A. The Conventional Template
A typical loan transaction between an Independent Film Production Company and a Bank might look something like this: Bank simply lends money to a Special-Purpose Entity (“SPE”), owned and controlled by Producer (plus whomever else). Lender charges interest, probably gets some points, and (depending on how aggressive it is) also might get an equity “kicker” in the film’s net proceeds (in the range of, say, 20%).
B. Potential Issues Raised by the Conventional Template
The Conventional Template presents several issues, as follows:
1. While Lender would prefer to be indifferent to the structure and operation of Producer SPE, if and to the extent it is improperly structured, it has the potential to become destabilized. For example, if a person contributes “services” to the Producer SPE, as opposed to an “asset,” i.e. cash or a screenplay with an established valuation, that person will experience ordinary income, because services are not property. In my experience, this happens “a lot.”
2. If Lender has an interest in the film, other than as a creditor – for example, the hypothetical 20% “equity” interest, however it might be characterized – then, there is risk the Members of Producer SPE (i.e., Producer, et al.) might not be considered “at risk,” which also could affect dramatically their anticipated tax profile.
3. The characterization of Lender’s interest, on a “substance-over-form” basis, also could have significant implications. For example, it is not hard to envision a scenario under which it might be re-characterized as a Membership Interest in Producer SPE. Or, Lender and Producer SPE could be deemed to have created some kind of a new entity for tax purposes, say, a de facto joint venture.
4. Another potential problem is California’s usury statute, which provides for an effective limit on interest of 10%/year. Lender needs to make sure the applicable provisions of the Loan Agreement either get around this, or put Lender in a position to qualify for one of the exemptions (of which there are several). This becomes an issue whenever there is additional consideration to Lender, besides interest, conventionally understood. Note, it would be difficult to characterize any such participation by Lender as a “warrant,” because this implies taking some kind of an ownership interest in Producer SPE.
5. Even though it’s not as much of a problem as it formerly may have been, there still is the specter of “lender liability”-type claims, particularly when Lender (or its designee) controls the flow of funds to Producer SPE. Practically speaking, this type of claim probably would be asserted, if at all, only in a context where the Members of Producer SPE had experienced some catastrophically adverse tax consequence, and were looking around for someone else with whom they could “share their loss.”
C. Proposed New Template
The most significant feature of the Conventional Template is, fundamentally, it is based on a lending type of structure. While this is fine so far as it goes, it is inefficient, because it does not correctly apportion to Lender the entrepreneurial rents it ought to derive, in consideration for providing financing for the film. I don’t care what people say about the primacy of the “creative process,” the simple fact of the matter is, funding always is the most difficult part of the equation to put together.
Furthermore, production funding often is untimely. I have seen dozens of commercially viable, or even commercially extraordinary, packages go by the wayside, simply because there is a mis-match between the availability of funding, the anticipated start-date, and lead cast availability.
A slight re-conceptualization of the existing structure would enable Lender to correct this imbalance.
In principle, here are the steps:
1. Instead of simply loaning money to Producer SPE, Lender forms its own SPE. Lender (or an intervening corporate entity) is Lender SPE’s sole Member. Lender SPE then acquires all of the rights to the underlying screenplay from Producer SPE (or directly from the writer – much of the time Producer SPE itself doesn’t even have title yet). Lender SPE then enters into a Production Services Agreement with Producer SPE. Lender SPE – not Producer SPE – will own the © copyright to the film (albeit encumbered forwards with distribution commitments, and backwards with talent commitments).
2. Lender (or an intervening corporate entity) then establishes a line of credit to Lender SPE, equal to the full amount of the final approved budget. This is not treated as a loan, though; rather, as a capital contribution.
3. Lender SPE is structured as an LLC. However, because it has a single corporate Member, it must (a) elect to be taxed as a corporation, or (b) do nothing. If it “does nothing,” then it is deemed to be a “branch” or “division” of the corporate Member. Lender clearly doesn’t want this, as it’s important for Lender SPE to remain bankruptcy-remote. So, Lender SPE elects to be taxed like a corporation.
4. As a result, Lender SPE will end up accruing a net operating loss (“NOL”). Set forth below are six hypothetical situations: three for a $15 million film, and three for a $20 million film. Each budget level further is broken down into “low,” “medium” and “high” performance scenarios. “Low” means the picture loses $5 million; “medium” means it breaks even; and “high” means it makes $5 million. These are, of course, just illustrations. It’s easy to model any number of different variations on the theme.
