By Michael R. Morris, Esq.
Favorable tax law changes originally made in 2006 continues to offer significant tax planning opportunities for both songwriters and music publishers. The potential tax breaks for songwriters were especially ground-breaking, permitting self-created musical compositions or copyrights in self-created musical works to be electively treated as capital assets. Why does this matter? Because gain upon the sale of a long-term capital asset (i.e., an asset held more than 12 months) is generally taxed at an extremely favorably 15% rate, in lieu of regular personal income tax rates presently ranging as high as 35%. Thus, a seller of eligible self-created musical compositions or copyrights in musical works can save a bundle in taxes. Under a related law, buyers of these rights can elect to write off the purchase price over five years, enabling music publishers to take a tax deduction for the purchase price of copyrights (including songwriter advances) ratably over five years. Let's take a closer look at how these favorable tax laws work.
Elective Capital Gains Treatment for Self-Created Musical Works
Under prior law, copyrights, literary, musical or artistic compositions, letters or memoranda or similar property were not considered "capital assets" in the hands of its creator. Thus, a songwriter who sold his or her own songs, like an artist selling a painting, paid "ordinary" income tax rates (currently up to 35%). Conversely, the same songs in the hands of the music publisher who bought those copyrights were considered tax-favored "capital assets." Not only could the music publisher take a tax deduction for the cost of acquiring the copyrights (as a yearly percentage of the purchase price), but the subsequent resale of such copyrights would be at a tax favored capital gains rate of 15% (provided the songs had been held by a non-corporate publisher for at least the 1-year long-term capital gains period). Congress sought to redress this imbalance in tax rates between songwriters and publishers, stating in a report: “ … it is appropriate to allow taxpayers to treat as capital gain the income from a sale or exchange of musical compositions or copyrights in musical works the taxpayer created.”
Initially, this favorable capital gains election for self-created musical works was set to expire on December 31, 2010, but fortunately for songwriters, it was made permanent. However, this lower capital gains rate is not automatic! A songwriter selling compositions held more than 12 months must affirmatively elect the lower tax rate (sounds like a no-brainer, unless you want to voluntarily reduce the national debt).
This tax law does not define what constitutes a self-created "musical composition" or a self-created "musical work." For example, if one songwriter contributed lyrics and another music to a composition, should there be any tax difference? Probably not. But what if a writer's existing poem became the lyrics of a song to which another writer contributed the melody. That song would generally be covered by a single copyright, and in this author's opinion, the sale of that song should entitle the creators of both the lyrics (i.e. the poem) and the melody to favorable capital gains treatment, even though the sale of the stand-alone poem would not qualify.
The law also fails to address what music assets in addition to self-created songs qualify as "capital assets," only stating that both self-created "musical compositions" and "copyrights in musical works" qualify for elective capital gains treatment. Thus, royalty and other income from the exploitation of musical compositions is not eligible for reduced capital gain rates. However, the term "copyrights in musical works" is intuitively more expansive than "musical compositions," and could include copyrights in self-created sound recordings (which, of course, would be recordings of "musical compositions"). This distinction can have real financial impact upon an artist selling both self-created master recordings and the underlying self-created musical compositions. For example, an artist might sell a library of existing recordings concurrently with the copyrights in the underlying musical compositions to a film-TV music production house. Again, this author believes the transfer of master recordings constitutes the sale of a copyright in a self-created musical work, but the IRS has not yet issued any interpretive rulings.
Just when the 1-year holding period for long-term capital gains treatment begins can also be an interesting question. Obviously, the 1-year period begins from creation of the work for a songwriter who always retained ownership. But what about situations where a songwriter (or heirs) have rights to reclaim previously granted copyrights under the termination provisions of Sec. 203(a) of the Copyright Act? For example, grants made after 1977 of rights in a copyright may be terminated at any time during the 5-year period beginning 35 years after the date the original grant was executed. The right to the subsequent reversion of a previously transferred copyright gets triggered by the songwriter (or statutorily prescribed heirs) providing timely notice and making the proper filing under Sec. 203 (such right would then be "vested"). This notice must be given not less than 2 nor more than 10 years prior to the effective date of termination. Once the termination provisions of Sec. 203 have been met, the copyright automatically reverts at the designated future date during the 5-years following the expiration of the 35-year grant.
Since the rights to this future reversion can be sold, does the 1-year long term capital gain period begin from the date the Sec. 203 notice was given, enabling the sale of that right to be eligible for favorable tax treatment? Or does the 1-year holding period only run from the date the copyright actually reverted? The earliest effective date for termination under Sec. 203 is January 1, 2013 (for grants made on January 1, 1978). Only if the sale of a future reversion is considered the sale of a copyright in a musical work would the songwriter (or heirs) be eligible for reduced tax rates on sales made 1 year after complying with the Sec. 203 termination provisions. Otherwise, the 1-year long-term capital gain holding period would only commence from the date of actual copyright reversion, so that copyrights which begin reverting in 2013 would only then become eligible for long-term capital gain treatment (after being held for at least 12 months following reversion). Again, the IRS has issued no pronouncements on this issue.
Last year, the IRS did, however, issue proposed and temporary regulations providing that the election to treat a musical composition or copyright as a capital asset must be made separately as to each composition or copyright sold or exchanged during the taxable year. This election must be made on or before the due date of the tax return for the year of sale or exchange (including extensions). Accordingly, creators of musical compositions and copyrights in musical works who sold such rights in 2008 are reminded that an affirmative election is necessary to take advantage of favorable capital gains rates.
Five-Year Amortization Period for Musical Works.
Buyers of eligible musical works and copyrights also continue to get “tax bang” for the buck. Under prior law, the cost of acquiring a musical copyright generally had to be amortized and deducted over the period that the song was projected to generate income under the "income forecast" method (a frequently complicated computation).
Since 2006, any expenses paid or incurred creating or acquiring any "applicable musical property" can be amortized over the 5-year period beginning with the month during which the property was "placed in service" (for example, when a song gets exploited). Both songwriters who incurred expenses creating "applicable musical property" and music publishers who acquire them can take advantage of this business-friendly 5-year schedule. For example, assume a music publisher paid $1,000,000 for applicable musical property on January 2, 2008 and places it in service on January 31, 2008. Provided the 5-year amortization election is made, the publisher would get to deduct $200,000 as an expense for 2008 (and a like amount for 2009-2012). The term "applicable musical property" is defined as any musical composition (including any accompanying words) or any copyright with respect to a musical composition that is depreciable under the income forecast method. This means that sound recordings are probably not eligible for the 5-year amortization schedule.
Congress has lowered tax rates for songwriters who sell their catalogs and electively take advantage of capital gains treatment, provided such songs were held more than one year. This is in stark contrast to the higher non-capital gain tax rates paid by authors and painters who sell their literary works or paintings. In addition, music publishers buying songs can recover the purchase price over an election 5-year period.
Questions do remain as to what constitute self-created musical works eligible for favorable capital rates. Does it include sound recordings and/or vested future reversion rights? Hopefully, the IRS will provide rulings that favorably resolve these issues. In the meantime, these tax incentives afforded songwriters and publishers will continue to provide a powerful stimuli to the music publishing market.
© 2009 Valensi Rose PLC
* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * *
Michael R. Morris is a former president of the California Copyright Conference and a principal in the Century City law firm of Valensi Rose PLC (www.vrmlaw.com). A former IRS trial attorney and Certified Specialist – Taxation Law (State Bar of California), Michael's practice emphasizes music, entertainment and tax-related matters.