Advances to Talent

Agreements for the services of talent, such as actors, directors, producers, writers and so forth, frequently provide that the talent is entitled to a combination of fixed compensation in the year the services are rendered plus contingent compensation, if earned out, typically in later years. The contingent compensation is usually payable on the occurrence of one or more events, perhaps the film achieving certain levels of box office receipts, the studio reaching certain financial targets or other specified occurrences. The structure of the contingent payments vary widely, and might be styled as a fixed amount, a percentage of net profits or adjusted gross, or otherwise.

While not an everyday occurrence, it is not unheard of for a studio to be willing to pay the talent a nonrefundable advance against this back-end participation. When this happens, it usually occurs (if at all) when the film is doing exceptionally well following release and the studio is anxious to keep its star player happy.

In yet another example of the lunacy of the tax laws as they apply to compensation for personal services, it is possible that the advance payment described above might be subject to a 40% penalty ' 20% under Sec. 409A of the Internal Revenue Code of 1986, as amended (IRC), and 20% under the laws of those states, such as California, that have conformed to Sec. 409A. This could push the effective marginal tax rate on the advance to over 80%. Needless to say, this result is disastrous, and extreme care must be taken not to run afoul of the rules.

Background of IRC Section 409A

Section 409A, which was enacted as part of the American Jobs Creation
Act of 2004, is titled “Inclusion in Gross Income of Deferred Compensation
Under Nonqualified Deferred Compensation Plans.” It was enacted in response to a perceived tax abuse perpetrated by high-level Enron executives. These
executives participated in a traditional nonqualified deferred compensation plan maintained by Enron and apparently had many millions of dollars invested in this plan. Unlike a qualified plan, such as a 401(k) or a defined contribution plan, the Enron plan was unfunded and the executives were unsecured general creditors of Enron with respect to amounts owed to them under the plan. As a result, a bankruptcy of Enron would have wiped out their interests in the plan.

Apparently anticipating Enron's demise, the executives all exercised a right granted to them under the plan to withdraw funds from the plan at any time, as long as they forfeited 10% of the funds to be withdrawn. This so-called “haircut provision” was a necessary part of the plan in order to prevent the executives from being in constructive receipt of plan assets from the moment the executives originally deferred their compensation. Without the haircut provision, the executives would have been able to withdraw funds from the plan at any time without penalty ' a plan feature that would have denied them the tax deferral. At the time, haircut provisions in nonqualified deferred compensation plans were extremely common and were supported by existing tax law.

The Enron executives exercised their haircut provisions and withdrew millions of dollars from the plan. Shortly thereafter, Enron collapsed. Congress was outraged by the fact that the executives profited while the shareholders and employees suffered, and it enacted Sec. 409A in response.

Section 409A is undeniably one of the most complicated sections of the Internal Revenue Code. It has already spawned hundreds of pages of tortured regulations which themselves, to this day, leave unresolved numerous critical issues (including the treatment of advances to talent). Section 409A is typical bad tax legislation for the following reasons.

First, it was enacted in response to a very specific, very narrow perceived tax problem arising in the arena of nonqualified deferred compensation plans for high-level corporate executives. Rather than just solve the precise problem, though, Sec. 409A completely rewrites decades of well-settled tax law relating to deferred compensation, pushes strongly and negatively into areas not previously thought of as deferred compensation, and has already cost companies and individuals untold millions of dollars in compliance costs.

Second, Sec. 409A is at least the third major attempt by Congress to use the tax laws to legislate executive compensation problems. The first two are: Secs. 162(m), which denies public companies tax deductions for compensation to selected individuals in excess of $1 million per year; and 280G, the golden parachute provision which seeks to discourage compensatory payments contingent on changes in corporate control. It is widely believed that Secs. 162(m) and 280G, which have been part of the tax landscape for many years, have utterly failed to achieve their stated objectives. In fact, some observers believe that these provisions have actually encouraged executives to act in exactly the ways the legislation seeks to discourage.

Section 409A is just the next sad stage in this misguided effort to legislate corporate behavior. Equally unfortunate is the long reach of Sec. 409A into areas that are far removed from executive compensation, such as payments to talent.

