Why Filmmaking Cannot Be A Hobby...

 

Blast! Director Paul Devlin on the IRS’s battle with documentary filmmakers.


Last year at a summit meeting of the independent film community called “The Conversation,” Ira Deutchman was compelled to propose, “Filmmaking has never been a business…it’s a hobby.”

Sentiments like this are not uncommon after the hardships filmmakers have faced in recent years, the multiple threats to our business models that accompanied both technological change and the global economic crisis. In fact, many filmmakers have been forced to re-evaluate the economic viability of their entire enterprises.

Soul-searching in tough times is important, but our community must be extremely careful with our language and avoid using words like “hobby.” Why? Because the IRS is listening! If you are deducting filmmaking expenses from other sources of income on your tax returns, then you must identify your filmmaking as a for profit business and not a hobby.

Documentary filmmakers have become especially vulnerable to the perception that they are engaged in a hobby rather than an activity for profit. Because development takes so long and revenue sources are so difficult to sustain, filmmakers often endure losses over many years. They persevere because they become so passionate about their subject matter and the need to spread their message to the world that generating a profit may not seem primary.

Unfortunately the unfair and incorrect perception that documentary filmmakers are not interested in profit has resulted in unsettling scrutiny of our industry by the U.S. Internal Revenue Service. In a case now in U.S Tax Court in Arizona, the IRS has been asked to demonstrate whether or not the primary purpose of documentary filmmaking in general is “to educate and to expose” and is thus “an activity not engaged in for profit.”

This may sound absurd, but it is very serious. If the IRS wins their case against Arizona filmmaker Lee Storey (Smile ’Til It Hurts: The Up With People Story), documentary filmmakers may no longer be permitted to deduct expenses associated with making their films from other sources of income. Furthermore, filmmakers who have already deducted these expenses may be faced with potentially ruinous audits.

Storey is a practicing attorney in Arizona who made her debut feature after she learned that her husband was secretly a former member of the singing phenomenon Up With People. According to LA Weekly, Smile ’Til It Hurts: The Up With People Story “is a withering critique of the organization’s religious cult roots [and] right-wing political subtext” while still being respectful of the fact that members found “a way to affect positive, even progressive, change in the world.” The award-winning movie screened to enthusiastic reviews at Docuweeks, Slamdance, Full Frame, Big Sky, Michael Moore’s Traverse City fest and the Florida Film Festival, among others.

In 2010, the IRS audited Storey. She had set up an LLC for her filmmaking, but the IRS determined that her filmmaking activity was not engaged in a profit-making enterprise. As a result, business deductions associated with her film over three years were disallowed. The IRS determined that she owed the government more than $300,000 in back taxes, penalties and interest. She has appealed and is now in an expensive, drawn-out battle to demonstrate the profit motive, not only of her own filmmaking activity, but that of all documentary filmmakers.

In recent weeks, the documentary community has mobilized, realizing the devastating potential of Storey’s case. My own experience with a recent IRS audit makes me know that this threat is all too real.

The business of nonfiction filmmaking in the U.S. has become ever more competitive, speculative and entrepreneurial. Often even veteran filmmakers are expected to have significant portions of their films completed to demonstrate merit before funders will participate. As a result many filmmakers are investing substantial amounts of their own money to get their films off the ground.

This investment can stretch over many years as the project develops. During this time costs absorb revenue so there is little opportunity to profit until the project is complete and sales can be made. Deducting losses during the development period from other sources of income to reduce personal income tax can help ease the financial burden facing independent filmmakers.

The IRS has no problem with a taxpayer deducting expenses for an activity from the income of that activity, even when the activity is considered a “hobby.” However, when expenses from that activity create losses that offset other sources of income (such as income from a “day job”), the IRS requires that the taxpayer be able to demonstrate that it is “an activity engaged in for profit.”

Last year, the IRS audited my 2007 and 2008 tax returns. After conducting two arduous interviews lasting many hours each and combing through my meticulously well-documented financial records, the IRS revenue agent determined that my own documentary film business was “an activity not engaged in for profit.” This is the euphemism the IRS uses for “hobby.” Although he cited several factors, many years of losses provided the primary basis for his determination.

