The headline on the front page of Saturday’s Wall Street Journal said it all, “Stocks Cap Worst Week Since 2008.” All three of the major indicators tumbled badly for the week and are likely to remain in negative territory for the year. The S&P 500 finally broke the lows set in February and March. Now it’s about 18% off the recent peak. U.S. small cap stocks and international stocks already went into a bear market (>20% off peak). Of the eight big asset classes — everything from bonds to U.S. and international stocks to commodities, not a single one of them is on track to post a return this year of more than 5%, a phenomenon last observed in 1972. So, you are looking like at another historically tough year. Nothing’s working, not large or small-cap stocks in the U.S., not international or emerging equities, not Treasuries, investment-grade bonds, commodities or real estate. Most of them are down, and the ones that are up are doing so by percentages in the low single-digits. That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied. In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.
As I noted in last month’s newsletter, there are a host of economic and political issues worrying the markets: interest rates, trade and tariffs, slowing growth in China, and “Brexit”. As of midnight Friday, you can add the partial federal government shutdown to that weighty list. The Trump Administration and Congress couldn’t agree on a funding plan even for the next couple of months. Presumably, the main sticking point was the President’s insistence on funding for a wall on the U.S. southern border. I doubt that the shutdown will have much impact on the economy so long as it is relatively short-lived. The markets were also disappointed in what they heard from Fed Chair Jerome Powell last Wednesday as the Fed’s FOMC Committee increased short-term interest rates by a quarter of one percent. The Committee evidently feels that two additional increases may be justified in 2019, even though they lowered their growth projection, and there is virtually no evidence of inflation in the economy.
The yield “spread” between short and long-term rates narrowed, putting additional pressure on the shares of banks and other financial institutions. The yield curve continued to flatten, worrying some analysts that it might become inverted, with short-term rates higher than long-term rates. Mortgage rates were virtually unchanged, though the housing sector continues to be weak. There’s a wide difference of opinion about where the U.S. economy is headed in the year ahead. Many economists and analysts believe that we’ll continue the strong performance we’ve had in 2018. They expect strong job growth to continue, wages to rise, and inflation to remain low. Others are less optimistic, worried that growth will not only slow, but that there’s a good chance of a recession just over the horizon. Which camp you’re in, if either, will color your reaction to last week’s announcement by the Federal Reserve that they would be increasing short-term interest rates, continuing on a path to “normalize” rates over the next year or two.
The markets begin 2019 with a “stealth recovery” as all of the major indicators recorded positive increases. What’s driving the advance over the past three to four weeks? It doesn’t seem to be corporate earnings, which have been mixed for the companies that have reported so far. Projected earnings gains for the coming year are expected to show a growth rate of mid to high single-digits, compared with average gains last year of over 20%.
The gains have also come in the face of the longest government shutdown in our history. The shutdown was eating into 1Q GDP growth at the rate of 0.1% each week, according to some analysts. My guess is that the markets are finally coming to realize that they front-loaded the benefits of the 2017 tax bill, which are now beginning to fade. Those gains will pretty much be exhausted by 2020. Averaging the results for 2018 and 2019 might be the best way to handle the situation.
The wall! The government shutdown! Trump! Pelosi! McConnell! So many things to think about and to worry about. Do they have an impact on the U. S. economy or don’t they? It’s becoming more obvious that they do matter and that the general dysfunction in Washington, DC, is starting to infect the rest of the country. Quite a few years back, I heard Bill Seidman, an economist and then head of the FDIC, wittily introduce himself at a banking conference. He said, “I’m Bill Seidman, and I’m from Washington, DC. That’s 37 square miles surrounded by reality!” Everyone chuckled, but it’s becoming more obvious each day that he was on to something.
The government shutdown was a harsh reality for the 800,000 or so federal workers who didn’t received a paycheck and became more of a problem for millions of others whose jobs are interconnected with the U.S. government in some way or another.
Analysts are scrambling to figure out what the impact will be on the nation’s GDP for the first quarter of 2019. Some have predicted that each week of the shutdown will subtract a tenth of a percentage point from the nation’s overall output. A few extremists have even projected a flat or negative GDP for the quarter if the shutdown continues for another couple of months.
The economic impact of the shutdown obviously has to be weighing on the minds of the Federal Reserve and its FOMC Committee. My guess is that they will push back any short-term interest rate increases until at least late 2019, in order to offset the damage done to the economy from the shutdown. If the Fed doesn’t raise rates in 2019 it will likely give a boost to stock prices, and even bond prices as well.
How will the shutdown impact the monthly jobs numbers and the nation’s unemployment rate? No one knows for sure, and even some of the government agencies responsible for the data have been shut down. As economists are entering into relatively uncharted territory.
Everyone loves the story of the film, produced for $750,000 by a handful of private investors (entrepreneurs, doctors and small business owners) with most of them contributing $10,000 to $20,000, that grossed $5,000,000 at the box office.
Anyone who has produced an independent film will tell you the most difficult task is raising money to pay for the production (although the rest is not easy either). If you’ve never produced an independent film, it is almost impossible to raise the money for it outside of a friends/family round or by being fortunate enough to obtain intellectual property with a following (i.e., book rights, life story rights, etc.).
One way “not” to raise money for an independent film, is to run around your town with a script and attachment letters and start taking money from people. Worse yet, take out newspaper ads for investors. This physically can be done, but the potential downside is jail. Read that twice. The penalties for violating securities laws when raising money for a movie can be criminal in nature, as well as civil. Accordingly, as fun as it is exciting as it may be to treat movie money like the wild west, it is not advisable. You can find money for a film in a million different ways and places. But lawyers can only participate in film financing situations that are in compliance with state and federal laws. Complicating the scene are the credit crunch and the precarious state of foreign pre-sales. The world’s film buyers are pickier than ever, and their offers are lower — and banks aren’t able to gap the shortfall. So, the pressure is on equity investors to foot the majority of a pic’s budget.
Raising money is the key to any independent film, regardless of your position, experience, and past credits, and there are only a few ways to actually accomplish that. Being that a film finance closing can last anywhere from 4–12 weeks, this can be a relatively clean, straightforward experience, or three months of hell. Simply put, a finance plan is the best indicator of a producer’s financial I.Q. We need to know that you know how much money you really need and where you’re going to get it from.
The new and first-time producer usually has to go the private equity route. The other financing methods usually depend on relationships and track records the producer has, which, if you’re a first-time filmmaker, you may not have. With larger budgets, equity usually covers 25%-60%. For lower budget projects under $5,000,000, equity usually covers 80%-100% of the budget. As an investor, you would be much happier giving a filmmaker a dollar knowing they can at least guarantee you 50 cents back from tax incentives and foreign sales and without carving out debt positions. Generally, for the lower budget indie film, producer is unlikely to get pre-sales, mainly due to the inability to attract pre-sellable cast at lower budgets. Therefore, if your budget is $500,000 and you have pre-sales in your finance plan, it’s a dead giveaway to the savvy investor that you do not know what you’re doing.
Movies that are getting made have a substantial slug of equity in there. Certain equity partners would rather own the whole film than pay expensive debt costs. Unlike other industries, there are two discrete types of equity sales in the motion picture industry. The first is sale of securities in the film company. By selling stock in a corporation or membership interests in the LLC, the company raises funds by increasing the amount of equity owned by people other than the filmmaker. The manager-managed LLC or the limited partnerships are the more common investment vehicles for such project financing. The second form of equity financing involves selling the film’s distribution rights, which we will discuss later.