The Basic Rules

Section 409A does not actually repeal the decades-old tax laws relating to deferred compensation. Instead, it adds additional requirements. These requirements fit in three broad categories.

First, strict time guidelines are imposed relating to the time when deferral elections can be made. Second, amounts that are deferred may be paid to service providers only at certain predefined times or events. Third, accelerating or further deferring the payout of deferred compensation is prohibited. It is this third prohibition that causes concern in the area of advances to talent, which could be viewed as accelerated payments of deferred compensation.

As mentioned above, the price of noncompliance is severe: a 20% federal tax penalty (plus, depending on the facts, interest and a loss of deferral). State penalties, such as those imposed in California, may serve to double the impact of the federal penalties.

Application of the Rules to Advances

The concept that these draconian anti-Enron rules should apply to compensation paid to talent boggles the mind ' and yet it now seems clear that they do indeed apply. When Sec. 409A was first enacted, it seemed inconceivable that advances to talent could be snared by the rules. In fact, in 2005, I co-authored a piece that described in general terms the implications of the newly enacted Sec. 409A on advances to talent against back-end participations (see, “Federal Tax Reform Includes Traps for Deferred Compensation Deals,” Entertainment Law & Finance, Vol. 21, No. 1, April 2005; available online for subscribers or purchase at www.ljnonline.com/issues/ljn_entertainment/21_1/news/144206-1.html), and expressed the widely held perception among practitioners that Sec. 409A should not be problematic for advances. First, the limited guidance that had been promulgated at the time didn't seem to concern itself with this particular problem. Second, IRS personnel working with the Sec. 409A rules made off-the-record comments expressing their belief that Sec. 409A should not apply to such advances. Finally, the policy reasons that resulted in the adoption of Sec. 409A had nothing to do with, and were not violated by, advances to talent. Pending the issuance of final guidance under Sec. 409A, practitioners commonly expressed the view that the rules shouldn't apply because the purpose of Sec. 409A was to stop perceived deferred compensation abuses that had absolutely nothing to do with advances to talent.

Unfortunately, there is nothing in the very lengthy final regulations that were subsequently promulgated, or in the other (limited) guidance that has been issued to date, that addresses this issue. In addition, studios themselves have recently been raising Sec. 409A as a defensive tactic against requests for advances by talent. We are thus left to deal with the rules head on.

Definition of Deferred Compensation

The starting point in the analysis is the definition of deferred compensation. If a payment arrangement does not constitute deferred compensation, then Sec. 409A does not apply. If a payment arrangement does constitute deferred compensation, then an exception must be sought. Unfortunately, “deferred compensation” is defined very broadly and arises if a service provider (the talent) has a legally binding right during a taxable year to compensation that may be payable in a later taxable year. The fact that there is no assurance that any amount will actually be paid in a future year does not mean that the service provider does not have a legally binding right to payment in the year the services are initially rendered. An agreement pursuant to which talent provides services in one year with a contractual right to contingent compensation in a later year seems to fall squarely within the definition of deferred compensation.

Having concluded that the compensation arrangement appears to create deferred compensation, the good news is that there are a number of possible ways around the Sec. 409A problem (which arises not by virtue of merely characterizing a payment arrangement as deferred compensation, but in this case by taking a potentially prohibited accelerated payment against that compensation). Because the availability of one or more of these “outs” depends entirely on the specific facts, though, each case must be analyzed carefully and separately.

Exception 1: Short-Term Deferrals.

Probably the most useful exception is the one for short-term deferrals. There is no deferral of compensation as long as the compensation is received no later than 2' months into the tax year following the first tax year in which the amount is no longer subject to a substantial risk of forfeiture. The concept is that payments made within a short time period following the date on which the service provider is first entitled to the payment is not deferred compensation.

