Home Shaping SuccessSM
By Jon M. Garon*
This is part of a series of book excerpts from The Independent Filmmaker's Law and Business Guide: Financing, Shooting, and Distributing Independent and Digital Films designed to introduce filmmakers and others interested in creating content on the legal issues involved in the filmmaking process.
For many independent filmmakers, the LLC is the best choice for forming a film production company. It can be taxed as either a corporation or a partnership, and its operating agreement is more flexible than corporate bylaws for structuring the film company’s operations, but it limits personal liability as effectively as a corporation. Another advantage of the LLC and partnership forms is the ability to allocate gain, loss, deductions, and credits to participants in a way that maximizes their value to investors.
Nonetheless, a different structure may be preferred, depending on the particular makeup of filmmakers and investors. For films heavily financed by outside investors, the traditional corporate form may be best. Some investors may be reluctant to participate in an LLC, a relatively new business form, and may prefer the more traditional corporate structure. An S corporation combines this familiarity with the tax benefits of a partnership.
C corporations may serve the interests of the investors most effectively. The filmmaker can issue multiple classes of stock and draft different shareholders’ agreements to achieve the same results as with an LLC’s operating agreement. The company will lose the tax advantages of a partnership, but for some investors they will have little value, particularly if the investors are more interested in the long-term growth of their investments than in deducting short-term losses. Corporations are strongly favored for investments such as technology firms that have the possibility of expanding into the public markets. While going public is not a significant possibility for most film companies, the structure may further encourage investors.
Limited partnerships are well suited to individual filmmakers who need to raise capital but want to retain sole operational control over most aspects of the film company. The limited partners participate by contributing the necessary capital for the business, but they do not interfere with its operations. The filmmaker is not protected by limited liability, but since it only shields the filmmaker from liability as an officer or director of the business, and most risk of tort liability will arise from activities in which the filmmaker is personally involved, that protection would be of little value.
If an individual filmmaker is not seeking investment financing, there may not be any benefit to forming a corporation, an LLC, or a limited partnership. Not only is the value of limited liability negligible, but most debt will come from personal loans or unsecured personal credit cards, and the financial risk associated with these obligations will not be changed by using a formal business structure. If the filmmaker is a guerrilla artist, or if she is shooting a short project with a small cast and crew, then she may be best advised to remain a sole proprietor.
On the other hand, if the size of the project increases or if investors are brought in, it is very important that the filmmaker switch to a formal business entity. The worst choice is to ignore the problem and have the law treat the project as a general partnership. The decision to switch need not be made immediately. Tax laws allow the sole proprietor to exchange the business for the assets of a new entity without paying a tax penalty.2 But from the outset of the film project, the filmmaker should have the business management in mind, and she should work with a lawyer and accountant as early as possible so that the necessary business entity can be created when the filmmaker is ready.
Many filmmakers hope to launch an ongoing film company with the creation of their first film. At the same time, they need to keep the investments of each film project separate in order to ensure that the profits from each film are distributed to the investors of the particular project. To accomplish both goals, a popular structure calls for the creation of two limited liability companies, one to serve as the ongoing film business and the other to serve as the fundraising vehicle for the particular project.
1. The Umbrella Company Organized for Multiple Projects
The umbrella company is formed as an LLC owned and operated by the production team. The team may be organized in many different ways: it may consist of a group of producers; a team of writer, director, and producer; a director and actors; or any other possible combination. This company generally has only limited financial needs, and any investors are investing in the overall success of the business, not a particular project. The structure provides for limited liability for all participants and the taxation benefits of a partnership.
The umbrella LLC then serves as the sole manager of a second LLC formed to finance, develop, and distribute a particular motion picture. The investors in the movie are members of the second LLC. This maximizes the control that the filmmakers have over the project while allowing the relationship among the filmmaking team to be carefully crafted to reflect the rights and interests of each of its members.
In the operating agreement of the umbrella LLC, each member of the filmmaking team will negotiate the appropriate arrangement for compensation, responsibility, and control. If the team is composed solely of producers, the arrangements may be very similar for each member of the team. If the team is organized more like a rock band, with a writer, director, actor, and producer each contributing different talents and financial resources, the operating agreement can be drafted to reflect those differences. In addition, these terms may be modified without having to be ratified by the film’s investors, since they are members of the other LLC, not this one.
The umbrella company is only necessary when a team of people are working together to create the movie, but given the highly collaborative nature of filmmaking, these projects have a much greater chance of success than projects attempted by a single filmmaker.
