under regulations in the appropriate manner to the recapture of intangible drilling and development costs from oil or gas properties. Also, for purposes of this provision a unitization or pooling arrangement (within the meaning of section 614 (b) (3)) is not to be treated as a disposition.*

In addition, the rules relating to the distribution of property by partnership to a partner which are applied (under sec. 617 (g)) to distributions of any property or mine with respect to which mining exploration expenditures have been deducted are to be applied in a similar manner to the distribution of oil or gas property to a partner and to the distribution of other property to a partner by a partnership which, after the distribution, continues to hold oil or gas property. For purposes of these rules, where a partner sells or exchanges his interest in a partnership holding an interest in oil or gas property, intangible drilling costs which would be subject to recapture under these provisions (should the partnership dispose of its interest in the property) are to be treated as an unrealized receivables (within the meaning of section 751). Thus, any gain realized by the partner upon the sale or exchange of his interest would be subject to ordinary income treatment to the extent of his share of these costs. Similar rules are to apply upon the sale or exchange of stock in a subchapter S corporation (in accordance with regulations to be prescribed by the Secretary or his delegate).

Effective date

The rules providing for the recapture of deductions for intangible drilling and development costs are to apply to dispositions of oil and gas properties in taxable years ending after December 31, 1975, with respect to intangible drilling and development costs paid or incurred after December 31, 1975.

Revenue effect

It is estimated that this provision will result in an increase in budget receipts of $7 million for fiscal year 1977, $14 million for 1978, and $65 million for 1981.

5. Motion Picture Films

a. At Risk Rule and Capitalization of Production Costs (secs. 204 and 210 of the Act and secs. 280 and 465 of the Code)

Prior law

Under prior law, motion picture shelters generally had two basic forms. In one format, a limited partnership was formed to purchase the rights to an already completed film. The purchase price was heavily leveraged (and often unrealistically inflated) and the partners claimed substantial depreciation deductions. The principal features of the shelter was deferral and leverage. This format was sometimes referred to as a "negative pick-up" or "amortization purchase" transaction.

Also, arrangements under which the interests of two or more parties in a drilling venture (such as a leaseholder and a driller) shift after a certain amount of production is obtained are not generally to be considered a disposition where the shift in interests occurs under an agreement made prior to the time that the intangible drilling expenses were paid or incurred.

In the second type of format, the limited partnership was formed to produce a film (rather than to buy a completed film). The partnership entered into an agreement with a studio, with a distributor or with an independent producer to produce a particular film. The partnership used the cash method of accounting and wrote off the costs of production as they were paid. Typically the partnership was heavily leveraged and significant costs were paid with borrowed funds. The principal elements of this form of motion picture shelter were also deferral and leverage. The partnership in this type of shelter was sometimes referred to as a "service company' a "service company" or "production company."

Another variation of this shelter was the film distribution partnership. In this shelter, the partnership also did not own an interest in the film, but obligated itself to distribute the film. By writing off the costs of distribution, the deferral occurred for the partners because the partnership's income from its distribution services was not realized until later years.

The basic principles of partnership tax law which benefited the motion picture tax shelter (and other shelters as well) included the use of the partnership form to allow limited partners to take into income their distributive share of the partnership's income or losses (which are generally determined under the partnership agreement). Also, the amount of partnership loss which the partner may deduct included not only his own equity contributions to the partnership, but also his share of any nonrecourse debt which the partnership has incurred (see regulations § 1.752-1 (e)). There were also several aspects of prior law, however, which relate particularly to motion picture shelters.

(1) Film purchase shelter

The income forecast method.-Motion pictures were usually (and may continue to be under the Act) depreciated on the "income forecast" method. (Rev. Rul. 60-358, 1960-2 C.B. 68; Rev. Rul. 64-273, 1964-2 C.B. 62.) This method is used because, unlike most other depreciable assets, the useful life of a motion picture is difficult to ascertain. Under the income forecast method, the taxpayer computes depreciation by using a fraction, the numerator of which is the income received from the film during the year and the denominator of which is the total estimated income which the film is expected to generate over its remaining lifetime. This fraction is then multiplied by the cost of the film. For example, if the taxpayer has a basis of $500,000 in his interest in the film, the income from the film through the end of the first year is $750,000, and the total estimated income from the film over its lifetime is $1,000,000, the taxpayer would be allowed to depreciate 75 percent of his basis, or $375,000. (If the income forecast increases or decreases as a result of changed circumstances, this change is taken into account for later periods. Thus, in the second year, depreciation under the income forecast method might be based on an income forecast denominator which was more or less than the amount used for the first year.)

