In recent years, music catalogs have turned into stable and accessible income-generating assets. Manatt, Phelps & Phillips LLP’s Beau Stapleton and Burak Ahmed look at the tax advantages that artists get from Section 1221(b)(3) of the tax code, which allows for capital gains treatment on the sale of self-made musical works.
Much has been written about the recent boom in music catalog sales. The market has seen unprecedented deals, with artists such as Paul Simon, Bruce Springsteen, Bob Dylan, Sting, and Neil Young receiving paydays in the hundreds of millions of dollars—often at multiples of more than 20 times annual net royalty income. But 2022 brought headwinds to the marketplace. Rising interest rates, the diminishing availability of marquee catalogs, and higher scrutiny from financing partners have led some to proclaim that the catalog sale boom is over.
Despite these pressures and claims, the catalog market’s fundamental underpinnings remain intact. On the buy side, year-over-year increases in digital and performance revenue, as well as ever-expanding data sources for forecasting and analysis, have turned music catalogs into stable and accessible income-generating assets. On the sell side, a catalog sale presents an artist with significant tax advantages due to a unique provision in the tax code—Section 1221(b)(3)—that allows for capital gains treatment on the sale of self-made musical works.
While many catalog deals during the first years of the Biden administration took place under fear that this preferential tax treatment might soon end, a material change to the tax code now seems unlikely in the face of our post-midterm divided government. Instead, legislative gridlock likely will make the 1221(b)(3) election a major driver of catalog sales for the next several years.
When the US enacted its first income tax laws in 1913, it didn’t distinguish between capital and ordinary income assets. But without such a distinction, income from the sale of investment property sporadically subjected taxpayers to higher tax brackets and overall taxes than if the income had been recognized annually. Congress addressed this issue in 1921 by enacting legislation that distinguished ordinary income from capital gains and, except for a brief period between 1988 and 1990, has provided capital gains with lower tax rates for a century.
A capital asset has historically been defined in negative terms as all property except specifically excluded property that is considered ordinary income property, such as property held for sale to customers in the ordinary course of business (i.e., inventory). But over the years, Congress has carved out certain asset classes for capital gains treatment to promote various tax policies.
During World War II, for example, Congress recharacterized a business’s depreciable property so that manufacturers could receive an ordinary tax deduction on a loss and capital gains treatment on a gain—the best of both worlds. Similarly, in 1954, Congress granted certain inventors capital gains treatment on the sale of their patents as an incentive to spur inventions—a benefit that was removed in 2017 on the basis that such sales resemble inventory.
Professional songwriters were historically ineligible for capital gains treatment on catalog sales. Courts reasoned that a “professional” creator held their works much like a business held its inventory: for sale to customers in the ordinary course of business. However, courts held that amateur creators were entitled to capital gains treatment because their works weren’t regularly held for sale to customers in the same manner.
This distinction ended in 1950 after then-General Dwight Eisenhower sold the rights to his World War II memoirs, “Crusade in Europe,” for $635,000 (almost $8 million today). To ensure he would receive capital gains treatment on the sale, Eisenhower secured an advance ruling that he was an amateur writer as opposed to a professional one.
His resulting tax windfall outraged enough members of Congress to amend the definition of a capital asset in 1950 to specifically exclude all self-created copyrights as well as literary, musical, and artistic compositions. For songwriters, the amendment meant that any sale of their musical works would be precluded from receiving capital gains treatment—a rule that remained in place for the next half century.
In 2000, various artist groups, including the Nashville Songwriters Association International, began lobbying Congress to enact legislation granting songwriters preferential tax treatment on the sale of their compositions. It was the height of the Napster era, and songwriter royalty revenue was cratering in the face of peer-to-peer file sharing.
After a six-year campaign, Congress amended Section 1221(b)(3), allowing songwriters to treat their catalog as a capital asset at the time of a sale. The financial implications of this provision for the songwriter are significant: Hold on to your catalog and pay ordinary income tax at up to 37% on future royalties, or sell to the highest bidder and pay a one-time capital gains tax at the maximum rate of 20%.
The 1221(b)(3) election didn’t generate an immediate sales boom. At the time, most institutional investors remained wary of an industry struggling to find its footing in the digital age. But over the succeeding decades, peer-to-peer sharing applications gave way to downloading, which led to the mass adoption of streaming services.
Music royalty revenue stabilized and began showing regular year-over-year growth—often well into double digits. The same digital technologies that revolutionized how society consumed music allowed labels and publishers to accumulate data that would provide unprecedented insights into global music usage. As a result, songwriter royalties transformed into a predictable stream of income that sophisticated buyers could plug into forecasting models to predict investment returns.
When the Covid-19 pandemic swept the globe in early 2020, musicians who were accustomed to generating a substantial portion of their income from touring were forced off the road. When looking for other sources of income, they found a new market of buyers willing to pay large multiples to replace their future royalty income with a sizable upfront purchase price. And when they recognized the availability of a favorable tax rate—up to a 17% spread from what most are paying on royalty income—the choice to sell became an easy one. This unprecedented alignment of interests among buyers and sellers drove the headline-grabbing reports of repeated hundred-million-dollar catalog sales.
We are undoubtedly entering a second act of the music catalog sale boom. Rising interest rates have tempered buyers’ excitement for song catalogs, and with them has come downward pressure on purchase price multiples. But the fundamentals that brought us the boom in the first place remain—good data, solid royalty earnings and forecasts, and, at least through our next election cycle, legislative gridlock that makes a change to the Section 1221(b)(3) election unlikely.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Beau Stapleton is a partner at Manatt Entertainment and works with entertainment stakeholders as they undertake complex and often cross-industry deals. Stapleton has experience working at the intersection of the music, film, television and digital industries.
Burak Ahmed is a tax attorney in Manatt’s Los Angeles office who focuses his practice on advising public and private companies on a variety of accounting and legal matters. Burak, who has experience in corporate and tax law, prepares transaction documents for diverse types of mergers and acquisitions, tax-free reorganizations, cross-border transactions, and state and local taxation issues.
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