparently unless the contract is exclusive and for the life of the copyright (i.e., cast as a sale for tax purposes) the IRS contends that royalty income is generated.

In GCM 37710, the IRS concluded that "rent" income was generated from the airing of athletic events that were exclusive but not copyrighted (I.e., fixed in a tangible medium of expression). On the other hand, agreements to air special programming developed by the taxpayer and copyrighted, were deemed to generate royalties and thus passive income under the S corporation rules. Here, active business involvement is irrelevant; even though the tax payer was an active trade or business, the income was passive under the S corporation rules since it constituted royalties. However, if the exclusive right to the copyrighted material is licensed for the life of the copy right, It is treated as a sale and royalty income is avoided. In this area, the IRS gives weight to the contract language designation of royalty vs. rent.

Finally, since there are specific exceptions from the copyright personal holding company problems for produced film "rents," the movie industry is not as entangled in the personal holding company problem. But closely held record labels that structure distribution via royalty arrangements and superstar artists who own their masters can run afoul of the rent vs. royalty problem under the personal holding company rules as well as the S corporation rules.

Mr. Curtis is a partner in the Brentwood, Tenn., 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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