Many independent filmmakers – including successful directors such as Spike Lee and Francis Coppolla – have used their personal funds to finance all or part of their films. There are no legal limits or restrictions on this practice. Despite the adage that a filmmaker should only spend other people’s money, personal funds are invariably part of the film financing mix. While there are many ways to structure these types of deals with many different ways for the investors to re-coup their investments and turn a profit, they all revolve around the same questions that must be answered: (i) How much ownership does the investor receive for the investment? (ii) How will the investor re-coup their investment? (iii) How will the investor’s see a profit? (iv) How much equity is the filmmaker putting in?
Background checks of publicly available records will certainly help identify convicted felons and anyone cast out of the fully regulated sectors of the financial community. But are such willful miscreants really the source of most film litigations? The complexity inherent in film funding — typified by smoke-and-mirror accounting and “waterfall” recoupment schedules that seem to punish those taking the greatest risks — means cinema is always prone to borderline behavior and bare-knuckle negotiating tactics from all quarters. Therefore, it is imperative that you spend the money to consult with an attorney on any equity structure.
Investors have been known to act against their better judgments, of course. In his chapter for the book, “Film And Risk”, prominent Los Angeles-based entertainment lawyer Bill Grantham recalls coming across projects that were so obviously flawed he begged clients not to get involved with them, sometimes providing detailed written explanations of exactly how they were going to lose all their money. They did it anyway — evidence of a psychological component to film investing that stretches beyond steely business calculation.
Even the most coldly detached investor still needs to guard against common pitfalls. A film might be a roaring success, but because some investors chose to invest in the overhead and development costs of the production company in a “first-in, last-out” position, they may have lost out on windfall profits. Alternatively, investors may find themselves too far down the revenue sharing waterfall in a film whose budget over-runs have led its producers to stack new senior financing tranches on top of investors’ equity claims.
Do You Need a Private Placement Memorandum (PPM)?
The most common source of seed capital when starting a business is friends or family. However, in general, the amount that can be raised from friends or family is no more than $100,000. As such, a PPM is generally not required to raise capital from family members and close friends.
A private placement (also known as unregistered offering) is a securities offering exempt from registration with the SEC. Production companies and film funds, will engage in private placements to raise equity or debt financing from a small group of select investors instead of the public, usually from institutional investors and high net worth individuals. In general, investing in private placements is risky: private placement offerings are not registered with the SEC; most private placement securities are restricted securities and can tie up your investment for a year or more; and most private placements do not have the same investor protections as registered offerings, such as the comprehensive disclosure requirements that apply to publicly traded companies.
While there is some overlap, a PPM is not the same thing as a business plan. The detailed “description of the securities” and the “risks factors” are perhaps the most important difference between the PPM and a business plan. Unlike a business plan, the PPM focuses on the structure and terms of the deal, and the attendant risks of the investment, whether they be equity securities or debt securities. The PPM should be a descriptive document. It should allow readers to reach their own conclusions regarding the merits of the deal. A major downside of seeking money from non-accredited investors is the much greater disclosure requirements. On the other hand, in general, the legal disclosure burdens are dramatically reduced (subject to the antifraud provisions of the securities laws), when only accredited investors (earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or (2) has a net worth over $1 million, excluding primary residence) are involved. In which case, you may avoid using a PPM to raise funds.
A Term Sheet is typically used for a negotiated transaction with a small number of investors. On the other hand, a PPM normally sets fixed terms the company wants, and which can be circulated to a relatively larger group of potential investors. Unlike the Business Plan, both the PPM and Term Sheet describe the deal. Both the Term Sheet and PPM define exactly what the investor is getting, who else is in on the deal and what percentages of the company is owned by them. However, unlike the PPM, a Term sheets does not have adequate warning about the risks of the investment. Risks factors in a Term Sheet would be a mere formality, since experienced accredited investors perform their own due diligence and risks assessment before they invest.
If you want Hollywood to invest in your movie, don’t send them a PPM. Studios will usually finance a movie idea if it’s a proven concept or appeals to the biggest demographic. No amount of fancy disclosures about the market and sales predictions will make a difference. You don’t need a PPM to pitch your project to Hollywood or to obtain studio financing. Angel Investors and high-net individuals typically like to negotiate the terms of the deal with a term sheet. Once the deal is fully negotiated, the term sheet goes back to the company’s attorneys who use it to draft a subscription agreement or stock purchase agreement, LLC operating agreement, or other document establishing the rights and preferences of the investor.
A PPM is not required for every capital raise. Rule 504 of Reg D provides an exemption from registration for securities offerings of less than $5 million within a 12-month period. A company may offer and sell these securities to an unlimited number of accredited and non-accredited investors. Under Rule 506(b), a company can raise an unlimited amount of money from an unlimited number of accredited investors, but from no more than 35 non-accredited investors. Both Rule 506 of Reg D and the antifraud provisions of the federal securities laws mandate that issuers disclose truthful and accurate information to investors, there is no requirement to provide any specific information or disclosures to accredited investors.
There are two general approaches to raising capital via private placement: (1) an offering with fixed terms to a relatively large group of potential investors, and (2) a negotiated transaction with a lead investor or smaller number of potential investors. For an offering to a small number of sophisticated (experienced) investors, usually only a term sheet will be necessary. However, for a larger group of investors, a PPM may be required or prudent. In any event, for offerings of more than $5 million to non-accredited investors, you must prepare, draft and deliver a lengthy PPM.
In order to help you determine which approach to take, you need to know how much money you need to raise, how you intend to use the capital, how much creative control you want to negotiate to retain, the stage or round of funding, who your prospective investors are, what your potential investors’ past behavior (as investors) is like (such as expectations of potential investors regarding PPMs), the Blue Sky law of each state in which your potential investors reside, and who is selling your securities for you if not yourself (such as a broker-dealer).
The decision of whether you need to use a PPM to raise money is rarely simple. But regardless of whether you use a PPM or not, you should prepare detailed disclosure documents in order to avoid liability for misstatements or securities fraud, especially if the nature and operations of your business and/or the terms of the investment offering are very complex.
Whether or not a PPM is used, each transaction and offering of securities should be carefully reviewed by legal counsel to determine the minimum level of disclosure that must be provided to prospective investors under applicable federal and state securities laws, and to catch and correct any compliance issues.
The most common lender transactions in the film industry do not quite fall into any of the categories described above. They typically are not supported by hard assets, so to speak, rather by distributor contracts. Those transactions may take the form of worldwide negative pickups, domestic and international split rights deals or foreign pre-sales. If the film producer can obtain a distribution agreement and guarantee from a credit-worthy distributor, the producer may be able to use that agreement or those agreements as effective collateral for the loan. Unfortunately, this form of lender financing of feature films is not available for most of the films sought to be produced by independent film producers. While it is common to see the financing plans for projects with budgets $3 million and up consisting of foreign pre-sales, it is not so common below $3 million.
