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Disposition of Income Forecast Method Issues

Department of the Treasury
Internal Revenue Service
Washington, D.C. 20224

Large and Mid-Size Business Division

Date: 01-05-05

MEMORANDUM FOR:
LMSB INDUSTRY DIRECTORS
DIRECTORS, FIELD OPERATIONS, COMMUNICATIONS, TECHNOLOGY & MEDIA
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PRE-FILING & TECHNICAL GUIDANCE

FROM: Frank Ng Industry Director, Communications, Technology & Media

SUBJECT: Disposition of Income Forecast Method Issues

Introduction
This memorandum is intended to provide guidance to effectively utilize resources in the resolution of cases involving the net vs. gross and the participation/residual issues generally arising in motion picture and television production and distribution cases. Section 242 of the American Jobs Creation Act (AJCA) amended section 167(g) of the Code, effective 10/22/04. While the amendments are prospective (i.e., for property placed in service after 10/22/04), Congress has urged the Service to expedite the resolution of open cases taking into account the principles of these amendments. Accordingly, the guidance provides a fair and balanced approach in applying Congressional intent as reflected in the legislative history of the AJCA.

Background
The net vs. gross issue concerns whether income in the income forecast fraction includes distribution costs. Taxpayers using the net method exclude distribution costs. Rev. Rul. 60-358, 1960-2 C.B. 68. Under section 167(g)(5)(E), as amended by the AJCA, taxpayers must use the gross method and include distribution costs in the income forecast fraction.

The participation/residual issue concerns the proper time for adding these payments to a film's basis. Taxpayers use at least two different methods:

  • Transamerica (1) - Participations/residuals are estimated at the date of a film's release, added to a film's basis, and amortized over the income flow.
  • Associated Patentees (2) - A deduction for depreciation is taken in the taxable year when the participation/residuals are paid.

The Service took the position that participations and residuals are deferred compensation under section 404 and may not be added to a film's basis until the payment is included in income of the recipient. Section 167(g)(7)(A) permits a taxpayer, for purposes of determining depreciation under the income forecast method, to include participations and residuals in basis for the taxable year in which the property is placed in service i.e., the Transamerica method. In the alternative, section 167(g)(7)(D)(i) allows a taxpayer to claim a deduction for depreciation of the participations and residuals in the taxable year they are paid i.e., the Associated Patentees method.

Guidance - Net vs. Gross Issue

  • If a taxpayer placed property in service before 10/23/04 and used the gross method, the agent should not require the taxpayer to switch to the net method.
  • If a taxpayer placed property in service in a taxable year ending before 12/30/03 (the effective date of section 1.446-1T(e)(2)(ii)(d)), the taxpayer may switch from the net to the gross method by filing amended federal tax returns to effect the change in computing depreciation for such property. In the alternative, the taxpayer may treat this change in computing depreciation as a change in method of accounting and file a Form 3115 for the current year. This fact pattern will be rare since most taxpayers used the gross method.
  • With respect to property placed in service before 10/23/04 in a taxable year ending on or after 12/30/03, the agent should not permit the taxpayer to switch from the net method to the gross method if the taxpayer used the net method for such property on federal tax returns for two or more consecutive taxable years. Instead, the taxpayer must file a Form 3115 for the current year. If a taxpayer used the net method for such property on only one federal tax return, the taxpayer should file an amended federal tax return to effect the change from the net method to the gross method.
  • If a taxpayer placed property in service after 10/22/04, the taxpayer must use the gross method. If the taxpayer used the net method for such property on federal tax returns for two or more consecutive taxable years, a switch to the gross method is a change in method of accounting and the taxpayer must file a Form 3115 for the current year.
  • If a taxpayer previously resolved this issue during an examination, switching from the gross to the net method and now files a timely claim for a refund, switching back to the gross method, the agent should grant the taxpayer's claim, assuming the taxpayer and the Service did not sign a closing agreement when they previously resolved this issue.

Guidance - Participation/Residual Issue

  • If a taxpayer is using the Transamerica method for films placed in service before 10/23/04, the agent should not challenge the method.
  • If a taxpayer is using the Associated Patentees method for films placed in service before 10/23/04, the agent should not challenge the method.
  • If a taxpayer placed property in service in a taxable year ending before 12/30/03 (the effective date of section 1.446-1T(e)(2)(ii)(d)), the taxpayer may switch from the Associated Patentees method to the Transamerica method (or from the Transamerica method to the Associated Patentees method) by filing amended federal tax returns to effect the change in computing depreciation. In the alternative, the taxpayer may treat this change in computing depreciation as a change in method of accounting and file a Form 3115 for the current year.
  • If a taxpayer placed property in service before 10/23/04 in a taxable year ending on or after 12/30/03, the agent should not permit the taxpayer to switch from the Associated Patentees method to the Transamerica method (or from the Transamerica method to the Associated Patentees method). The taxpayer must file a Form 3115 for the current year, using a modified cut-off method.
  • If a taxpayer placed property in service after 10/22/04, the taxpayer may use either the Associated Patentees method or the Transamerica method.
  • If a taxpayer previously resolved this issue during an examination, switching from its original method, the Associated Patentees method or the Transamerica method, and now files a timely claim for a refund, switching back to its original method, the agent should grant the taxpayer's claim, assuming the taxpayer and the Service did not sign a closing agreement when they previously resolved this issue.
  • Some taxpayers are on the cash basis and use the Transamerica method. Section 242 of the AJCA does not prohibit a cash basis taxpayer from using the Transamerica method as long as the property is being depreciated under the income forecast method.

This LMSB directive is not an official pronouncement of the law or the Service's position and cannot be used, cited, or relied upon as such.

Contact
If you have any questions, please contact Art Lucchese, Entertainment Industry Technical Advisor, at (630) 493-5328. (Art.Lucchese@irs.gov)

cc: Commissioner and Deputy Commissioner, LMSB Director, Performance, Quality and Innovation

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[1] Transamerica Corp v. United States , 999 F.2d 1362 (9th Cir. 1993).

[2] Associated Patentees, Inc. v. Commissioner, 4 T.C. 979 (1945).

Page Last Reviewed or Updated: 06-Nov-2014