Many taxpayers in the media and entertainment (M&E) industry have questioned which cost recovery deductions they should treat as depreciation and amortization for purposes of IRC Section 163(j) and add back to determine adjusted taxable income (ATI).

IRC Section 163(j) was enacted as part of the Tax Cuts and Jobs Act (TCJA). When applicable, it limits the amount of business interest expense that is deductible in a tax year. IRC Section 163(j) generally limits business interest expense in any tax year to 30% of ATI plus floor plan financing interest. IRC Section 163(j)(8) defines ATI as a taxpayer's taxable income computed without regard to (i) any item not related to a trade or business, (ii) any business interest income or business interest expense, (iii) the amount of any NOL, (iv) the amount of any IRC Section 199A deduction, (v), any deduction allowable for depreciation, amortization, or depletion (for tax years beginning before January 1, 2022), and (vi) other adjustments to be provided by Treasury.

Because M&E taxpayers can recover the cost of content in a variety of ways, many have questioned the application of IRC Section 163(j) for purposes of determining ATI. As shown in the chart, generally any deduction that is treated as a depreciation or amortization expense under IRC Sections 167, 168, or 197 should be added back to determine ATI.

As seen in the table, participations and residuals (P&R) may be treated as depreciation and amortization for IRC Section 163(j) purposes and added back to determine ATI. P&R merits additional discussion. M&E taxpayers typically incur two kinds of P&R. One is P&R that is paid to talent in exchange for services. A common example of this is an actor or actress who receives a percentage of certainly defined net profits from a film. Famous examples of talent who purportedly received substantial P&R include Tom Hanks for Forrest Gump, Will Smith for Men in Black and Bad Boys II, Jack Nicolson for Batman, and Arnold Schwarzenegger for Twins. Another example of P&R is an amount that is paid to acquire or license content, (outside of IRC Section 197) and varies with the performance of the content.

IRC Section 167(g)(7) defines P&R quite broadly as, "with respect to any property, costs the amount of which by contract varies with the amount of income earned in connection with such property." In general, taxpayers that owe P&R cannot deduct such costs until payment unless they elect the income forecast method under IRC Section 167(g)(7)(A) to capitalize and depreciate. This election, which was first allowed for content placed in service after October 22, 2004, effectively codified the taxpayer's victory in Transamerica Corp. v. United States, 999 F.2d 1362 (9th Cir. 1993).

The ability to use the income forecast method for P&R is an exception to the general tax treatment that requires an item to satisfy the requirements of IRC Section 461, including economic performance, before it can be included in basis and depreciated. For example, P&R that is paid to talent in exchange for service is deferred compensation and would typically, outside of this exception, not be deductible until paid under IRC Section 404 because economic performance is not met until payment. (Such amounts could be accrued if they were paid within 2 ½ months of the end of the year in which they were incurred). The key conceptual point to remember is that P&R is a cost of the content that is recovered as depreciation expense even if it is deductible when paid. This treatment has a long history, tracing itself back to Associated Patentees, Inc. v. Commissioner, 4 T.C. 979 (1945).

Consistent with the treatment of P&R as depreciation expense, a change from deducting P&R when paid to depreciating it under the income forecast method is treated as a nonautomatic change in a permissible method of accounting that is not eligible for an IRC Section 481 adjustment (i.e., a cut-off method must be used). Such a method change may be favorable if P&R is deferred and the income forecast method would result in faster cost recovery.

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