Pre-sales agreements are pre-arranged and executed contracts made with distributors before the ﬁlm is produced, and are based on the perceived strength of the project as assessed by each distributor after reviewing numerous factors, including the script, the attached talent, and the marketing strategy. Once you enter the pre-sales agreements, there are two ways to go: (i) you can take out a bank loan using the pre-sales as collateral; or (ii) receive a direct payment at a discount from the distributors themselves.
This financing strategies requires the filmmaker to either repay the loan based on the pre-sales or a direct payment from the distributors before profiting on the film, and the filmmaker will likely have to personally guarantee the loan or advance payment in the event the film cannot be completed. Nonetheless, since pre-sell agreements allow the filmmaker to finance a project without personal funds at stake, they remain very attractive to the filmmaker. The pre-sell and distribution deals vary significantly. There are costs involved in putting such deals together. Packagers can take anywhere from 5%-15% of every sale. Sales agents’ fees vary between 10%-25% for obtaining distribution contracts only — and as much as 30%-35% should they secure a cash advance or bank contract.
Those that are lucky might be able to use a negative pickup as a type of film financing arrangement. A negative pickup is a contract entered into by an independent producer and a movie studio wherein the studio agrees to purchase the movie from the producer at a given date and for a fixed sum. Depending on whether the studio pays part or all of the cost of the film, the studio will receive the domestic, international, DVD, Blu-ray and/or TV rights to the film, with net profits split between the producer and the studio. By combining a negative pickup, other deals collateral to the production and pre-selling territories not covered in the negative pickup, a producer will usually cover all his costs and make a small profit before production has begun. But financing of the production up to its completion date is the responsibility of the producer—if the film goes over budget, the producer must pay the difference himself or go back to the studio and renegotiate the deal. Most negative pickup contracts, either from motion picture studios or television networks, are bankable at pretty much dollar for dollar (less fees); if one holds a negative pickup contract, one essentially holds a cheque from the studio for the cost of the film, post-dated to the day one delivers the film to them. So, while the studio technically does not pay the producer until the film negative is officially delivered (thus “negative pickup”), the producer can nonetheless get a bank loan against a negative pickup contract, which helps the producer to pay for production of the film.
The studios and distributors will contain this risk by offering the negative pickup contract only to a production that has financiers, a script, and key creative personnel, particularly the director and stars, already attached. Thus the conundrum: unless a film has U.S. distribution, a lot of investors and foreign buyers will not pre-buy a film, and unless the film is already financed, the studios do not want to guarantee distribution. This catch-22 is often resolved by attaching a major actor to the film; the mere appearance of an American movie star’s name on a film’s poster is often enough to drive box office to cover distribution in many foreign markets. Because of the complexity of these pre-sales deals, it is wise to consult with counsel before entering into one.
Loans/Gap or Bridge Financing
Raising debt capital is less complicated because the company is not required to comply with state and federal securities laws and regulations. The company is not required to send periodic mailings to large numbers of investors, hold periodic meetings of shareholders, and seek the vote of shareholders before taking certain actions. These latter two considerations only apply to corporations. Manager-managed LLC and limited partnerships do not require the meetings and investor approval on most issues.
Many filmmakers obtain loans for their films, although loans are usually only given once other financing is in place. Usually, filmmakers only use loans to fill in the “gap” or as “bridge” financing between what they have raised and the total cost of the film. With gap financing, banks provide a loan of between 10%-30% of a film’s budget against the value of all the distribution markets that remain unsold. As the pre-sales market continued to soften, the gap has widened further. So-called “super-gap” financing has recently emerged, essentially a riskier form of mezzanine-style financing in which more (up to 35%) of a film’s budget is borrowed against future revenue projections. In return for financing more of the budget, super-gap lenders demand higher interest rates.
What happens when your combination of presold minimum guarantees, gap financing, and soft money is still insufficient to cover the financing of a particular project? The answer has been to turn to some kind of private financing. Be careful about debt disguised as equity. Again, debt is usually the last piece of financing you bring in.
The game is finding a way of getting your money out soon. It’s a strange psychological thing. What I have discovered in this business is that if you simply call something, ‘debt’, then pretty much everybody says, ‘Yeah, well, you obviously come out ahead of the equity.’ Even if it’s just really basically a piece of hidden equity. Most filmmakers switch that around and look for debt first because it’s easy, but debt financing can’t actually close until all the rest of the financing is present and spoken for. Don’t allow filmmakers to claim they already have the debt piece figured out when they don’t have any financing in place or a pre-sellable movie with estimates.
Every company who engages in debt financing is different, but most will want to recoup their loan in first position before equity investors which can be a deal breaker right off the bat depending on what kind of deal you made with your principle financiers. Debt companies also charge interest and fees commensurate with the amount but also the experience of the filmmaking team and who is financing. Their opportunity cost is always deploying funds to the most ‘sure thing’ possible so they take vetting seriously.
For this reason, it’s often easier to work with private lenders rather than companies when covering your debt piece since the requirements might be easier to surmount for smaller films and companies. Of course, you have to find these private lenders first but since you’re offering a pretty solid deal backed by a state or country tax certificate, their risk is much lower than if they were making an equity investment. Their potential upside is also lower since they’re only earning interest on the loan and not back end participation, but it’s a great way for someone to diversify into a low risk deal.
The bottom line is this – debt is not for everyone and not available to most who think it is. You really have to come at it from the last piece of the puzzle after everything else is in place and you can serve as proof of value and collateral of the loan, the film package must demonstrate to the lender the value of the project. Since filming has not yet begun, the collateral includes tax rebate certificate (that hasn’t been collateralized yet by someone else), the screenplay and story rights; legally binding commitments by the key personnel to participate in the film; the production budget – including a draw-down schedule for the use of the proceeds as they are paid to the filmmaker throughout production; and most importantly, legally binding guarantees for the territory sales, negative pick-up, or other financing arrangement. These contracts must specify the guaranteed minimum the filmmaker will be paid, and that amount can be used as collateral to be pledged against the value of the loan.
The challenge with this late-stage private financing is two-fold. The producer is lumbered with high transaction fees, on top of all the bank charges, agency commissions, pre-paid interest, deferrals, and other contingencies that have already taken a bite out of the budget. The investor is also buying into a movie in which all the saleable foreign markets have been disposed of already. The only real asset that remains is the 20% tier of the foreign contracts and subsidy contracts which is not covered by the bank loan. This is also the riskiest tier. If the producer manages to bring the movie in on budget, some of that equity investment can be paid back from the contingency funds released by the completion bond company. Beyond that, the investor must hope that the unsold American rights will find a distribution home. If the film does not earn sufficient return to repay this loan, the filmmaker will be on the hook for the total unpaid loan amount. Another area to make sure that you are protected.
Most states (and several countries around the world) provide government aid for the development, pre-production, production, post-production and distribution of film, documentary, television series, commercials, video games and other audiovisual works. Such “soft money” sources include tax credits, tax deductions and tax shelters, cash rebates and grants, film funds and co-production funding. A Tax Shelter is a government-approved tax incentive program whereby a production company can raise production financing from a country’s taxpayers. Producers who qualify for these incentives are offered an average subsidy of 25 cents for every dollar of allowable production expense, a figure that has risen to more than 40 cents on the dollar for shoots in Alaska and Michigan.
In addition to state incentives there are also federal tax benefits available as well. If the film is made in the United States, producers may further educate potential investors on how to utilize the tax code Section 181 to reduce their tax burden and hence reduce their risk in financing the project.