Here is how the short-term deferral rule might work in the context of participations or other contingent compensation. Suppose an actor's loan-out corporation is paid $1 million in fixed compensation for the actor's work on a film, plus 5% of the studio's adjusted gross from the film after the studio receives $100 million in adjusted gross. The contract provides that at the end of each calendar quarter, the studio will prepare and send to the loan-out corporation a calculation showing whether the studio has hit the $100 million mark and, if it has, an additional calculation showing whether any amounts are payable to the loan-out corporation. If the calculation indicates that amounts are payable, then a check will be enclosed with the quarterly statement.

In the absence of the short-term deferral rule, and as mentioned earlier, the arrangement would likely constitute deferred compensation (unless another exemption applies) and, as such, would be subject to the severe penalties if accelerated payments (i.e., advances) were made. The short-term deferral exemption will apply in this situation if the circumstances of the contingent payment constitute a substantial risk of forfeiture.

The Section 409A regulations provide that one of the ways compensation is subject to a substantial risk of forfeiture is if entitlement to the amount is conditioned on the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. A condition related to a purpose of the compensation may relate to the studio's business activities or organizational goals. The regulations give the example of the attainment of a prescribed level of earnings or completion of an IPO. Certainly the studio's achieving targeted earnings from a film project should qualify under this test.

Note that the risk of forfeiture must be “substantial.” This requires a careful analysis of the exact contingencies that must be satisfied in order for the talent to receive payment. If the barrier to payment is too low, the IRS will conclude that there is no substantial risk of forfeiture, and the short-term deferral rule will not apply. For example, I would be concerned if the contingent payment were triggered, say, at a zero or very low level of gross receipts by the studio, which might support the argument that it is highly likely that a payout will occur and thus the risk of forfeiture is not substantial.

Note also that the short-term deferral exemption is not available if the payment is not made during the tax year in which the risk of forfeiture disappears or within the first 2' months of the following tax year. If the short-term deferral exception is not available, then the payment will be treated as deferred compensation and an advance against it will be subject to the Sec. 409A penalties (unless another exemption applies).

Loan-out Corporations

Use of loan-out corporations complicates the full availability of the exemption. Suppose the talent agreement is with a loan-out corporation rather than with the talent individually. As discussed above, payments to the loan-out corporation may be eligible for the short-term deferral exemption. The question then becomes how to get that compensation out of the loan-out corporation and into the hands of the individual talent. The amounts payable by the loan-out corporation to the individual appear to be deferred compensation, consistent with our assumption that the individual worked in one year and is receiving payment in a future year, and thus are themselves subject to the Sec. 409A penalty tax unless they qualify for their own exemption. The short-term deferral approach again seems to be a good plan, although there are some uncertainties in its application because of the fact that the talent typically controls the loan-out corporation. At the very least, a properly drafted employment agreement between the talent and the loan-out corporation should be in place.

Note that if the loan-out corporation has an S election in effect, the corporation could conceivably distribute the amounts to the individual owner as noncompensatory distributions, rather than salary and/or bonus. The risk is that that such distributions may be subject to IRS challenge as not constituting a sufficient level of compensation. Practitioners in the area debate inconclusively the necessary minimum level of compensation from an S corporation loan-out company to its sole shareholder. It is safe to say, though, that to take the position that none of the amounts received by the corporation as contingent compensation are themselves compensation when distributed to the shareholder is quite risky.

Exception 2: Independent Contractors.

The regulations contain an exception for payments to independent contractors. While at first blush this sounds like an exception that will exempt most arrangements with talent, unfortunately there are several obstacles.

The definition of “independent contractor” in the regulations is drawn very narrowly. The primary requirement is that the service provider must provide “significant services” to two or more service recipients (studios) to which the service provider is not related and that are not related to one another. There is a safe harbor if the revenues generated from the services provided to one party (or group of related parties) in a year do not exceed 70% of the total revenues generated by the service provider from the trade or business of providing such services.

This exemption is problematic in many situations. While the talent may work for different studios each year, perhaps the talent worked only for one studio during the year in question. Or perhaps one project for that year was so successful that it accounted for more than 70% of the talent's revenues. Or perhaps the talent worked on two major projects, but they were both for the same studio. Again, the analysis is highly fact-specific.

