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Cruising for Phantom Income

November 3rd, 2006 by David Kronemyer · No Comments

It was only a few months ago that Sumner Redstone unceremoniously dumped Tom Cruise, Thompson, A., “It’s a wrap for Par, C/W Prods.,” Hollywood Reporter (Aug. 23, 2006). While Redstone’s concern with Mr. Cruise’s allegedly ticket-sales-inhibiting behavior was the ostensible reason, there can be no question that economics was behind it. At $10 million/year, Mr. Cruise’s deal was the “richest on the lot,” Sperling, N., “Biz eyeing economics of Cruise-Par breakup,” Hollywood Reporter (Aug. 24, 2006); Gardner, C., “It’s a war of the words,” Daily Variety (Aug. 22, 2006); Halbfinger, D., “Allies Start to Escalate Dispute Between Cruise and Viacom,” New York Times (Aug. 24, 2006). This not only irritated other actors, with arguably better box office results/potential, but also could have triggered “favored nations” clauses, obligating Paramount to pay to others, what it was paying to Cruise.

Now, amidst a furor of publicity, United Artists announces it has given Mr. Cruise a 30% interest in the company, which will be his new “production home.” Just like Steven Spielberg is not obligated to make movies for Paramount, even though it bought DreamWorks, so Mr. Cruise is not obligated to make movies for United Artists. Furthermore, it appears Mr. Cruise put none of his own money into the deal, Sperling, N., “Cruise, Wagner take over United Artists,” Hollywood Reporter (Nov. 3, 2006); LaPorte, N., “UA lighting the Cruise fuse,” Daily Variety (Nov. 2, 2006); Eller, C., “Cruise in deal to revive UA,” Los Angeles Times (Nov. 3, 2006); Holson, L., “Mission: Rescue Operation,” New York Times (Nov. 3, 2006).

Whether designed or not – and I’m sure it was – Mr. Cruise’s new affiliation with United Artists looks a lot like what happened when the company initially was formed. As recounted by Tino Balio in his book United Artists – the Company that Changed the Film Industry 10 (1987):

“Founded in 1919 by Mary Pickford, Charlie Chaplin, Douglas Fairbanks, and D. W. Griffith, UA operated solely as a distributor of high quality independent productions. Unlike the other majors, UA never owned a studio nor had actors under contract. Pioneers in every sense of the term, UA’s founders were strong-willed, temperamental, idiosyncratic, but eminently gifted artists who responded to the economic implications of stardom by becoming entrepreneurs. In forming UA, talent for the first time ever acquired complete autonomy over their work. Pickford, Chaplin, and their partners had risen from the ranks of contract players to reach the status of independent producers. As heads of their own production companies, they controlled all artistic aspects of their work – from the creation of the scenario, to the selection of the director, to the final cut. By organizing a distribution company, they could oversee, in addition, the crucial functions of sales, advertising, and publicity.”

While the purpose of Mr. Cruise’s takeover of UA is not to form a distribution company, all of the other attributes of the “first” UA could apply to this iteration of it, as well. But there’s an important wrinkle: Mr. Cruise has not put in one penny of his own money. In contrast, to capitalize UA initially, all four of the partners put in $100,000 each, Balio, T., United Artists – The Company Built By The Stars 28 (1976). Pickford and Chaplin both had ready money to invest, though they still owed films on their prior contracts with Associated First National Exhibitor’s Circuit. Griffith, in order to raise his share, actually signed a three-picture contract with First National, thus keeping himself tied up until 1920. Only Fairbanks was immediately free, and his was the first UA release (entitled His Majesty, the American), Koszarski, R., An Evening’s Entertainment – the Age of the Silent Feature Picture, 1915 – 1928 77 (1990). Each partner agreed to deliver three pictures a year – in other words, UA would release one picture per month. Significantly, each partner’s films not only would be self-produced, but self-financed, as well, Bach S., Final Cut 36 (1985). Mr. Cruise, of course no more would finance one of his own films than fly to the moon; that will be taken care of either by MGM, the distributor/owner-of-the-other-70%, or by one of the soon-to-be-completely-broke “hedge funds” that recently have spawned, like salmon in their ancestral ponds, see my prior note, What Exactly Is It that a Hedge Fund Hedges?

Even though I am dubious about its financial underpinnings, I applaud the recent disintermediation of studios, as producers go directly to the financial markets to secure funds in order to make their films, see, e.g., Goldsmith, J., “A flexible film fund,” Daily Variety (Oct. 22, 2006); “Your Own Private Equity,” Daily Variety (Sep’t 10, 2006); Ross, M., “Dough buoys pic pools,” Daily Variety (May 14, 2006); Goldsmith, J., “Studios tending hedges,” Daily Variety (Jan. 22, 2006); Bart, P., “Hedge your bets,” Daily Variety (Jan. 22, 2006); and Synder, G. & LaPorte, N., “Funds pop for pix,” Daily Variety (Jan. 19, 2006). Many studies have shown that the main reason why people go to see a movie is because of who’s in it, not because of what studio’s releasing it.

The trend towards greater empowerment of talent vis-à-vis the studios probably began with the formation of the original UA. It continued with the legendary Lew Wasserman, when he still was an agent. Mr. Wasserman invented the personal holding company. “Other MCA clients [asked MCA] to turn them into corporations. High-earning stars, who were taxed at the 90 percent level on their personal income, could pay a fraction of that to the government in capital gains taxes if they incorporated,” McDougal, D., The Last Mogul 116 (1998).

That is, instead of getting taxed on your personal income, like any working stiff, your income goes into a corporation. The corporation pays you a modest salary, which does get taxed, but also pays all of your expenses. But in the meanwhile, you’ve created an “asset” – something with tangible value, i.e., your participation share in a motion picture. Which you then can sell as a “capital” asset, and pay only a capital gains tax, as opposed to a tax on ordinary income. The difference in rates in the 1930s was staggering. Now, it’s just “a whole lot;” tax on a long-term capital gain is about half of that on ordinary income.

There still is a problem, though, and that has to do with something called “phantom income.” I don’t know the intricacies and nuances of the way Mr. Cruise’s new deal with UA was structured. BUT, if he’s acquiring a 30% interest, AND he’s not paying anything for it, then as a matter of Federal tax law, he’ll have attributed or “phantom” income, equal to (at least) the value of what the Sony-led consortium paid, pari passu. That was around $5 billion, “MGM Investors Approve Sale to Group,” New York Times (Dec. 18, 2004). 30% of $5 billion is $1.5 billion. In its annual “Forbes 400” compensation survey, Forbes Magazine estimated Mr. Cruise’s net worth at $200 million, “Not As Rich As You’d Think,” Forbes (Sep’t 18, 2006); other sources put it as high as $450 million. Tax on $1.5 billion at the maximum ordinary income rate of 35% is $530 million. Even for someone of Mr. Cruise’s reported wealth, this would be quite a bite. Fortunately, I’m sure Mr. Cruise was well-advised.