Like bridge loans, tax credits can be helpful in filling in the gap between the money a filmmaker raises and the budget of the film. Individual states and countries allow film producers to subsidize the money spent on production through tax benefits. Typically, this requires the filmmaker to film a significant portion of the production in a local area, hire a certain number of local crew employees, rent from local vendors, and run payroll through local services. Tax credits are based on a lengthy application process and are often difficult to procure (Ex. NY is 16 to 18 month waiting period on a tax rebate). So, as investors that’s something that you need to account for in terms of recoupment. But, depending on the state or country, the benefits can be significant. For example, a $1 million movie can end up actually costing $750,000. This means that the filmmaker only needs to raise 75% of the film’s budget. In some cases, states allow for tax credits to be traded at a discount to rich people or entities looking to offset their own profits, in which case a percentage of the money is available to the production upfront. Whatever the system is, the attraction of such incentives is obvious: the more that soft money is able to reduce the budget, the quicker the film becomes profitable and the sooner equity holders get to share in that profit stream. “Anyone who makes a film in the US without a tax rebate is a de facto idiot,” proclaimed “Boyhood” producer John Sloss. As with the other forms of financing, due to the complexity of these transactions, its important for a filmmaker to know the rights regarding tax credits.
If your production will qualify for tax credits, many equity investors would prefer that the tax credits not be used as part of the finance plan to cash flow production. Therefore, if you’re able to qualify for Government subsidies, that doesn’t necessarily mean you have to increase your budget incrementally. You may use the tax credits or rebates to pay back your investors, rather than scaling up the budget because of it. Therefore, up to 80% of your investor’s investment can be secured by subsidies. These government subsidies can act as a partial safety net for the investor, if and when the movie flops at the box office and VOD.
How Do I Get Paid?
Most investors almost always skip to this. From the onset, it is important to note that there are multiple exit strategies for film investors looking to get back their equity capital. Some don’t even involve waiting until a film is released in theaters or watched on a small screen. Every year, at least one major film festival can point to an independent feature film whose distribution rights are sold on the spot for a multiple of its production budget. This immediate return of capital eliminates the investor’s exposure to performance risk — the ideal outcome for an investor, unless they are keen to play the long game and participate in the upside alongside the distributor.
It is very important that a good business plan set out exactly how a potential investor is going to get their money back and make a profit, how much time it’ll take and the order in which investor will recoup its investment. More often than not, a film has to start generating an income stream from its distribution before investors begin to see meaningful returns. For example, in a typical sales cycles, it may take 18-24 months after completion of the film before you can start positive cash flow.
Most filmmakers in the independent film world likely have to defer their producer fees and, if other talent will agree to defer their fees, then that much less money has to be raised to make the film. The problem with this method is that the “risk takers” are working for free and relying on the film’s success for payment. Certainly a gamble especially since all deferred fees will likely be paid only after the loans and investors have recouped.
Whether a first time or experienced filmmaker/producer, you will probably have to use a combination of the above financing options to make a film. Under any of the above options, the key is to present as complete a package as possible with all relevant, legally airtight attachments, a fleshed out budget and, at least, one experienced person to lend gravitas to the film. You might give financiers some assurance that the film will be made if all of these requirements are met.
So, what is a revenue waterfall? This is the contractual order in which financial contributors to a film’s production are repaid. From the total income to producer from worldwide sales and government incentives:
1. Any tax obligations and bank loan are repaid first
2. The costs associated with arranging distribution, including, sales agent’s fee and expenses, are paid
3. Equity investor’s first share (up to 120% of their investment)
4. The completion guarantor is repaid
5. Payment of any deferments to talent
6. Finally, you deduct investor’s share of profits (50%). Typically, any third-party talent participants (residuals/participation share) are paid from the producer’s share of profits, except for those participations that are deducted “off-the-top”, that is, before any division between producer and investor.
This is a simplified picture. As with all industry-specific corporate financing, there are many structures which can significantly increase the complexity of the returns waterfall. This is why a well-structured business plan is so important, balancing the competing claims on any film in a hopefully fair and equitable manner. While investors tend to concern themselves with limiting their downside exposure, going so far as to insist on significant fees within the film’s budget to help hedge their risk, it’s often the allocation of the upside that can cause greater problems. Even if it can obtain a relatively favorable recoupment position (e.g., ahead of deferrals) and a premium, a lot of money is paid out ahead of the investor. Another key consideration is timing. One of the reasons why investors like to keep budgets low is that this accelerates the break-even point and improves the internal rate of return on that investment. Too big a budget, especially in these times of diminishing pre-sales, and your capital is stuck.
There is no structure or mechanism to increase liquidity of film investments, either through clear exit strategies, or secondary capital markets. The dirty secret of film investment is that it is a long recoupment cycle with little planning for an exit strategy. Without a way to get out, fewer people choose to get in. It takes a particular investor to want to lock up an investment for four years. It’s important you work with a seasoned film financing consulting companies and/or law firm prior to moving forward with any film project as a financier.
Ready to start your own rental empire? The first step is to buy a property with more than one unit. For the average American, one of their biggest expenses is their mortgage payment, or their rent. According to the Bureau of Labor Statistics, roughly half of the typical American’s expenses come from just two categories – housing and transportation (excluding taxes), with 33% of total spending on housing alone. This payment is holding them back from accumulating significant savings, and the financial freedom that more capital to invest could provide them. What most people don’t know, is that this payment is optional. It’s possible to own your own building for less than $10,000 down, and never have to make another payment again. It’s not easy, and you’re going to have to put in a lot of sweat equity, but it will save you hundreds of thousands of dollars over 30 years. This investment is called a house hack. If you’ve never heard of house hacking, pay attention.
The concept of house hacking is simple. You buy a duplex, triplex, or quadplex with an FHA loan (3.5% down), and your tenant’s rent covers all or most of your mortgage and other expenses. If it’s done right, you can drastically increase your available capital for investing every month. If it’s done wrong, you can purchase a money pit of a property that’s hard to manage and will cost you more than renting. If you’re not willing to take a bit of a risk, this investment probably isn’t for you. For whatever reason, the FHA, and even the VA, considers any property with four units or less as a single purchase. This means you can buy a duplex, triplex, or fourplex with an FHA loan or a VA loan. In order to qualify, you have to live at the property, using it as a primary residence. That’s where the multi-unit part of the plan comes into play: You live in one of the units and rent out the rest.
It’s one of the easiest and most efficient means one can use to move towards early financial freedom while working a full-time job. In this situation, the owner now has a stabilized property that allows him/her to live for free, still have capital to repair their building as needed and is now free to invest what they would have been spending on rent. In fact, in a year or two, the owner can refinance into a traditional mortgage, and house hack a new property. You might be able to continue to acquire a rental property capable of sustaining early financial freedom in less than 10 years, depending on the market and real estate cycle. And, it’s no harder to buy a house-hack than it is to buy a home, financially speaking. It’s important to note that older building with major capital expenditures coming soon might be have enough cashflow to breakeven so looking for a with newer plumbing, electrical, sewer, HVAC, and a new roof.
Can you buy a second FHA home?
Once you are stable with your first property, you might want to purchase another property to rent out or move into. In this scenario, it’s tempting to use the FHA program again. However, that option may be limited.