The film purchase transaction worked as a tax shelter only where

the purchase price of the film (including nonrecourse indebtedness) exceeded its economic value.1

However, there was a substantial question even under prior law whether taxpayers in a film-purchase shelter were legally entitled to claim depreciation based on nonrecourse indebtedness where the "purchase price" of the film was in excess of the income forecast on the film. While the authorities in this area have not been uniform, there are several cases which have disallowed the depreciation deduction based on nonrecourse liability where there was no substantial prospect that this liability would be discharged. In Leonard Marcus, 30 T.C.M. 1263 (1971), the court held that where the taxpayer purchased two bowling alleys for a 5 percent down payment, with a 20-year nonrecourse note for the balance, the taxpayer could depreciate only the basis represented by his down payment, and that the note could be taken into account for purposes of increasing the taxpayer's basis only to the extent that payments were actually made. The court held that the liability represented by the note was too contingent to be included in basis until payments were made.2

In Marvin M. May, 31 T.C.M. 279 (1972), the Tax Court held that a transaction in which the taxpayer purchased 13 television episodes for $35,000, and obligated himself to pay an additional $330,000 on a nonresource basis was a sham, because this amount was far in excess of the fair market value of the films and there was no realistic prospect (or intention) that the debt would ever be paid. Therefore the court disallowed the depreciation deduction claimed with respect to the film. See also Rev. Rul. 69-77, 1969-1 C.B. 59.3

It would seem that some of these same principles could often be applied in the case of a film purchase shelter, where the purchase price of the film consists largely of nonrecourse indebtedness and substantially exceeds the film's income forecast.

Depreciation recapture.-There is some question as to whether a movie film in the hands of a limited partnership, such as those described here, constitutes a capital asset (within the meaning of sec. 1221), or "property used in the trade or business" of the taxpayer

1 Assume, for example, that a limited partnership pays $1,000,000 for a film (consisting of $200,000 in cash and a 10-year nonrecourse note for $800,000). After the film is released. it becomes apparent that the film may not be successful and an income forecast of $200.000 is made for the film. Assuming $160.000 of this revenue (or 80 percent of the predicted total) were realized in the first year, the partners would depreciate 80 percent of their basis in the film. or $800.000 for a net tax loss (after taking account of the $160,000 of income from the film) of $640,000.

On the other hand, where the income stream is equal to or greater than the purchase price there was no shelter. For example, if the film is purchased for $2 million (and has this as its basis), but has an estimated income stream of $4 million, $3 million of which is earned during the first year, the result would be as follows. The partners would be allowed to take 75 percent of their $2 million basis as depreciation in the first year under the income forecast method (or a $1,500,000 deduction). However, the film would be also generating $3 million of income which the partners would have to recognize. Thus, the net tax effect would be positive taxable income to the partners of $1,500,000. Where the purchase price of the film and its estimated income stream are exactly equal, the depreciation deduction and the amount of income from the film should exactly offset each other.

In Marcus, the 20-year term of the note was substantially in excess of the useful life of the bowling alleys.

.

As indicated above, under the partnership provisions, the partner could add to his basis in the partnership his share of the nonrecourse liabilities. However, section 752 (c) provides that "a liability to which property is subject" shall be considered as a liability of the owner of the property "to the extent of the fair market value of such property ." Since the "fair market value" of a movie film ordinarily will not exceed its total projected lifetime earnings, this suggests that a partner's basis could not, even under prior law, include his share of nonrecourse indebtedness to the extent that this indebtedness (plus the partner's down payment) exceeded the income forecast for the film.

79-667 - 77-6

which is neither "inventory," nor "property held by the taxpaper primarily for sale to customers in the ordinary course of his trade or business" (within the meaning of sec. 1231).

If the film is not a capital asset (or section 1231 property), any income received with respect to the film would be ordinary income. Assuming that the film is found to be a capital asset, income realized on the sale or exchange of the film would be subject to the depreciation recapture rules of section 1245. Thus, the proceeds of the sale in excess of the taxpayer's adjusted basis would constitute ordinary income to the extent of any depreciation previously allowable with respect to the film.1

Even if the film is not sold, there should eventually be recapture of the depreciation attributable to the unpaid balance of a nonrecourse note which entered into the depreciable basis of the film. If the film is successful and the loan is repaid out of the partnership income, each partner must take into income his distributive share of the amounts used for repayment; the partner's basis would not be affected. (The partner's basis would increase to the extent that his distributive share. of the partnership income was used for partnership purposes, such as repayment of the loan, but his basis would decrease in an equal amount because his share of the nonrecourse partnership liability was being reduced by the repayment.) If the film is not successful and the nonrecourse debt becomes worthless, a default, foreclosure or abandonment of the debt generally constitutes income to the partnership because such events are treated as a "sale" of the movie film, which is subject to the recapture rules of section 1245.5

The rules on depreciation recapture are essentially the same under prior law and under the Act.