The agent’s report disallowed all deductions that resulted in losses for 2007 and 2008. I was going to owe up to $80,000 in back taxes and penalties to the U.S. and New York State governments. Moreover, this meant I would not be able to deduct most of my business expenses for 2009 and 2010. I was not only being put out of business, my personal financial well-being was threatened.

I was outraged. Filmmaking was my pasttime? Clearly, the agent had no idea how much work goes into making an independent film. I did my best to describe the grueling shoots in far away places, the all-night edits, the endless fundraising and marketing, and the constant efforts to sell, sell, sell. Did he really think I had no interest in making money?

My entreaties had no effect. The agent had made up his mind. He insisted that my filmmaking was an activity not engaged in for profit and my tax deductions over the years were, therefore, not legitimate. I owed the IRS big-time.

As a matter of survival, I had to become an expert on the IRS “hobby loss rule,” consulting with lawyers and accountants and doing my own research to challenge the revenue agent’s determination. Otherwise I would not be making independent films again.

Stuart Wolff, a tax preparer who works with many independent artists in New York, advised me that I needed to better separate my filmmaking income from my personal income. Years ago, I had moved away from a Sole Proprietorship, which provides almost no separation. A C-Corporation is designed for large companies and does not allow the flow-through of losses and profits to a personal tax return. The best choice for independent filmmakers is either a Limited Liability Company (LLC) or an S-Corporation.

Wolff recommended that I dissolve my Limited Liability Company (LLC) and set up an S-Corporation. “Technically, an LLC is a separate entity, but it gets filed under your personal tax return using a Schedule C. So you risk the perception that the business is not separate from your personal activity.” He explained that an S-Corporation requires a completely separate tax return. Of course, filing an additional return costs more money if you are paying a tax preparer, and there are no guarantees that the IRS will not also audit an S-Corporation. But the S-Corporation has the advantage that you can still carry over business losses and profits to your personal tax return, while more clearly delineating your business activity with a separate filing.

Creating a more defined separate business entity with an S-Corporation might help me for the future, but not for the returns I filed as an LLC that were now being audited. For more help, I turned to Richard C. Antonelli, a tax lawyer with offices in New Jersey and New York. Now in private practice, Antonelli spent 15 years working for the IRS as a revenue agent, appeals officer and then as an attorney litigating cases in tax court.

“It’s a common misperception that multiple years of losses automatically indicate that your activity is a hobby rather than a business,” Antonelli told me. “In fact, the IRS guidelines focus on the inverse: if your business is profitable three out of five years, then you have what’s called “safe harbor,” a presumption by the IRS that your business is an activity engaged in for profit, even though you may have had some years of losses.”

But what if I can’t demonstrate even that much profitability, just losses in the past five years? Is my case hopeless?

“Not at all,” Antonelli assured me. “In fact the IRS guidelines for revenue agents specifically state that not meeting the presumption rule cannot be the sole basis for disallowing losses. Determinations must be made on a case-by-case basis using nine factors.”

I searched online for the IRS guidelines and became an expert on the nine factors used to decide “whether a taxpayer operates an activity with an actual and honest profit motive”:

• the manner in which the taxpayer carried on the activity,

• the expertise of the taxpayer or his or her advisers,

• the time and effort expended by the taxpayer in carrying on the activity,

• the expectation that the assets used in the activity may appreciate in value,

• the success of the taxpayer in carrying on other similar or dissimilar activities,

• the taxpayer’s history of income or loss with respect to the activity,

• the amount of occasional profits, if any, which are earned,

• the financial status of the taxpayer, and elements of personal pleasure or recreation
 
As I researched, I became reassured. When applied to my filmmaking, these factors clearly indicated that mine was “an activity engaged in for profit.” I kept careful records, had expert advisors, spent more time making my own films than at my day job, etc. Also reassuring was the fact that no single factor or combination of factors was conclusive. The IRS guidelines gave the example that “if five factors say the activity is not for profit, but four are on the profit side, the activity still could be determined to be engaged in for profit.” Although based on facts, a determination was essentially subjective.

Antonelli pointed out that the IRS gives much recourse to taxpayers not in agreement with a revenue agent’s report: “The first step is to set up a meeting with the agent’s supervisor. If the supervisor doesn’t see it your way, then we appeal. The appeal may take up to a year. And if an appeal is not successful, we take the case to tax court. But hopefully it doesn’t go that far.”