You can obtain a second home, but it’s done on a case-by-case basis. You usually need to show need, such as relocating for a job, or prove that your expanding family can’t fit into your old home anymore.
FHA loan requirements are also such that you might not be able to count the income you receive from your rental property in your application. Unless you have 25 percent equity in your home, your income from renting out an FHA home might not be taken into consideration.
For many people, though, living in that first FHA property provides them the resources they need to take the next step. If your tenant is covering your own housing costs, that can help you build a large fund to use as a down payment on another property down the road.
You can use a program like FHA loans to get started as a landlord. It takes a couple years to really get going, but it’s one way start the process immediately — even if you don’t have a lot of money.
Finding Your House Hack
Finding a good property to house hack isn’t easy, but it can be done if you’re persistent. Have strict parameters. For example, don’t look at a property unless the total rent is at least 1% of the purchase price of the building. Ideally, closer to two percent, but a 1% deal can still cash flow. In certain markets, like St. Louis, it’s possible to find deals closer to 2 or 3% price to rent, but that might not be in an area you want to live in or manage. If you’re starting out, interview several realtors, and find one that has experience working with investors, and ask them to help you find your first property.
Your realtor should set you up with MLS alerts, so every deal that meets your criteria will be sent to your email. If you like a property, it’s time to schedule a showing. When you view a new property, be sure to inspect the following:
• Age of the roof
• Major cracks
• Water in the basement
• Do doors and windows open easily?
• Condition of the windows
• Is any paint peeling
• How nice are the kitchen and bathrooms (these rent houses)
It’s unlikely that you’ll find a property at a good price where all of these are in good condition, so you need to budget the cost of repairs into your projections. After you view a building you can make an estimate of the major repairs that will be needed, and make a more accurate model of how much to save for repairs and maintenance every month. While it’s very tempting to offer on a nice property, you can’t get emotionally invested. This is a business, and needs to be treated as such. Only buy something that makes a lot of sense on paper, because it’s probably going to do a lot worse in reality. You want an investment with enough margin for things to go wrong and you still end up OK. Buying a property that barely cash flows on paper is a recipe for disaster. Once you’ve found your property, a good agent will help you make the right offer. Be sure to include a personal letter to the owner for every offer that you make. If two offers are equal, the offer with a convincing letter is probably going to win the house. You can reuse the same letter on every house you offer on, and just make minor tweaks based on the situation. Assuming the offer is accepted, you’re officially under contract!
Financing: Know FHA loan requirements
Before you commit to house hacking, it’s important to understand what happens when you use FHA loans to buy properties. You can make this strategy work with just about any type of loan. However, FHA home loans are especially good because of the low down payment option. With this type of loan, you can pay as little as 3.5 percent for a down payment. For many people, that’s much more affordable than trying to come up with 10 or 20 percent to put down.
On top of that, FHA loan requirements are more flexible when it comes to your credit. It’s possible to qualify for 3.5 percent down with a credit score as low as 580. Even though it helps to have good credit, you can still become a landlord with less than perfect credit. There are limits to how much you can borrow. The FHA sets loan maximums based on home prices in the area. It’s done on a county-by-county basis, so talk to a mortgage professional about the limit in your neighborhood. Depending on the FHA loan limits and the cost of properties, you might be limited to a duplex for your first house hacking experience.
Next, you need to commit to living in the home for at least year. You must also move into the home within 60 days of closing.
Finally, you need to make your FHA loan payments on time and in full each month. I recommend saving up a buffer fund. That way, if your rental unit is empty for a few months, your finances aren’t strained. I can’t stress enough the importance of being able to afford your mortgage, even if you plan to rent out the other unit(s). Financing for a house hack is a bit more difficult than a conventional loan. FHA properties have to pass a more rigorous inspection, and peeling paint isn’t allowed. While this can limit some potential deals, it’s possible to do the work before you close, or use an FHA 203k renovation loan. A good agent and lender will be able to help you navigate through the FHA financing process. Before you schedule any showings, it’s important to get pre-approved, or your offers won’t be taken seriously.
Why House Hacking is so Awesome
Buying an owner-occupied investment property and renting out the additional bedrooms and/or units is probably the single most effective hack that a median wage-earner can make to begin moving towards financial freedom rapidly. It takes the largest expense in your life and wipes it out entirely. Why would you bother to remain disciplined day in and day out with the fun stuff in your life, when you can automatically save yourself tens of thousands of dollars per year through the combinatorial benefits of house hacking?
House hacking leaves the purchaser with three excellent options if done correctly:
1. It allows the house hacker to live happily at low cost indefinitely.
2. It allows the house hacker to move away and retain the property as a cash flowing rental.
3. Like every homeowner in the country, the purchase retains the right to sell the property.
Few people have all three of those excellent options. Few people are able to move anywhere they want at a moment’s notice and convert their home into an excellent cash flowing rental property. This is the ultimate low-risk, high-reward way to buy your first or next property if you aspire to early financial freedom and want to accelerate your wealth accumulation.
The decision as to whether you need a dental treatment is often in a gray area. One dentist will say one thing, one will say another. This is normal, and it’s to be expected. But it means that the usual signs of insurance fraud – a practitioner prescribing more procedures than his or her colleagues – are more difficult to detect, because there’s more variation, and it’s more difficult to really pin down a procedure as unnecessary.
You need medical insurance, if only to protect against the cost of an accident or illness so expensive that you could be ruined financially. But do you really need dental insurance? It’s an interesting question, because you can avoid the most likely causes and expenses of dental problems, decay and gum disease, by brushing and flossing your teeth diligently. Several studies have shown that visiting the dentist twice a year doesn’t deliver notable benefits compared with one exam a year. But some teeth are more prone to problems, and when they have a problem, the costs can mount quickly.
On average, Americans pay about $360 a year, or between $15 and $50 a month, for dental insurance. Costs will vary depending on your state. Most plans come with a maximum annual benefit or coverage limit. This limit usually falls between $1,000 and $2,000 person (a figure which hasn’t changed since the 1970s). Adjusted for inflation, dental insurance plans should be paying out between $4,000-8,000 a year by now, according to MarketWatch.com.
Unlike medical insurance, which covers costs after your bills reach the amount of your deductible, dental insurance cuts off coverage after your bills reach the annual limit. With dental insurance you may have a deductible to pay before coverage kicks in. After you’ve met it, your insurance pays a percentage of your dental costs; you pay the remainder, called coinsurance. The coverage stops entirely when the insurance company’s payout reaches that maximum benefit amount. Beyond that, you’ll pay 100% of your costs out of pocket. And the two annual cleanings often “included” in a plan count toward your max. In addition to your benefit being limited to a maximum of about $1,000 to $2,000, you’ll be trading away the potential to pick your dentist of choice (and location) and perhaps negotiating a price, all for the benefit of saving a few hundred dollars.
If you plan to get insurance, your best bet is to purchase a policy before, not after, you need major work. Otherwise you could be waiting months (sometimes years) for coverage to begin a procedure.
What does a monthly dental premium cover?
The National Association of Dental Plans (NADP) describes these elements of coverage in a typical plan, which provides a level of coverage known as 100/80/50 coverage:
- Preventive care: periodic exams, X-rays and, for some age groups, sealants — 100 percent.