As above, the presence of loan-out corporations adds a second layer of complexity to the analysis. The loan-out corporation may be an independent contractor with respect to the studio, but, as described above in connection with the short-term deferral exemption, the funds still need to be paid by the loan-out corporation to the individual talent. And certainly the talent is not an independent contractor with respect to his or her own loan-out corporation, so that exemption will not be available for the second level of payments. But as described in the preceding section, the short-term deferral exemption may apply.

Exception 3: Accrual Method of Accounting.

If the service provider is on the accrual method of accounting, there should not be a problem under Sec. 409A. That accounting method itself eliminates the possibility of deferring compensation. In practice, though, this escape is of minimal utility because most of the relevant service providers (individuals and loan-out corporations) are on the cash method of accounting.

Exception 4: Fresh Compensation.

This is not really an exception to the definition of deferred compensation, but a position that seems plausible in appropriate, if narrow, circumstances. As mentioned at the outset, there are situations in which an advance is paid even though it is not earned out. Talent may be owed contingent compensation based on a net profits interest, but the project may never make it to net profits. For reasons unrelated to the contingent compensation, though, the studio may be prepared to make a large upfront payment to the talent, perhaps to secure the talent's participation on a future project.

In this situation, the payment should not be problematic under Sec. 409A because it is not deferred compensation at all, but rather something else entirely, such as a signing bonus. The catch, though, is that in order to avoid the new payment being treated as a forbidden advance, the documentation of the new payment must probably not provide that the new payment is credited against any potential contingent compensation that might become due on the original project.

Final Thoughts

Section 409A is a brutally complicated provision, the interpretation of which is aided neither by the policy considerations that spawned it nor by intuitive notions of what the right answer should be. The application of Sec. 409A to advances to talent, not to mention to other compensatory structures within the entertainment industry, is uncertain and risky. I have tried in this article to highlight the main potentially applicable ideas, without delving into close statutory and regulatory analysis. There are undoubtedly (and hopefully) additional arguments as well. As such, this discussion is necessarily incomplete, but I hope that it will generate some thoughts on how to address this tricky issue.

Agreements for the services of talent, such as actors, directors, producers, writers and so forth, frequently provide that the talent is entitled to a combination of fixed compensation in the year the services are rendered plus contingent compensation, if earned out, typically in later years. The contingent compensation is usually payable on the occurrence of one or more events, perhaps the film achieving certain levels of box office receipts, the studio reaching certain financial targets or other specified occurrences. The structure of the contingent payments vary widely, and might be styled as a fixed amount, a percentage of net profits or adjusted gross, or otherwise.

While not an everyday occurrence, it is not unheard of for a studio to be willing to pay the talent a nonrefundable advance against this back-end participation. When this happens, it usually occurs (if at all) when the film is doing exceptionally well following release and the studio is anxious to keep its star player happy.

In yet another example of the lunacy of the tax laws as they apply to compensation for personal services, it is possible that the advance payment described above might be subject to a 40% penalty ' 20% under Sec. 409A of the Internal Revenue Code of 1986, as amended (IRC), and 20% under the laws of those states, such as California, that have conformed to Sec. 409A. This could push the effective marginal tax rate on the advance to over 80%. Needless to say, this result is disastrous, and extreme care must be taken not to run afoul of the rules.

Background of IRC Section 409A

Section 409A, which was enacted as part of the American Jobs Creation
Act of 2004, is titled “Inclusion in Gross Income of Deferred Compensation
Under Nonqualified Deferred Compensation Plans.” It was enacted in response to a perceived tax abuse perpetrated by high-level Enron executives. These
executives participated in a traditional nonqualified deferred compensation plan maintained by Enron and apparently had many millions of dollars invested in this plan. Unlike a qualified plan, such as a 401(k) or a defined contribution plan, the Enron plan was unfunded and the executives were unsecured general creditors of Enron with respect to amounts owed to them under the plan. As a result, a bankruptcy of Enron would have wiped out their interests in the plan.