No kidding! That would be an expensive, exhausting ordeal. My goal was to win right out of the gate and convince our revenue agent’s supervisor.

Armed with my new understanding of the law, I sat down with my office to make our case. We created an exhaustively documented report of more than 50 pages, using the nine factors as guidelines to substantiate with facts why our business was an activity engaged in for profit. I read the opening summary out loud at the meeting with the revenue agent’s supervisor and my tax preparer, Stuart Wolff.

The supervisor was sympathetic and our report was hard to refute. However, she was not completely convinced. After an impressive presentation of all the accoutrements of our profession, with an emphasis on the moneymaking efforts, she smiled and commented casually, “This is great. You like making films don’t you?” “Of course I do,” I responded, relieved at making a more personal connection. “It’s a lot of fun.”

Wolff gave me a sharp look and I realized with dread that I had made a potentially fatal error. The last of the factors is “elements of personal pleasure or recreation.” I changed tone immediately, “But sometimes I hate how difficult it can be — shoots that go on indefinitely, wading through hundreds of hours of footage can be sheer drudgery, the pressure of 20-hour editing sessions to make a deadline has adverse effects on my health and the travel can be wearing, weeks away from friends and family. It’s a really tough job.”

I had regained my footing and shifted direction. “But the sacrifice is worth it because the potential pay off is huge. My friends Annie Sundberg and Ricki Stern just grossed close to $3 million with their movie about Joan Rivers, A Piece of Work. Morgan Spurlock had no idea Super Size Me was going to be such a huge hit when he started making films. And look at Michael Moore! His documentaries have earned close to $200 million at the box office. I’ve leaned my lesson. My next film is my most commercial project yet.  It could be the next documentary blockbuster!”

Phew — that was more what she wanted to hear. I was indirectly referencing what I nicknamed the “wildcat oil well principle,” based on an example the IRS uses to illustrate this guideline: “…an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated.”

What better description of the film industry? Even for the major studios, it’s the occasional blockbuster that earns “substantial ultimate profit” and sustains the vast majority of films, which are financial failures. My model was similar except that as an independent, I could make only one film at a time, over the course of several years. When that blockbuster arrives, however, it will justify all the money losers in my “highly speculative venture.”

The supervisor was still concerned about the many years of losses. However, our report, the description of the film industry business model and my honest interest in making a profit appeared to be convincing. Several weeks later, I received notification that the original revenue agent’s determination had been overturned. I was, in fact, engaged in an activity for profit. My business expenses would be allowed and I owed only a minor amount in back taxes. I had dodged a devastating bullet.

Like any filmmaker, I was called upon by the IRS to prove the profit motive of my individual film practice. Storey’s case in Arizona, however, has much broader implications for all documentary filmmakers.

In Storey’s case, the U.S Tax Court in Arizona is ruling not just on whether an individual filmmaker is engaged in an activity for profit. Judge Diane Kroupa has decided to rule on whether documentary filmmaking in general can be compatible with a profit motive when its primary purpose is “to educate and to expose.”

Certainly many of us can think of enterprises in which the main mission is “to educate and to expose,” while still making a profit. Regardless, the U.S Tax Court in Arizona seems determined to target aggressively all documentary filmmaking as an activity not engaged in for profit. If this opinion is memorialized in a ruling against Storey, documentary filmmakers may no longer be able to deduct business expenses associated with filmmaking from other sources of income. It is very likely I would have lost my case if this precedent had been set prior to my audit.

Even more disturbing, if Storey loses her case, is the possibility that documentary filmmaking in general could become a “red flag” for IRS agents. The precedent could provide incentive for individual IRS agents to audit any documentary filmmaker who has ever reported losses going back three years (or more, depending on the circumstances). This could produce a profoundly destabilizing outcome for the documentary community. Even a successful defense is costly, distracting and intimidating.

Storey insists that she was very motivated by potential profit from the project’s inception:  “The movie has a built-in target of 20,000 Up With People alumni, performing to 3,600 worldwide communities, 20 million viewers, and staying in 450,000 host families, not to mention annual hoopla over their four Super Bowl halftime shows. There is a huge, clearly defined core audience that any filmmaker would envy.” Still the IRS is claiming there was no profit motive in the making of Smile ’Til It Hurts.

