On August 3, 2018, the IRS and Treasury issued proposed regulations that provide guidance regarding the additional first year depreciation deduction under Section 168(k) of the Internal Revenue Code. The proposed regulations reflect the changes enacted by the Tax Cuts and Jobs Act and apply to taxpayers who deduct depreciation for qualified property acquired and placed in service after September 27, 2017. The proposed regulations are scheduled to apply to qualified property placed in service during or after the taxpayer's tax year in which the final regulations are published in the Federal Register. However, taxpayers have the ability to choose to apply the proposed regulations to qualified property acquired and placed in service after September 27, 2017, for tax years ending on or after that date.

Background

The proposed regulations provide some helpful guidance for taxpayers with films and television programming. Section 181 permits taxpayers that make a proper election to deduct up to $15M / $20M of costs of certain qualified films and television programs as they are paid or incurred. (Section 181 also applies to certain live theatricals but these are not addressed in this Tax Alert.) To qualify, Section 181(d) requires that a film or television program must have 75% or more of certain production expenses related to compensation incurred in the United States. Section 181 does not apply to used property. Thus, a film or television program that has been released or had a commercial exhibition is not eligible to make an election. Reg. Section 1.181-1(a)(2)(ii). Any cost in excess of the amount deducted under Section 181 is recovered through depreciation under Section 167 beginning in the year the property is placed in service.

The Tax Cuts and Jobs Act extended bonus depreciation to qualified films and television programming. See new Section 168(k)(2)(A)(i)(IV). This permitted 100% expensing for a film or television program that was eligible to make a Section 181 election but considered without regard to the cost limit or expiration date of Section 181. It applied to property acquired and placed in service after September 27, 2017, and before January 1, 2023. The 100% expensing amount is reduced 20% per year for years beginning after December 31, 2022. The current expiration date for Section 181 is December 31, 2017, except for property that had commenced production before December 31, 2017. While the new bonus depreciation rules can apply in certain instances to the acquisition of used property, this is not the case for qualified Section 181 property, which by definition, cannot already have been released or commercially exhibited.

As explained below, the proposed regulations provide helpful guidance regarding the application of bonus depreciation to qualified Section 181 property. This Tax Alert emphasizes two items with respect to qualified Section 181 property in particular: (i) certain aspects of when a property is acquired and placed in service, and (ii) the ability to elect out of bonus depreciation.

Important implications of bonus depreciation for qualified Section 181 property

Guidance regarding when qualified Section 181 property is acquired and placed in service. In accordance with the effective date in Section 13201(h) of the Tax Cuts and Jobs Act, and Section 168(k)(2)(A)(iii) and (B)(i)(ll), the proposed regulations require that qualified property must be placed in service after September 27, 2017, and before January 1, 2028. Section 168(k)(2)(H), and the proposed regulations, expressly provide that qualified Section 181 property is treated as placed in service at the time of initial release or broadcast. See Prop. Reg. Section 1.168(k)-2(b)(4)(iii). There are several key points related to when a property is treated as being acquired. First, a property must be acquired after September 27, 2017, or acquired pursuant to a written binding contract after September 27, 2017. Prop. Reg. Section 1.168(k)-2(b)(5). A contract is binding only if it's enforceable against the taxpayer under state law and does not limit damages to a specified amount. A liquidated damages provision of at least 5% of the contract price will not be treated as limiting damages to a specific amount. Importantly, because many film and television productions are performed by third parties, property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in its trade or business is acquired pursuant to a written binding contract. Prop. Reg. Section 1.168(k)-2(b)(5)(ii). Moreover, if the written binding contract states the date on which the contract was entered into and a closing date, delivery date, or other similar date, the date on which the contract was entered into is the date of acquisition. Note, neither an option to acquire or sell property or a letter of intent for an acquisition is a binding contract. Prop. Reg. Section 1.168(k)-2(b)(5)(iii)(C) and (D).

For self-constructed property, the taxpayer is treated as satisfying the acquisition rules if it begins the manufacture, construction, or production of the property after September 27, 2017. Prop. Reg. Section 1.168(k)-2(b)(5)(iv)(A). Helpfully, qualified Section 181 property is treated as acquired on the date principal photography commences. Prop. Reg. Section 1.168(k)-2(b)(5)(v)(A). Thus, for example, pre-September 27, 2017 development work done before principal photography, assuming all other criteria are satisfied, should still be eligible for bonus depreciation.

Guidance regarding electing out of bonus depreciation for qualified Section 181 property. A taxpayer can elect not to claim bonus depreciation. Section 168(k)(7). The election out is required to be made for a class of property. It was not clear how this would relate to qualified films and television programming. The proposed regulations are favorable and give taxpayers flexibility by treating each separate production as a class of property. See Prop. Reg. Section 1.168(k)-2(e)(1)(ii)(E). Thus, taxpayers will be able to exclude a particular film or television show if they choose to do so. The election "must be made in the manner prescribed by Form 4562." Additional flexibility is provided for the 2017 tax year because a taxpayer can also elect to deduct 50% instead of 100% bonus depreciation, although this applies to all qualified property acquired after September 27, 2017, and placed in service for the year that includes September 28, 2017. Prop. Reg. Section 1.168(k)-2(e)(3).

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