Section 409A and Deferred Compensation Paid to Independent Filmmakers
by Moulton Moore on May 31, 2013 in Financing
Legal issues may be the most remote worry that keeps independent filmmakers up at night. There are often more tangible and immediate stresses: finding financing, getting film festival screenings, building positive publicity and momentum for a film, and securing distribution arrangements. For filmmakers who have a few minutes to polish their legal acumen, however, Section 409A of the Internal Revenue Code provides plenty to talk about.
What is Section 409A and Why Does it Matter to Filmmakers? Section 409A provides strict rules regarding the timing of payment of “deferred compensation,” which is often (and at times unknowingly) granted or provided to filmmakers and other talent in the filmmaking world in contracts with studios, networks and other content distributors. If violated, Section 409A imposes draconian tax liabilities on filmmakers who are cash-basis taxpayers, ranging from 20% to over 40% of the compensation at issue, depending on the state of residence of the filmmaker-taxpayer.
Background to Section 409A. Congress enacted Section 409A in 2004 primarily to penalize abusive tax-deferral practices employed by companies and their executives with respect to deferred compensation plans and funding arrangements. Such tax-deferral practices were publicly scrutinized in the wake of the Enron scandal. As implemented by the Treasury Department, however, Section 409A has an extremely broad reach and applies not only to corporate America’s compensation practices but also to compensation arrangements that are prevalent in the entertainment industry, including for filmmakers.
Section 409A Applies to Deferred Compensation. Section 409A’s strict payment-timing rules apply only to “deferred compensation.” What is deferred compensation? Deferred compensation generally means any taxable amount to which a filmmaker has a legally binding (i.e., contractual) right in a taxable year and that could be paid to the filmmaker in a later taxable year. As a simple example, if a filmmaker enters into a distribution contract in 2013 that provides for a back-end contingent payment right that could materialize in 2014 or later, the filmmaker’s contingent payment right could constitute deferred compensation under Section 409A.
Importantly, however, compensation is generally not considered deferred compensation if the legally binding right to the compensation first “vests” in a taxable year and the compensation must be paid no later than two and one-half (2½) months after the end of such taxable year (i.e., generally by March 15 of the following year). This type of compensation is commonly referred to as a “short-term deferral.” Continuing the above example, if the filmmaker’s back-end contingent payment right must contractually be paid to the filmmaker under all circumstances by no later than March 15, 2014, the filmmaker’s contingent payment right would constitute a short-term deferral under Section 409A and would therefore be exempt from Section 409A’s complicated payment-timing rules, which apply only to deferred compensation.
So, if compensation vests in one year and is paid by March 15 of the following year, it is a short-term deferral and does not constitute deferred compensation under Section 409A. When is compensation deemed to have “vested” under Section 409A? Compensation vests when it is no longer subject to a “substantial risk of forfeiture.” In layman’s terms, this means that compensation remains unvested so long as the following is true: (1) the filmmaker has to continue to provide substantial services through a future date to earn the compensation, or the filmmaker’s right to receive the compensation is subject to the attainment of a performance-based vesting condition; and (2) there is a substantial probability that the compensation will in fact not be earned by the filmmaker.
Let’s take a real-life example to consider whether compensation is “vested” and whether the compensation could be subject to Section 409A. An in-demand independent filmmaker’s agent successfully negotiates for the filmmaker an “adjusted gross receipts” contingent payment right with respect to a film produced and directed by the filmmaker and picked up by a major distributor. Given that the filmmaker has the right to a percentage of revenues generated by the film (as adjusted to deduct certain expenses specified in the filmmaker’s contract with the distributor), when is the filmmaker deemed to have vested in the right to payment? When the contract with the distributor is signed, when the film’s negative is produced, when the film is released theatrically (or in another window), or when all expenses that can contractually be deducted from revenues before the filmmaker’s participation begins are in fact deducted against revenues? And, in the much more common situation of a filmmaker whose agent negotiates a “net profits” participation contingent payment right, is the payment right vested only when net profits are in fact generated under the contract with the distributor (if not earlier upon one of the events listed above)? Further, if net profits are in fact generated in a particular year, triggering a payment right under the contract, can the payment right suddenly become unvested again if distribution and other costs for the film in a later year are greater than ancillary and other revenues generated by the film in such year, given that expenses and costs in the real world are dynamic?