Apparently anticipating Enron's demise, the executives all exercised a right granted to them under the plan to withdraw funds from the plan at any time, as long as they forfeited 10% of the funds to be withdrawn. This so-called “haircut provision” was a necessary part of the plan in order to prevent the executives from being in constructive receipt of plan assets from the moment the executives originally deferred their compensation. Without the haircut provision, the executives would have been able to withdraw funds from the plan at any time without penalty ' a plan feature that would have denied them the tax deferral. At the time, haircut provisions in nonqualified deferred compensation plans were extremely common and were supported by existing tax law.

The Enron executives exercised their haircut provisions and withdrew millions of dollars from the plan. Shortly thereafter, Enron collapsed. Congress was outraged by the fact that the executives profited while the shareholders and employees suffered, and it enacted Sec. 409A in response.

Section 409A is undeniably one of the most complicated sections of the Internal Revenue Code. It has already spawned hundreds of pages of tortured regulations which themselves, to this day, leave unresolved numerous critical issues (including the treatment of advances to talent). Section 409A is typical bad tax legislation for the following reasons.

First, it was enacted in response to a very specific, very narrow perceived tax problem arising in the arena of nonqualified deferred compensation plans for high-level corporate executives. Rather than just solve the precise problem, though, Sec. 409A completely rewrites decades of well-settled tax law relating to deferred compensation, pushes strongly and negatively into areas not previously thought of as deferred compensation, and has already cost companies and individuals untold millions of dollars in compliance costs.

Second, Sec. 409A is at least the third major attempt by Congress to use the tax laws to legislate executive compensation problems. The first two are: Secs. 162(m), which denies public companies tax deductions for compensation to selected individuals in excess of $1 million per year; and 280G, the golden parachute provision which seeks to discourage compensatory payments contingent on changes in corporate control. It is widely believed that Secs. 162(m) and 280G, which have been part of the tax landscape for many years, have utterly failed to achieve their stated objectives. In fact, some observers believe that these provisions have actually encouraged executives to act in exactly the ways the legislation seeks to discourage.

Section 409A is just the next sad stage in this misguided effort to legislate corporate behavior. Equally unfortunate is the long reach of Sec. 409A into areas that are far removed from executive compensation, such as payments to talent.

The Basic Rules

Section 409A does not actually repeal the decades-old tax laws relating to deferred compensation. Instead, it adds additional requirements. These requirements fit in three broad categories.

First, strict time guidelines are imposed relating to the time when deferral elections can be made. Second, amounts that are deferred may be paid to service providers only at certain predefined times or events. Third, accelerating or further deferring the payout of deferred compensation is prohibited. It is this third prohibition that causes concern in the area of advances to talent, which could be viewed as accelerated payments of deferred compensation.

As mentioned above, the price of noncompliance is severe: a 20% federal tax penalty (plus, depending on the facts, interest and a loss of deferral). State penalties, such as those imposed in California, may serve to double the impact of the federal penalties.

Application of the Rules to Advances

The concept that these draconian anti-Enron rules should apply to compensation paid to talent boggles the mind ' and yet it now seems clear that they do indeed apply. When Sec. 409A was first enacted, it seemed inconceivable that advances to talent could be snared by the rules. In fact, in 2005, I co-authored a piece that described in general terms the implications of the newly enacted Sec. 409A on advances to talent against back-end participations (see, “Federal Tax Reform Includes Traps for Deferred Compensation Deals,” Entertainment Law & Finance, Vol. 21, No. 1, April 2005; available online for subscribers or purchase at www.ljnonline.com/issues/ljn_entertainment/21_1/news/144206-1.html), and expressed the widely held perception among practitioners that Sec. 409A should not be problematic for advances. First, the limited guidance that had been promulgated at the time didn't seem to concern itself with this particular problem. Second, IRS personnel working with the Sec. 409A rules made off-the-record comments expressing their belief that Sec. 409A should not apply to such advances. Finally, the policy reasons that resulted in the adoption of Sec. 409A had nothing to do with, and were not violated by, advances to talent. Pending the issuance of final guidance under Sec. 409A, practitioners commonly expressed the view that the rules shouldn't apply because the purpose of Sec. 409A was to stop perceived deferred compensation abuses that had absolutely nothing to do with advances to talent.

