SCOTUS Reports

Tag: Motion Picture Investment

  • Follender v. Commissioner, 89 T.C. 943 (1987): Determining At-Risk Amounts Without Present Value Discounting

    Follender v. Commissioner, 89 T. C. 943, 1987 U. S. Tax Ct. LEXIS 155, 89 T. C. No. 66 (1987)

    A taxpayer’s at-risk amount for borrowed funds under section 465 is the full amount of the principal they are personally liable for, without discounting to present value.

    Summary

    In Follender v. Commissioner, the U. S. Tax Court addressed whether a limited partner’s at-risk amount should be discounted to present value when assuming the principal obligation of a recourse note without interest. David Follender assumed a portion of a $4. 6 million recourse purchase note for a motion picture investment, but not the nonrecourse interest. The court held that Follender’s at-risk amount was the full $257,058 of principal assumed, rejecting the Commissioner’s argument for discounting to present value. This decision clarified that section 465 does not require present value calculations for at-risk amounts, focusing instead on the actual liability for the borrowed amount.

    Facts

    David B. Follender and Irma R. Follender, as limited partners in Brooke Associates, invested in the motion picture “Body Heat. ” Brooke Associates purchased the film from the Ladd Company for $9,940,000, financing it with a $4,600,000 recourse purchase note due in 1991. Follender assumed primary obligation for $257,058 of the note’s principal but not the nonrecourse interest. The partnership’s offering memorandum detailed the investment structure, including the recourse note and the limited partners’ obligations.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in the Follenders’ 1981 federal income taxes, arguing that Follender’s at-risk amount should be discounted to present value. The case was heard by the U. S. Tax Court, which issued its opinion on October 28, 1987, holding that the at-risk amount should not be discounted.

    Issue(s)

    1. Whether Follender’s at-risk amount should be increased by the full $257,058 of the recourse purchase note’s principal he assumed, without discounting to present value.
    2. Whether nonrecourse interest on the recourse purchase note should be treated as contingent interest under section 483, affecting the partnership’s basis in the motion picture.
    3. Whether Follender would be liable for increased interest under section 6621(c) if the court decided the at-risk issue in favor of the Commissioner.

    Holding

    1. Yes, because section 465 does not require discounting borrowed amounts to present value when determining at-risk amounts. Follender’s at-risk amount was the full $257,058 he assumed.
    2. No, because the nonrecourse interest was not contingent interest under section 483, as its liability and amount were determinable at the time of sale.
    3. This issue was not reached because the court held for Follender on the at-risk issue.

    Court’s Reasoning

    The court reasoned that section 465(b)(2) allows taxpayers to be considered at risk for amounts borrowed to the extent they are personally liable, without any statutory directive to discount these amounts to present value. The court rejected the Commissioner’s argument that the difference between the face value and present value of the obligation constituted an amount protected against loss under section 465(b)(4). The court also found that the nonrecourse interest on the recourse note was not contingent under section 483, as its rate and due date were fixed, and the likelihood of payment was supported by pre-release revenue estimates. The court’s decision was unanimous, with no dissenting opinions, and emphasized the legislative intent behind section 465 to limit deductions to amounts economically at risk.

    Practical Implications

    This decision provides clarity for tax practitioners and investors in structured financing arrangements, particularly those involving recourse and nonrecourse obligations. It confirms that at-risk amounts under section 465 should be calculated based on the full amount of the principal obligation, without applying present value discounting. This ruling impacts how partnerships and investors structure their financing to maximize tax benefits while ensuring compliance with at-risk rules. It also affects how the IRS assesses at-risk amounts in audits, potentially reducing disputes over valuation methods. Subsequent cases, such as Melvin v. Commissioner, have reinforced this principle, guiding practitioners in advising clients on the tax treatment of similar investment structures.

  • Tolwinsky v. Commissioner, 86 T.C. 1009 (1986): When Depreciation Applies to Contractual Income Interests

    Tolwinsky v. Commissioner, 86 T. C. 1009 (1986)

    A contractual right to payments contingent on the success of a motion picture is depreciable if it is exhausted over time.