Like mine, Storey’s case is strong for most of the nine criteria. So the IRS has focused on the final one, “elements of personal pleasure or recreation.” Regarding her filmmaking, Storey admits, “Yep, I love it and the IRS is using clips of me on You Tube saying how much I enjoy making films. That doesn’t mean it isn’t hard work or that I love every aspect of documentary filmmaking. I told them at trial that I also love my law job, which I do! Why can’t you like what you are doing and make money too?”

The sad irony is that the IRS’s case against Storey may make it impossible for her to profit from her movie. In fact, it could force her into personal bankruptcy. “I’ve spent a fortune because the IRS made me go to trial. And it isn’t over. There may be appeals, and the IRS may come after me for 2009 and 2010 also even if I win. Why? The IRS attorney here in Arizona said: ‘Because we can.’”
Aware of the broad implications of Storey’s case, The International Documentary Association (IDA) has assembled a coalition of organizations and prominent individual filmmakers to provide advocacy. Michael Lumpkin, executive director of the IDA, recently posted on the IDA website:

To support Storey, IDA has filed an amicus brief in the case urging the U.S. Tax Court to recognize that the production of a documentary film is, at its core, a “for profit” business such that business expenses are deductible for tax purposes.
 
By doing so we hope to ensure that all filmmakers receive the respect they deserve, and that the many sacrifices they make in the pursuit of their art and livelihood will not be made in vain.”

Entertainment attorney Michael Donaldson works on a pro bono basis with the IDA on its many advocacy efforts and filed the brief on their behalf. According to Donaldson, “The Storey case is one that could have ripple effects across the entire independent film community, which is why we stepped in.”

A glimmer of good news is that if Storey wins her case, it could set a precedent that works in favor of our industry. This has made Storey a de-facto defender of all documentary filmmakers. To support her cause, you can visit smiletilithurts.com and contribute to Storey’s legal defense fund or buy a DVD of her film.

So why is the IRS targeting documentary filmmakers so aggressively, while huge corporations seem to get a pass? It’s not like we have a whole pile of money to hand over. Conspiracy theorists might look with raised eyebrows at this issue alongside other legal controversies coming out of Arizona. Perhaps documentary filmmaking is being targeted precisely because the primary mission assigned to it by Judge Kroupa, “to educate and to expose,” is threatening to those in power.

But Antonelli offers a more mundane explanation. “When the IRS becomes aware of possible tax abuses in certain industries, whether it’s through their own audits or from third party information, they will focus on that industry to generate revenue and to encourage compliance.” The problem is that taxpayers who do not abuse the system get caught in this web. Moreover, those with limited resources who cannot afford proper representation may become easy targets. As Antonelli points out, “Unfortunately, there are some in the IRS who will take advantage of the pro se [without an attorney] taxpayer.”

On the other hand, there may be an upside to all of this. My audit focused my office’s attention on how we run our business. As a result, our bookkeeping improved and we became more aware of how we spend our time. We streamlined communication, implemented more professional practices, such as making revenue projections, and we examined expenditures more carefully and made efforts to reduce them. New projects are now evaluated on their likelihood to profit, not only on how passionate we feel about them. The IRS ordeal may force documentary business models like mine to mature.

Perhaps it is even possible that we, as a community, will look back on this moment and decide that the IRS has done documentary filmmaking a major service. The industry expectation that documentary filmmakers are willing, even happy, to accept major, ongoing financial losses to get our films made and seen has become institutionalized in recent years. The IRS has now given us all official notice that this model is not sustainable and will be challenged aggressively. In order to maintain a steady stream of high-quality content, our industry will be forced to create a new paradigm that compensates filmmakers fairly so that we have reasonable expectations of profiting from our work. With the IRS looking over our shoulders, filmmakers will need to insist on this.

The alternative is that many of these valuable films will cease being made. It will no longer be viable for independent documentary filmmakers to initiate and sustain them speculatively with personal finances. And if that is the outcome, we will all be the poorer for it.

At the very least, never again should any of us refer to our filmmaking as a hobby.


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