- Basic procedures:office visits, extractions, fillings, root canals (sometimes) and periodontal treatment — 70 percent to 80 percent.
- Major procedures: crowns, bridges, inlays, dentures and sometimes implants and root canals — 50 percent or less.
Orthodontics coverage usually can be purchased as a rider and cosmetic care isn’t covered. So, in deciding if an insurance plan is right for you, weigh:
- The annual premium
- The cost of the dental care you need
- Your policy’s limit on how much it pays out in benefits and whether you can roll over unused benefits from the previous year
- Policy coverage
While many dental policies focus on preventive measures by offering two annual visits, you’ll really start seeing the savings with more expensive treatments, like root canals and crowns.
What types of dental insurance plans can you choose from?
The typical dental plan falls into one of three categories.
- Indemnity or fee-for-service plans
- PPO or Preferred Provider Organization plans
- HMO or Health Maintenance Organization plans
Indemnity or fee-for-service plans
This plan allows you to pick a dental provider and your plan pays a percentage of the provider’s fee.
Pros: These plans let you choose from the widest variety of providers. The deductible (the amount you pay for procedures before insurance coverage kicks in) may be lower than other plans. The annual maximum coverage limit may be higher.
Cons: The premiums (what you pay monthly) tend to be higher than other plans. You’ll be paying your share of service costs up front.
This plan is best if: You have a certain dental provider you want to see, or you anticipate needing major, costly procedures.
PPO or Preferred Provider Organization plans
With a PPO, you pay lower fees to see certain in-network or “preferred” providers.
Pros: The insurance network pays more than they might with an indemnity plan or HMO plan. You aren’t required to see in-network providers, but you save money when you do.
Cons: You’ll pay more if you see a provider out of the network. PPO plans often come with a maximum amount they’ll reimburse in a calendar year. Some procedures may not be covered or have a waiting period before coverage starts.
This plan is best if: You don’t need major dental work right away, but want to be prepared in case you need it in the future. You’d like some flexibility in your choice of dental providers but don’t want to pay high premiums.
HMO or Health Maintenance Organization plans
With an HMO, you’re required to see dental providers in the insurance network.
Pros: Preventive services—cleanings and X-rays—will be 100 percent covered, while basic procedures come with a co-pay. You may not have a deductible or maximum annual limit and premium payments will likely be lower.
Cons: Major or restorative procedures may come with less than 50 percent coverage or no coverage at all. You won’t have a large choice of providers.
This plan is best if: You don’t anticipate needing any major dental procedures in the near future. You have no provider preferences as long as basic dental work is covered financially.
If you already have a dental provider you trust, see which plan their office recommends. Most plans won’t immediately cover pre-existing conditions or reimburse for major procedures completed before you got insurance. When in doubt, ask what’s covered and when. Keep in mind there’s always a possibility you may need a procedure you don’t anticipate—and it may not be covered by your policy. The higher your premium, the more likely you are to have coverage for more extensive work. Your dentist will often tell you (or you can ask) which procedures you’re likely to need down the line.
The perverse incentives by insurance companies
Insurance plans put perverse incentives in place for in-network dentists. When dentists become part of these networks, they agree to extremely low reimbursements for cleanings and exams, in exchange for a steady stream of patients. To make up for it, some dentists will perform procedures that have a significant patient portion or heavily promote cosmetic work as being necessary.
Often, it works like this: A dentist will agree to be “in-network” in exchange for a steady stream of patients from the insurance company. They get paid by the insurance company “by the head” instead of according to how much treatment they actually provide. If the insurance company agrees to send the dentist 12,000 patients per month, and the dentist gets $8 per head per month (this is called a capitation plan) then that’s $96,000 per month, regardless of what their costs are. See the problem?
So the incentive is to pocket as much of the cash as possible by reducing overhead. To reduce overhead, they’ll push off work that needs to be done in their patients and then promote treatments that aren’t covered by insurance.
With perverse incentives like these, how much is that in-network dentist or that free cleaning actually costing you and your family — both money-wise and health-wise?
What questions should you ask before picking a policy?
- Which dental procedures am I likely to need this year? How much would they cost out of pocket? How much would they cost with insurance?
- How much will I pay monthly and annually in premiums?
- How much will I pay for a regular cleaning without insurance? With insurance?
- What is the maximum annual payout for this insurance policy? Which procedures are covered?
How can you save money on dental care without insurance?
If you decide to skip dental insurance, you’ll still want to get your teeth cleaned once or twice a year. And you’ll want options if unexpected dental work comes up. Here’s where you can look for care outside of the typical insurance marketplace.
Visit a dental school
You’ll see students whose work is supervised by trained dentists. In exchange, you pay a low cost for appointments, even if you’re uninsured. The ADA lists dental schools across the country; find one near you.
Visit a dental clinic
Some clinics offer a sliding scale fee based on income, and diagnostic exams may be free. Find a local branch of a national clinic like America’s Dentists Care Foundation, or see what low-cost care options your state and local dental societies have to offer.
Dental school and clinic appointments are often in high demand. Be prepared to schedule far in advance or put your name on a waiting list. Even with walk-in clinics, it’s best to call ahead and find out their procedures before you go.
Look into a discount dental plan
It’s easy to confuse dental savings plans (also known as dental discount plans) with dental insurance, but they’re very different. Whether insurance or a discount plan — or some combination of the two — is right for you will depend on how much dental work you and your family get per year and how much you’re paying out of pocket.
Discount dental plans or dental savings plans can give you the security of coverage without the cost. You’ll pay an annual fee and get a discount, anywhere from 10 percent to 60 percent, on average dental care prices. Unlike insurance plans, there are no annual caps or waiting periods. With dental discount plans, you enjoy savings at participating dentists by paying the dentist directly for services at a lower price. This is not an insurance plan, so there are no copays or premiums, Before you buy into a plan, look over its list of covered procedures to see if they’re ones you are likely to use.
It may be a good option for people who don’t have access to dental insurance or who want services that aren’t covered by insurance. This might include senior citizens who don’t have dental insurance under Medicare or younger people who want discounts on something like teeth whitening, which traditional insurance typically doesn’t cover. You also might think about a dental savings plan if you need dental work that costs more than your dental insurance will pay. (Many dental insurance plans cap their total payout at less than $2,000 a year.) For example, savings of 50% on a couple of root canals that cost $1,000 each would add up quickly.
If you have a dentist you like, ask her if she takes part in one and how much you could save with it. If you’re open to new providers, call a few who are in the plan you’re thinking about to see if the savings would be worth it. Thousands of dentists take part in dental savings plans, and you can usually get a member list from the plan’s sponsor. While many reputable companies offer dental savings plans, the industry has attracted some fraudsters. Avoid scams by asking to be mailed information before you make a payment, and say no to high-pressure salespeople. You also can check with the Better Business Bureau or your state’s insurance regulator to see if a company has had complaints made against it.
Price check and do your research
Tooth pain is a great motivator. When you’re in pain, you’re often willing to fork over any sum to find relief. But take steps to make sure you’re paying market rate. First check the Healthcare Blue Book, a respected online tool that provides a fair price for thousands of medical and dental procedures in your ZIP code. And don’t be shy to call around to other dentists in your area to price shop. Ask friends and neighbors for recommendations, and check out any potential dentist with your state’s dental board to ensure he or she is licensed and to find out if any disciplinary action has been taken. Most offer an online search tool.