Unfortunately, there is nothing in the very lengthy final regulations that were subsequently promulgated, or in the other (limited) guidance that has been issued to date, that addresses this issue. In addition, studios themselves have recently been raising Sec. 409A as a defensive tactic against requests for advances by talent. We are thus left to deal with the rules head on.

Definition of Deferred Compensation

The starting point in the analysis is the definition of deferred compensation. If a payment arrangement does not constitute deferred compensation, then Sec. 409A does not apply. If a payment arrangement does constitute deferred compensation, then an exception must be sought. Unfortunately, “deferred compensation” is defined very broadly and arises if a service provider (the talent) has a legally binding right during a taxable year to compensation that may be payable in a later taxable year. The fact that there is no assurance that any amount will actually be paid in a future year does not mean that the service provider does not have a legally binding right to payment in the year the services are initially rendered. An agreement pursuant to which talent provides services in one year with a contractual right to contingent compensation in a later year seems to fall squarely within the definition of deferred compensation.

Having concluded that the compensation arrangement appears to create deferred compensation, the good news is that there are a number of possible ways around the Sec. 409A problem (which arises not by virtue of merely characterizing a payment arrangement as deferred compensation, but in this case by taking a potentially prohibited accelerated payment against that compensation). Because the availability of one or more of these “outs” depends entirely on the specific facts, though, each case must be analyzed carefully and separately.

Exception 1: Short-Term Deferrals.

Probably the most useful exception is the one for short-term deferrals. There is no deferral of compensation as long as the compensation is received no later than 2' months into the tax year following the first tax year in which the amount is no longer subject to a substantial risk of forfeiture. The concept is that payments made within a short time period following the date on which the service provider is first entitled to the payment is not deferred compensation.

Here is how the short-term deferral rule might work in the context of participations or other contingent compensation. Suppose an actor's loan-out corporation is paid $1 million in fixed compensation for the actor's work on a film, plus 5% of the studio's adjusted gross from the film after the studio receives $100 million in adjusted gross. The contract provides that at the end of each calendar quarter, the studio will prepare and send to the loan-out corporation a calculation showing whether the studio has hit the $100 million mark and, if it has, an additional calculation showing whether any amounts are payable to the loan-out corporation. If the calculation indicates that amounts are payable, then a check will be enclosed with the quarterly statement.

In the absence of the short-term deferral rule, and as mentioned earlier, the arrangement would likely constitute deferred compensation (unless another exemption applies) and, as such, would be subject to the severe penalties if accelerated payments (i.e., advances) were made. The short-term deferral exemption will apply in this situation if the circumstances of the contingent payment constitute a substantial risk of forfeiture.

The Section 409A regulations provide that one of the ways compensation is subject to a substantial risk of forfeiture is if entitlement to the amount is conditioned on the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. A condition related to a purpose of the compensation may relate to the studio's business activities or organizational goals. The regulations give the example of the attainment of a prescribed level of earnings or completion of an IPO. Certainly the studio's achieving targeted earnings from a film project should qualify under this test.

Note that the risk of forfeiture must be “substantial.” This requires a careful analysis of the exact contingencies that must be satisfied in order for the talent to receive payment. If the barrier to payment is too low, the IRS will conclude that there is no substantial risk of forfeiture, and the short-term deferral rule will not apply. For example, I would be concerned if the contingent payment were triggered, say, at a zero or very low level of gross receipts by the studio, which might support the argument that it is highly likely that a payout will occur and thus the risk of forfeiture is not substantial.

Note also that the short-term deferral exemption is not available if the payment is not made during the tax year in which the risk of forfeiture disappears or within the first 2' months of the following tax year. If the short-term deferral exception is not available, then the payment will be treated as deferred compensation and an advance against it will be subject to the Sec. 409A penalties (unless another exemption applies).

