The Downside Of Using Investment Contracts For Films

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t is extremely common in the film industry for investments in films to be documented with “investment contracts,” rather than as membership interests in an LLC used by almost all other industries. This practice evolved due to the film industry’s historic practice of relying on informal contracts (napkin deals do occur) and the perceived complexity of using LLCs. This article suggests a number of downsides to this approach.

Unlimited Liability. One potential downside is that an investment contract may be treated as creating a deemed partnership under state law if the investor has a share of net profits, as is common. This result applies notwithstanding the standard provision in investment contracts stating, “this is not a partnership,” since such clauses may be ignored by the courts if the transaction is in substance a partnership. If an investment contract is treated as creating a deemed partnership, it will be treated as a general partnership because there is no state filing for it, as would be the case for a limited partnership or LLC. The net result is that the investor may be treated as a general partner, so the investor may be liable for any third-party claims that arise in connection with production of the film. If the transaction had been structured as a membership interest in an LLC, the investor would have no risk of personal liability for such claims.

Tax Consequences to Investor. Notwithstanding the possible treatment of an investment contract as a partnership under state law, the tax rule is, “you made your bed, go lie in it.” Since the transaction is not structured as a partnership or LLC for tax purposes, the investors may not be entitled to any deduction for their investment, since there is no tax code provision that would permit it. The investors certainly don’t get any deductions directly attributable to the film (such as section 181 deductions). The result may be that the investors are taxed on 100% of any cash they receive, even if they don’t recoup their investment, and they may end up with an unhappy capital loss at some distant point in the future.

There is also uncertainty regarding the tax characterization of the payments the investors receive. The payments won’t be treated as “passive income” (which would permit the income to be offset by “passive losses), and it is not clear what withholding rate applies if the investors are foreign.

Tax Consequences to Producer. A corollary to the tax rule of “you made your bed, go lie in it,” is that the producer is probably immediately taxed on receipt of the investment, since an investment contract is treated as a current taxable sale of a potential future income stream. An investment contract isn’t a loan and it isn’t equity, since the tax definition of equity is an interest in an entity, such as a membership interest in an LLC. That leaves the only alternative for the payment the producer receives being taxable income. It is also not clear whether the producer can deduct any payments to the investor when made, or whether the payments have to be capitalized to the film. The producer will also be at risk if the producer doesn’t withhold tax if the investor is foreign.

Unclear Rights. While LLC’s have a set of statutory provisions outlining the rights of the members (such as inspection, voting, and dissenters’ rights), there are no such provisions governing investment contracts, so disputes can occur when the investor and the producer have different understandings of the investor’s rights.

Overlooking the Securities Laws. It is quite common for producers using investment contracts to not realize (or ignore the fact) that they are issuing a securities, which can expose them to criminal and civil liability. When membership interests in an LLC are issued, everyone is much more alert to the requirement to comply with the securities laws.

So at least take these issues into consideration before choosing an investment contract instead of an LLC. LLC agreements don’t have to be long or complicated. Indeed, they can be shorter than some investment contracts, so length alone should not be a consideration.