    Summary

    Nathan Tolwinsky, a limited partner in Hart Associates, Ltd. , invested in the partnership which acquired the motion picture ‘The Deer Hunter’ from EMI. The partnership’s investment was structured as a series of transactions involving intermediaries Great Lakes and Lionel. The court found that Hart did not acquire ownership of the film but rather a contractual right to contingent payments. This right was deemed depreciable, but the partnership’s basis for depreciation was limited to the cash paid and the acquisition fee, excluding a nonrecourse note that lacked economic substance. The court also disallowed deductions for interest, management fees, and other expenses, and denied an investment tax credit due to the absence of an ownership interest in the film.

    Facts

    EMI produced ‘The Deer Hunter’ and entered into a production-financing-distribution agreement with Universal Pictures. EMI then assigned its rights to British Lion and sold the film’s U. S. and Canadian rights to Great Lakes, which sold them to Lionel, who then sold them to Hart Associates. Hart’s acquisition included a cash payment and a nonrecourse note. The film was distributed by Universal and was successful at the box office. Hart claimed depreciation and other deductions based on its purported ownership of the film, which the IRS challenged.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Tolwinsky’s federal income taxes for 1978 and 1979. Tolwinsky petitioned the Tax Court. The Commissioner amended his answer to challenge the nature of Hart’s interest in the film, the depreciation deductions, and the investment tax credit. The case was tried and decided by the Tax Court, which issued its opinion in 1986.

    Issue(s)

    1. Whether Hart acquired a depreciable interest in the motion picture ‘The Deer Hunter’?
    2. If Hart did not acquire a depreciable interest in the film, did it acquire a depreciable interest in the contractual right to contingent payments?
    3. What is Hart’s depreciable basis in the contractual right?
    4. Is Hart entitled to deductions for interest, management fees, and other expenses?
    5. Was Hart engaged in an activity for profit?
    6. Is Tolwinsky entitled to an investment tax credit with respect to the film?

    Holding

    1. No, because Hart did not acquire all substantial rights in the film; EMI and Universal retained control over its exploitation.
    2. Yes, because the contractual right to contingent payments is subject to exhaustion over time.
    3. Hart’s depreciable basis is limited to the cash paid to EMI and the acquisition fee paid to TBC Films, excluding the nonrecourse note.
    4. No, because the interest on the nonrecourse note was not deductible, and the management fees were capital expenditures.
    5. Yes, because Hart had a reasonable prospect of making an economic profit.
    6. No, because Hart did not have an ownership interest in the film for investment tax credit purposes.

    Court’s Reasoning

    The court applied the economic substance doctrine, finding that the transactions between EMI, Great Lakes, Lionel, and Hart were structured to shift tax benefits without genuine business purpose. Hart did not acquire ownership of the film because EMI and Universal retained all substantial rights. The court determined that Hart’s interest was a contractual right to contingent payments, which was depreciable under the straight-line method. The court rejected the inclusion of the nonrecourse note in Hart’s basis, as it was not a genuine debt. The court also found that the management fees were not deductible as they were capital expenditures. The court concluded that Hart was engaged in an activity for profit based on the potential for economic gain from the film. Finally, the court denied the investment tax credit because Hart did not have an ownership interest in the film.

    Practical Implications

    This decision impacts how tax professionals should analyze similar transactions involving the purchase of income interests in creative works. It clarifies that contractual rights to contingent payments can be depreciated if they are exhausted over time, but the basis for such depreciation must reflect genuine economic investment. The ruling emphasizes the importance of economic substance over form in tax planning, particularly in the context of nonrecourse financing and the use of intermediaries. It also affects the structuring of film investments, as it highlights the limitations on claiming depreciation and investment tax credits without actual ownership. Subsequent cases have followed this decision in distinguishing between ownership and income interests in intellectual property.