Although there is no hard and fast rule on how often you should update your trust, conducting an annual review of the trust and asset schedule is recommended. Circumstances will inevitably change. There will always be changes in the law – especially the tax laws. There are also going to be changes in your family situation or the make-up of your assets over time.
The Federal Estate Tax Exemption has changed more than a half dozen times over the last fifteen years. Currently it is $11,180,000 per person. The marital clause in your trust or your parents’ trust may have been the most appropriate clause at the time it was drafted ten or fifteen years ago. However, today it may cause a lot of unnecessary capital gains taxes when the assets pass to your children (or to you when both of your parents pass in the case of your parents’ trust).
Further, the needs of your beneficiaries will more than likely change over time as well. For example, we often review trusts that have language that says when a child inherits, they can access 25% at age 21, 50% at age 25 and the balance at age 30. This was a popular way to drafting in the 1990s and into the 2000s. However, the state of the art in estate planning now -that more progressive attorneys use- is to protect children from divorcing spouses, creditors, predators and bankruptcy claims with cascading trust provisions. In the trusts where the balance is available in an outright distribution at age 30, there is no protection for a child should they go through a bad divorce, get sued, go through a bankruptcy or have some other serious creditor issue.
Asset alignment can also be a situation where the wheels can come off the proverbial estate planning bus. A change in the make up of the assets is something that happens almost universally to all our clients every couple of years. The issue that this brings in the estate planning context is that the assets are often not properly funded to the trust or aligned with the estate plan. This is why it makes sense to be meeting with your estate attorney on a regular basis in order to ensure all of your assets are properly funded or coordinated in your estate plan. The asset schedule at the back of your trust also requires a short formal amendment when those assets change.
Being proactive is worth its weight in gold and will ensure the plan works as planned down the road. Make sure to make course corrections as you go to protect yourself, your spouse and your children or other family members. No one wants court interference, extra taxes or a train wreck for their family to deal with in the future.
If you suspect you may need an update to your estate plan or funding of your assets to your trust, give me a call and I can put you in contact with low-cost legal solutions.
Crowdfunding websites such as Kickstarter, GoFundMe, Indiegogo, and Lending Club have become increasingly popular for both individual fundraising and small business owners looking for start-up capital or funding for creative ventures. The upside is that it’s often possible to raise the cash you need but the downside is that the IRS considers that money taxable income. Here’s what you need to know.
What is Crowdfunding?
Crowdfunding is the practice of funding a project by gathering online contributions from a large group of backers. Crowdfunding was initially used by musicians, filmmakers, and other creative types to raise small sums of money for projects that were unlikely to turn a profit. Now it is used to fund a variety of projects, events, and products and in some cases, has become an alternative to venture capital.
There are three types of crowdfunding: donation-based, reward-based, and equity-based. Donation-based crowdfunding is when people donate to a cause, project, or event. GoFundMe is the most well-known example of donation-based crowdfunding with pages typically set up by a friend or family member (“the agent”) such as to help someone (“the beneficiary”) pay for medical expenses, tuition, or natural disaster recovery.
Reward-based crowdfunding involves an exchange of goods and services for a monetary donation, whereas, in equity-based crowdfunding, donors receive equity for their contribution.
Are Crowdfunding Donations Taxable?
This is where it can get tricky. As the agent, or person who set up the crowdfunding account, the money goes directly to you; however, you may or may not be the beneficiary of the funds. If you are both the agent and the beneficiary you would be responsible for reporting this income. If you are acting as “the agent”, and establish that you are indeed, acting as an agent for a beneficiary who is not yourself, the funds will be taxable to the beneficiary when paid–not to you, the agent. An easy way to circumvent this issue is to make sure when you are setting up a crowdfunding account such as GoFundMe you clearly designate whether you are setting up the campaign for yourself or someone else.
Again, as noted above, as the beneficiary, all income you receive, regardless of the source, is considered taxable income in the eyes of the IRS–including crowdfunding dollars. However, money donated or pledged without receiving something in return may be considered a “gift.” As such the recipient does not pay any tax. Up to $15,000 per year per recipient may be given by the “gift giver.”
Let’s look at an example of reward-based crowdfunding. Say you develop a prototype for a product that looks promising. You run a Kickstarter campaign to raise additional funding, setting a goal of $15,000 and offer a small gift in the form of a t-shirt, cup with a logo or a bumper sticker to your donors. Your campaign is more successful than you anticipated it would be and you raise $35,000–more than twice your goal.
Taxable sale. Because you offered something (a gift or reward) in return for a payment pledge it is considered a sale. As such, it may be subject to sales and use tax.
Taxable income. Since you raised $35,000, that amount is considered taxable income. But even if you only raised $15,000 and offered no gift, the $15,000 is still considered taxable income and should be reported as such on your tax return–even though you did not receive a Form 1099-K from a third party payment processor (more about this below).
Generally, crowdfunding revenues are included in income as long as they are not:
– Loans that must be repaid;
– Capital contributed to an entity in exchange for an equity interest in the entity; or
– Gifts made out of detached generosity and without any “quid pro quo.” However, a voluntary transfer without a “quid pro quo” isn’t necessarily a gift for federal income tax purposes.
Income offset by business expenses. You may not owe taxes however, if your crowdfunding campaign is deemed a trade or active business (and not a hobby) your business expenses may offset your tax liability.
Factors affecting which expenses could be deductible against crowdfunding income include whether the business is a start-up and which accounting method (cash vs. accrual) you use for your funds. For example, if your business is a startup you may qualify for additional tax benefits such as deducting startup costs or applying part or all of the research and development credit against payroll tax liability instead of income tax liability.
Timing of the crowdfunding campaign, receipt of funds, and when expenses are incurred also affect whether business expenses will offset taxable income in a given tax year. For instance, if your crowdfunding campaign ends in October but the project is delayed until January of the following year it is likely that there will be few business expenses to offset the income received from the crowdfunding campaign since most expenses are incurred during or after project completion.
How do I Report Funds on my Tax Return?
Typically, companies that issue third-party payment transactions such as Amazon if you use Kickstarter, PayPal if you use Indiegogo, or WePay if you use GoFundMe) are required to report payments that exceed a threshold amount of $20,000 and 200 transactions to the IRS using Form 1099-K, Payment Card and Third Party Network Transactions. The minimum reporting thresholds of greater than $20,000 and more than 200 transactions apply only to payments settled through a third-party network; there is no threshold for payment card transactions.
Form 1099-K includes the gross amount of all reportable payment transactions and is sent to the taxpayer by January 31 if payments were received in the prior calendar year. Include the amount found on your Form 1099-K when figuring your income on your tax return, generally, Schedule C, Profit or Loss from Business for most small business owners.
Again, tax law is not clear on this when it comes to crowdfunding donations. Some third-party payment processors may deem these donations as gifts and do not issue a 1099-K. This is why it is important to keep good records of transactions relating to your crowdfunding campaign including a screenshot of the crowdfunding campaign (it could be several years before the IRS â€œcatches upâ€) and documentation of any money transfers.
Don’t Get Caught Short
If you’re thinking of crowdfunding to raise money for your small business or startup or for a personal cause, consult a tax and accounting professional first. Don’t make the mistake of using all of your crowdfunding dollars on your project and then discovering you owe tax and have no money with which to pay it.