Loan-out Corporations

Use of loan-out corporations complicates the full availability of the exemption. Suppose the talent agreement is with a loan-out corporation rather than with the talent individually. As discussed above, payments to the loan-out corporation may be eligible for the short-term deferral exemption. The question then becomes how to get that compensation out of the loan-out corporation and into the hands of the individual talent. The amounts payable by the loan-out corporation to the individual appear to be deferred compensation, consistent with our assumption that the individual worked in one year and is receiving payment in a future year, and thus are themselves subject to the Sec. 409A penalty tax unless they qualify for their own exemption. The short-term deferral approach again seems to be a good plan, although there are some uncertainties in its application because of the fact that the talent typically controls the loan-out corporation. At the very least, a properly drafted employment agreement between the talent and the loan-out corporation should be in place.

Note that if the loan-out corporation has an S election in effect, the corporation could conceivably distribute the amounts to the individual owner as noncompensatory distributions, rather than salary and/or bonus. The risk is that that such distributions may be subject to IRS challenge as not constituting a sufficient level of compensation. Practitioners in the area debate inconclusively the necessary minimum level of compensation from an S corporation loan-out company to its sole shareholder. It is safe to say, though, that to take the position that none of the amounts received by the corporation as contingent compensation are themselves compensation when distributed to the shareholder is quite risky.

Exception 2: Independent Contractors.

The regulations contain an exception for payments to independent contractors. While at first blush this sounds like an exception that will exempt most arrangements with talent, unfortunately there are several obstacles.

The definition of “independent contractor” in the regulations is drawn very narrowly. The primary requirement is that the service provider must provide “significant services” to two or more service recipients (studios) to which the service provider is not related and that are not related to one another. There is a safe harbor if the revenues generated from the services provided to one party (or group of related parties) in a year do not exceed 70% of the total revenues generated by the service provider from the trade or business of providing such services.

This exemption is problematic in many situations. While the talent may work for different studios each year, perhaps the talent worked only for one studio during the year in question. Or perhaps one project for that year was so successful that it accounted for more than 70% of the talent's revenues. Or perhaps the talent worked on two major projects, but they were both for the same studio. Again, the analysis is highly fact-specific.

As above, the presence of loan-out corporations adds a second layer of complexity to the analysis. The loan-out corporation may be an independent contractor with respect to the studio, but, as described above in connection with the short-term deferral exemption, the funds still need to be paid by the loan-out corporation to the individual talent. And certainly the talent is not an independent contractor with respect to his or her own loan-out corporation, so that exemption will not be available for the second level of payments. But as described in the preceding section, the short-term deferral exemption may apply.

Exception 3: Accrual Method of Accounting.

If the service provider is on the accrual method of accounting, there should not be a problem under Sec. 409A. That accounting method itself eliminates the possibility of deferring compensation. In practice, though, this escape is of minimal utility because most of the relevant service providers (individuals and loan-out corporations) are on the cash method of accounting.

Exception 4: Fresh Compensation.

This is not really an exception to the definition of deferred compensation, but a position that seems plausible in appropriate, if narrow, circumstances. As mentioned at the outset, there are situations in which an advance is paid even though it is not earned out. Talent may be owed contingent compensation based on a net profits interest, but the project may never make it to net profits. For reasons unrelated to the contingent compensation, though, the studio may be prepared to make a large upfront payment to the talent, perhaps to secure the talent's participation on a future project.

In this situation, the payment should not be problematic under Sec. 409A because it is not deferred compensation at all, but rather something else entirely, such as a signing bonus. The catch, though, is that in order to avoid the new payment being treated as a forbidden advance, the documentation of the new payment must probably not provide that the new payment is credited against any potential contingent compensation that might become due on the original project.

Final Thoughts

Section 409A is a brutally complicated provision, the interpretation of which is aided neither by the policy considerations that spawned it nor by intuitive notions of what the right answer should be. The application of Sec. 409A to advances to talent, not to mention to other compensatory structures within the entertainment industry, is uncertain and risky. I have tried in this article to highlight the main potentially applicable ideas, without delving into close statutory and regulatory analysis. There are undoubtedly (and hopefully) additional arguments as well. As such, this discussion is necessarily incomplete, but I hope that it will generate some thoughts on how to address this tricky issue.