I assumed 65% of the film’s budget is recouped during the first fiscal year. The rest might be spread out over the next two years (65% of 35% in FY2, and the balance in FY3). Again, these assumptions are easy to change.
For the $15 million films, I assumed Lender SPE would take an election to expense production costs, as per I.R.C. §181. For the $20 million films, I assumed 15-year depreciation under the income forecast method.
While no tax is payable, because the film loses $5 million, there is an unused $5 million NOL.
The NOL (created by expensing 100% of the budget against 65% of the income) reduces FY1 and FY2 taxable income by $5.25 million. This results in a tax saving of $1.79 million.
In this scenario, use of the NOL results in a tax saving of $2.38 million.
The results even are more dramatic when negative costs are capitalized, rather than expensed. Carrying back the NOL from FY4 to FY2, and from FY5 to FY3, results in tax saving of $1.79 million. Furthermore, at the end of 15 years, there is unused NOL of $15.5 million.
Doing the same thing in this scenario results in tax saving of $2.38 million. $14.88 million of NOL remains unused at the end of the depreciation period.
Finally, when the film makes money, there is a tax saving of $2.98 million, and $13.33 million of left-over NOL.
As you see from these examples, a “C” corporation can use NOL incurred in one taxable year, to reduce its taxable income in another taxable year. In fact, it can (a) carry the NOL backwards for two years, or (b) carry it forward for up to 20 years. For the “high” performing films, using alternative (a) enables Lender SPE to reduce significantly the amount of tax it pays in FY2 and FY3 (by carrying back the NOL generated at FY4 and FY5, respectively).
Can the NOL carry-forward be used for some other purpose, besides reducing tax in FY2 and FY3? The answer is yes; at some point during the 15-year depreciation cycle, the Lender SPE showing the NOL carry-forward should be merged or consolidated with another Lender SPE (from another picture) with taxable income, thus reducing that amount. The Internal Revenue Code sets forth complex but workable provisions governing this exercise.
Another important feature of this approach is, it doesn’t affect Producer in the slightest. The fact of the matter is, if the NOL resided in Producer SPE, Producer probably wouldn’t be able to use it at all, due to a combination of the “passive activity loss” (“PAL”) rules, and the “at risk” rules. On the other hand, “C” corporations (such as Lender SPE) are exempt from the “passive activity loss” rules, unless they are “closely held,” and this one isn’t. Lender SPE most likely is “materially participating,” anyway, so the PAL rules aren’t an issue.
We can quantify the anticipated benefit of this type of structure. Let’s assume Lender finances two independent films per month, which is 24 per year. Let’s assume six of these are $15 million, and 18 are $20 million. In each budget tier, let’s assume further, one-third are “low” performers, one-third break even, and one-third are “high” performers. As before, obviously we can adjust these numbers:
Not all of this will occur in FY1, of course; this is an overview of the entire cycle.
Here are a few more comments:
1. Producer should be indifferent to the deal structure Lender uses, as long as Producer’s getting the money to make the film.
2. If Producer wants to own the © copyright in Producer SPE, there is a way to accommodate this issue.
3. If Producer wants to be a Member of Lender SPE, there is a way to accommodate this issue. In brief, Lender SPE would issue two separate classes of LLC Membership interests, analogous to “common” (Producer) and “preferred” (Lender) stock. Because it has more than one Member, Lender SPE then could elect if it wanted to be taxed as a corporation, or as a partnership. If the latter, a different set of rules pertains. Because Lender would have a disproportionately large basis, in relationship to Producer, it would be entitled to the lion’s share of allocations, such as, e.g., of loss. This “partnership template” will be at least as favorable to Lender as the corporation template – or, at least, not materially less favorable, particularly in comparison with the Conventional Template.
4. By segueing into more of a “proprietary” mode, as opposed to “just being a lender,” Lender should be in a position to capture and retain more of the potential “upside.” For example, it’s not uncommon for motion picture financiers in the independent sector to command 50% (or more) of the net proceeds waterfall. In fact, it’s hard for me to remember a time when I haven’t done this, on behalf of the financing entity; it’s almost like it’s some kind of convention. Of course there will be situations for favored Producers where Lender might want to take less, but at least this should be the starting point. The advantage of this structure, though, is it is equally as good at hedging potential downside (through use of the NOLs), as it is at hedging potential upside.
Of course this only is a rough outline, and there are many nuances and possible pivot points. It certainly is not a formal legal opinion, or an offer to buy or sell a security. Rather, I hope I have been able to outline a reconceptualized structure, prospectively capable of generating significant additional marginal revenue, at no additional marginal cost.