2. The Subsidiary Company Organized as an Investment Vehicle for the Film
The terms of the film project LLC should establish that the company’s activities are limited to the particular motion picture. The company is managed by the umbrella LLC, so the operating agreement should be very clear regarding the authority of the manager—the managing company must have sufficient latitude to make the movie and clear direction regarding its authority to operate, and the role of the investor-members should generally be limited. This does not mean that the filmmakers are not obliged to update investors regarding finances, production, or distribution plans.
Most film investment companies are organized to make a single motion picture. But if the filmmakers know they are making a tent pole project— involving, for instance, a film, sequels, and video game tie-ins—the operating agreement can indicate that the manager has authority to retain earnings to invest in these additional projects. Such authority should be very clearly specified.
It is also important that the investment LLC’s operating agreement grant the filmmakers latitude to be involved in other projects while making the film. In the film industry, filmmakers typically work on multiple projects simultaneously, but this creates a situation in which these projects may be competing for investor dollars, time, and attention, or even film festival admission. To ensure that the investors are fully aware of this reality, the operating agreement should specify that the services of the umbrella LLC and its members are provided on a nonexclusive basis.
Finally, the operating agreement should set forth all the structures for recoupment of investments and profit participation, as well as the fees paid to the umbrella LLC for the management of the film project. While the operating agreement does not take the place of financial disclosure documentation, the two documents will closely resemble each other in many regards. This should allow the attorney to draft the two documents together, saving time and money. And since the operating agreement works as a blueprint for the operations of the company, it should also make it easier for the filmmakers to meet their obligations to their investors.
Technically, the managers of the umbrella LLC have no direct relation to the investors in the film project LLC, but the parties should not rely on this legal fiction; each filmmaker should treat his duties to the investors as if he were a personal manager of the film project LLC. The two-LLC structure is not likely to immunize the filmmakers from their ethical and fiduciary obligations, described in chapter 3, and should not be used for that purpose.
The required filings—the Articles of Organization—are often one-page fill-in-the-blank forms that must be submitted, along with a tax payment, to the secretary of state in the state in which the film company will be located. While simple to fill out, the Articles of Organization provide no information about how the business should be run. So in addition to this certificate, a film company LLC should have a written, signed operating agreement that serves as the articles and bylaws of the organization.
The operating agreement establishes the rules for managing and operating the business. Many of its provisions are common to every LLC, and these provisions will be found in virtually every form book. They establish the name and place of business of the LLC, regulate the admission and removal of participants, and provide for maintenance of capital accounts, terminations, and transfers of interest. Nonetheless, there are a few additional issues of particular concern for the filmmaker.
In many states, the operating agreement may simply indicate that the manager—the filmmaker—has sole management authority, that there will be no meetings, and that the profits and losses will be shared in a specified manner between the manager and the other members of the LLC. Investors in the film company, however, may not wish to give such unbridled discretion to the filmmaker, particularly over the raising of capital or other financial decisions. One of the primary benefits of the LLC is the opportunity to shape the business entity to reflect the nature of the investors’ interests and the filmmaker’s needs. Because the filmmaker needs to encourage investment in the film—a very risky investment—the filmmaker should provide operational protections for the investor as a way of encouraging investment and demonstrating responsibility regarding the enterprise.
The greatest drawback to the limited liability company is that the business and investment community has had limited experience with this organizational structure. Investors may be more willing to purchase shares of a corporation than to invest in an LLC, because they are used to financing businesses that use the more traditional form.
A second risk flows from the need to draft an operating agreement for each LLC. As with a corporation, standardized LLC operating agreements found in form books may not be appropriate for independent filmmakers. Each company will have its own investment strategies, distribution plans, and expectations regarding sequels and other projects, and these specifics should be reflected in the operating agreement. Some productions, for example, will restrict the movement of additional capital into the LLC to protect the original investors. (More often, however, film investors are not concerned about the size of other parties’ investments, as long as all the funds raised are used exclusively to make the film.)
The LLC has become a favorite vehicle for small business planners because it gives the owners maximum flexibility regarding the structuring of control and financing while reducing not only liability but also tax obligations. The owners of the LLC have the option to be treated as a partnership for tax purposes. In 1997, the Internal Revenue Service adopted rules that allow the LLC to elect whether to be taxed as a C corporation or as a partnership. By default, LLC entities are taxed as partnerships.
* Jon Garon is admitted in New Hampshire, California and Minnesota.
Adapted from The Independent Filmmaker's Law and Business Guide: Financing, Shooting, and Distributing Independent and Digital Films, A Capella Books (2d Ed. 2009) (reprinted with permission). Jon Garon is professor of law, Hamline University School of Law; of counsel, Gallagher, Callahan & Gartrell.