Answering many of the above questions is difficult given the scant guidance from the Treasury Department and the differing views among practitioners. The answers to the above questions are critical, however: once a payment right vests, if the payment is not structured as a “short-term deferral” (i.e., if it not contractually provided to be paid by March 15 of the year following the year in which the payment right vests), the payment generally constitutes deferred compensation under Section 409A.
What does this mean for filmmakers? Significant tax penalties can be imposed against a filmmaker if Section 409A’s payment-timing rules are violated on the face of the contract or in operation based on when payment is actually made. Such penalty taxes include (1) 20% of all deferred compensation payable to the filmmaker, (2) premium interest penalties and (3) for filmmakers subject to California income taxes, an additional 20% of all deferred compensation payable to the filmmaker.
To illustrate further, here is another example. An independent filmmaker who is a California tax resident enters into a service contract with a studio affiliate in 2013 to develop and direct a film. Pursuant to the contract, the filmmaker has a legally binding right to a director fee paid in installments (perhaps under a 20/60/10/10 formula) plus a percentage of the “net profits” (if any) generated by the film. Under the contract, net profits are accounted for annually and are payable “as soon as reasonably practicable” after the end of the calendar year in which net profits are generated. The film is released in 2014, performs better than expected in the theatrical exhibition window and generates net profits in each of 2014 and 2015 primarily because of revenues generated in subsequent distribution windows (e.g., video/DVD, pay-per-view, VOD, SVOD and cable). The filmmaker’s share of net profits for 2015 ($1,000,000) is calculated after the studio’s 2015 financial books are closed and the filmmaker’s business manager exercises an accounting right provided under the contract. The filmmaker is paid $1,000,000 in April 2016. Under these facts, the following penalty taxes – in addition to federal and California income taxes – could be levied against the filmmaker for violating Section 409A: (1) a federal Section 409A tax of 20% ($200,000); (2) a California Section 409A tax of 20% ($200,000); and (3) additional premium interest penalties. Out of the $1,000,000 earned by the filmmaker, and assuming federal and California income taxes equal $300,000, the filmmaker would take home less than $300,000—just enough to pay her agent, manager, lawyers and accountants!
Navigating Section 409A. As the above examples illustrate, violations of Section 409A can have real financial consequences for filmmakers. In many compensation negotiations outside the entertainment industry, companies can more easily structure compensation arrangements to be exempt from Section 409A and avoid Section 409A’s tax penalties. In the entertainment industry, however, structuring compensation packages for talent to be exempt from or to comply with Section 409A is more difficult because of the underlying business goals of studios, networks and other content distributors, as well as because of the nature of traditional entertainment industry compensation arrangements and the service relationship between talent and studios, networks and other content distributors. With the assistance of experienced compensation attorneys, many entertainment industry compensation arrangements can be structured to be exempt from or to comply with Section 409A. However, for filmmakers (and their agents and managers), navigating a compensation negotiation without thoughtful analysis and planning by an experienced compensation attorney could ultimately prove costly.
Written by the Partners of Moulton | Moore LLC:
Tim Moore
Tim Moore’s practice concentrates on entertainment and appurtenant corporate and executive compensation matters, including the representation of entertainment industry and creative professionals, media- and entertainment-related businesses and corporate executives.
Prior to founding Moulton | Moore LLP in February 2013, Tim practiced executive compensation law at Wachtell, Lipton, Rosen & Katz in New York, New York and at Skadden, Arps, Slate, Meagher & Flom LLP in Los Angeles, California, with a particular emphasis on structuring compensation arrangements for executives and companies in transactional contexts.
Tim has represented film producers, animators, sports and media agencies, owners of start-ups and entertainment-related businesses, creative professionals in the entertainment industry and,in various merger-and-acquisition transactions,target and acquiring companies and their executives.
Mike Moulton
Mike Moulton’s practice concentrates on entertainment and appurtenant corporate matters, including the representation of entertainment industry and creative professionals, media- and entertainment-related businesses and corporate executives.
Prior to founding Moulton | Moore LLP in February 2013, Mike practiced corporate law at Skadden, Arps, Slate, Meagher & Flom LLP, with a particular emphasis on mergers, acquisitions and corporate governance issues.
Mike has represented film producers, animators, sports and media agencies,owners of start-ups and entertainment-related businesses, creative professionals in the entertainment industryand both target and acquiring companies in various merger-and-acquisition transactions. Mike has also represented studios, event arenas and individual investors in connection with joint ventures, mergers and acquisitions and assessments of corporate strategic alternatives.