Many parents are looking for ways to save for their child’s education and a 529 Plan is an excellent way to do so. Even better, is that thanks to the passage of tax reform legislation in 2017, 529 plans are now available to parents wishing to save for their child’s K-12 education as well as college or vocational school.
You may open a Section 529 plan in any state, and there are no income restrictions for the individual opening the account. Contributions, however, must be in cash and the total amount must not be more than is reasonably needed for higher education (as determined initially by the state). There may also be a minimum investment required to open the account, typically, $25 or $50.
Each 529 Plan has a Designated Beneficiary (the future student) and an Account Owner. The account owner may be a parent or another person and typically is the principal contributor to the program. The account owner is also entitled to choose (as well as change) the designated beneficiary.
Neither the account owner or beneficiary may direct investments, but the state may allow the owner to select a type of investment fund (e.g., fixed income securities), change the investment annually as well as when the beneficiary is changed. The account owner decides who gets the funds (can pick and change the beneficiary) and is legally allowed to withdraw funds at any time, subject to tax and penalties (more about this below).
Unlike some of the other tax-favored higher education programs such as the American Opportunity and Lifetime Learning Tax Credits, federal tax law doesn’t limit the benefit only to tuition. Room, board, lab fees, books, and supplies can be purchased with funds from your 529 Savings Account. Individual state programs could have a more narrow definition, however, so be sure to check with your particular state.
Distributions from 529 plans are tax-free as long as they are used to pay qualified higher education expenses for a designated beneficiary. Distributions are tax-free even if the student is claiming the American Opportunity Credit, Lifetime Learning Credit, or tax-free treatment for a Section 530 Coverdell distribution–provided the programs aren’t covering the same specific expenses. Qualified expenses include tuition, required fees, books, supplies, equipment, and special needs services. For someone who is at least a half-time student, room and board also qualify. Also, starting in 2018, “qualified higher education expenses” include up to $10,000 in annual expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.
Note: Qualified expenses also include computers and related equipment used by a student while enrolled at an eligible educational institution; however, software designed for sports, games, or hobbies does not qualify unless it is predominantly educational in nature.
Federal Tax Rules
Income Tax. Contributions made by the account owner or other contributor are not deductible for federal income tax purposes, but many states offer deductions or credits. Earnings on contributions grow tax-free while in the program. Distribution for a purpose other than qualified education is taxed to the one receiving the distribution. In addition, a 10 percent penalty must be imposed on the taxable portion of the distribution, comparable to the 10 percent penalty in Section 530 Coverdell plans. Also, the account owner may change the beneficiary designation from one to another in the same family. Funds in the account roll over tax-free for the benefit of the new beneficiary.
Gift Tax. For gift tax purposes, contributions are treated as completed gifts even though the account owner has the right to withdraw them – thus they qualify for the up-to-$15,000 annual gift tax exclusion. One contributing more than $15,000 may elect to treat the gift as made in equal installments over that year and the following four years, so that up to $75,000 can be given tax-free in the first year.
Estate Tax. Funds in the account at the designated beneficiary’s death are included in the beneficiary’s estate – another odd result, since those funds may not be available to pay the tax. Funds in the account at the account owner’s death are not included in the owner’s estate, except for a portion thereof where the gift tax exclusion installment election is made for gifts over $15,000. For example, if the account owner made the election for a gift of $75,000 in 2018, a part of that gift is included in the estate if he or she dies within five years.
Tip: A Section 529 program can be an especially attractive estate-planning move for grandparents. There are no income limits, and the account owner giving up to $75,000 avoids gift tax and estate tax by living five years after the gift, yet has the power to change the beneficiary.
State Tax. State tax rules are all over the map. Some reflect the federal rules, some quite different rules. For specifics of each state’s program, see http://www.collegesavings.org.
Considering the differences among state plans, the complexity of federal and state tax laws, and the dollar amounts at stake, please call the office and speak to a tax and accounting professional before opening a 529 plan.
The U.S. economy is growing at an above-trend pace, and the rest of the world seems to be finding its footing. Meanwhile, the Federal Reserve (Fed) continues to normalize monetary policy, and it appears that other central banks are following suit. Interest rates have come down off the highs seen earlier this year, and equity valuations are no longer looking as pricey. With this as the setup, how should investors think about navigating markets during the second half of the year?
With respect to growth, the second half of this year should be better than the first. The weakening in global goods demand that led to disappointing growth metrics in the first quarter seems to have worked its way through the system, with U.S. consumption expected to have grown by nearly 4% from a year prior in the second quarter, and retail sales in Europe showing signs of stabilization. Furthermore, the Purchasing Managers Indices (PMIs) and other soft data all point to a continued improvement in growth outside of the U.S. While the hard data will need to provide confirmation of this trend, the clouds which have been hanging over the international economy for the past few months finally seem to be breaking.
Solid growth in and outside the U.S. would align with policymaker expectations, leading the Fed to continue hiking rates and the European Central Bank (ECB) to hike for the first time around the middle of next year. If these expectations are realized against a backdrop of solid economic growth, it could lead the dollar to soften, providing a boost to emerging markets and supporting a resynchronization of growth as we approach 2019. This resynchronization of global growth could help alleviate trade-related concerns, and provide support for risk assets to move higher. With earnings growth looking solid, equity valuations in-line with or below their long-term averages around the world, and interest rates still historically low, stocks should be able to rally into 2019. However, diversification should remain the central tenet of any investment strategy given the political risk premium which continues to exist in markets around the world.
Bad idea! Looking ahead to retirement, your objective should be to accumulate a 401K nest egg of financial assets as large as possible, and pay off your mortgage as soon as possible. You should pursue these objectives independently, not sacrifice one to obtain the other. On balance, that would be a loser, for multiple reasons.
1. Early Withdrawal Costs: Paying off a mortgage balance with a 401K balance of the same amount would not be a break-even but would generate a sizeable cash outflow because it would trigger tax payments plus a 10% early withdrawal penalty if under 59 ½. While there are exceptions to the withdrawal penalty, paying off a mortgage balance is not one of them.
2. Opportunity Cost on the Existing 401K Balance: An even larger loss from liquidating your 401K is the future earnings on the funds withdrawn. These earnings accumulate tax free until you are 70 1/2, and at that point you pay taxes only on the amounts withdrawn at your tax bracket at that time – which could be a lot lower than it is now.
3. Possible Earnings Opportunity Loss on New Contributions: If your intention is to abandon your 401K after it has been depleted, given that you are still many years from retirement, the largest loss would be the tax-deferred income you could contribute plus the tax-deferred earnings on those contributions that you would be making in future years. Your major objective should be to contribute as much as possible – I have no advice on that without knowing your circumstance – and obtain as high an earnings rate as possible. I do have some thoughts about that.
4. Maximizing Earnings on 401K Accounts: Over a period of years, the rate of return on your 401K should be well above your mortgage rate. A diversified portfolio of common stock will generate high rates of return over long periods along with high short-term variability. For example, during the period 1926-2012, the median return on the common stock of large companies over 25-year periods was 11.34%. The highest 25-year return was 17.26% while the lowest was 5.62%. Even if you consider the period starting August 2000, that experienced two bear market declines of 50%, the S&P 500 Total Return Index had an average return of 4.78%.