(2) Production company shelter

Cash method of accounting.-Under prior law, obtaining tax deferral through a production company transaction depended on whether the partnership could properly deduct its costs of producing the film as it paid them. This in turn depended on whether proper tax accounting practices permitted the partnership to treat these costs as an item of expense or required the partnership to capitalize these expenditures and amortize them over the life of the asset. (In this case, the asset was the partnership's rights under the contract with the distributor-owner of the film.)

Under prior law (and present law), a taxpayer is generally permitted to select his own method of accounting (sec. 446 (a)) unless the method selected "does not clearly reflect income" (sec. 446 (b)). If it does not, the law permits the IRS to compute the taxpayer's income in a way that will clearly reflect his income.

One problem with the motion picture service partnership's use of the cash method under prior law was the possibility that a particular partnership is really engaged in a joint venture with the distributor or with an independent producer, i.e., the investors provided financing

If the partner sold his interest in the partnership, the depreciation would be recaptured as an "unrealized receivable" under section 751.

Likewise, if the partnership discontinues its operations, this should constitute a constructive distribution of the partnership assets (including, for this purpose, the unpaid portion of the nonrecourse note) to the partners, which in turn triggers the recapture rules of section 1245.

and the studio/distributor or producer supplied personnel, production skills and also loan guarantees. As part owners of the film, the partnership would then have to capitalize its production costs.

6

In such circumstances the question is whether failure to capitalize the expenses of producing the film (and thus, of the partnership's rights under the contract) results in a material distortion of income. There is a strong argument, even under prior law, that a material distortion of income does occur under these circumstances. See Commissioner v. Idaho Power Co., 418 U.S. 1 (1974), holding that "accepted accounting practice" and "established tax principles" require the capitalization of the cost of acquiring a capital asset, including costs, such as depreciation on equipment, which would generally be deductible if they were not allocable to the construction of the asset. (The production company's contract rights are not a capital asset, but these rights are an asset with a long useful life, so there is a strong argument that the capitalization principle should apply.)

On the other hand, there is one case relied on heavily in the past by the investors in movie production partnerships which held that a building contractor's income was not distorted where the company constructed apartments and shopping centers under long-term construction contracts and deducted its costs on the cash method, while receiving payments over a five-year period after each project was completed. C. A. Hunt Engineering Co., 15 T.C.M. 1269 (1956). Production company investors have argued that the same result should be allowed in their situation.

A related question under prior law is whether a limited partnership producing a motion picture is engaged in selling or delivering a product (the film) and is therefore required to maintain an inventory. If this were the case, the labor costs paid in producing the inventory could not be deducted until the inventory item was sold. The argument against that view is that the production company was selling services (i.e. production services) rather than a product.

Another question under prior law is whether the funds supplied by the limited partners were merely part of a financing transaction in which the investors were basically only loaning money to the distributor or other party who would own the completed film. As creditors, the financing parties would not be entitled to tax deductions for the amounts which they are lending.

(3) IRS rulings position

The Service has issued several revenue rulings with respect to the use of limited partnerships and nonrecourse loans. Although these rulings have applicability outside the area of movie shelters, they also impose some limitations, at least insofar as the position of the Service is concerned, which apply both to the film purchase type transaction, and the production company arrangement.

In some cases, the personnel hired by the partnership to make the film were not in reality the investors' own employees but were supplied by the studio/distributor. In other cases, the investors' partnership subcontracted actual production work to the studio/ distributor (or to its agents). Factors such as these, along with the sharing of profits and risks of loss, the distributor's day-to-day involvement in production and budget changes, etc., would tend to support treatment of the partnership as a participant in a joint venture. Still another difficult question under prior law for the motion picture "service company" was whether the partnership was conducting a trade or business if it made only one picture or did not operate with regularity.

7 Rev. Proc. 74-17, 1974-1 C.B. 438; Rev. Rul. 72-135, 1972-1 C.B. 200; Rev. Rul. 72-350, 1972-2 C.B. 394.