Lee Storey, the producer and director of an award-winning documentary about the singing group “Up with People,” scored a major victory for filmmakers in a ruling by the U.S. Tax Court.

The Tax Court ruled last Thursday against the Internal Revenue Service in the case. The IRS had claimed that Storey, an attorney with the law firm Ballard Spahr LLP in Phoenix specializing in natural resources and water rights, merely did filmmaking as a hobby and was not entitled to write off over $250,000 in expenses for producing the film, “Smile ’Til It Hurts: The Up with People Story.”

The Tax Court, however, ruled that she was able to demonstrate that she was engaged in filmmaking for a profit and that her enjoyment of filmmaking as a hobby was not sufficient for the IRS to cause the activity to be classified as a hobby. The case has been closely watched in the documentary and independent filmmaking community, especially after a statement by the judge in the case, Diane Kroupa, aroused fears that documentaries might not qualify as for-profit activities (see Documentary Makers Protest Tax Court Ruling). Luckily for the filmmakers, Judge Kroupa ultimately ruled in their favor.

“I think it’s a huge victory for the arts,” Storey said in an interview Monday. “We all have to conduct our business as a business. There’s no question about that, and fortunately being the test case the facts were clearly on my side. I think one of the very interesting things is that the court acknowledged that it takes longer in some businesses to bring your product to market, particularly in the arts. And documentary films can take eight to 15 years to actually produce. Typically they range from five to seven [years]. It’s a huge victory and I think it can apply even to those who are in the music industry—bands and those developing recording careers. Some things just take time.”

Storey noted that it remains an open question whether the Section 181 election for expensing production costs will be extended by Congress. “I don’t know if it will be extended by Congress, but it’s designed to support filmmaking here in the United States as opposed to the $10 billion going abroad each and every year,” she said. “I took advantage of it, but if it’s extended I think it’s important for the accountants for documentary filmmakers to know how those elections should be properly made. I made that election and all of my deductions were allowed. I’m thrilled about this, to say the least. I will tell you, the film industry is breathing a nice collective sigh of relief because a negative ruling would have had a chilling impact on the film industry, without question.”

While she is a partner at Ballard Spahr, Storey does not practice tax law and she instead was represented by attorney Greg Robinson, a partner at Farley, Robinson & Larsen, another firm in Phoenix, after her previous tax attorney died midway through the case. The case involved production expenses for 2006, 2007 and 2008, and the IRS first took issue with the deductions in 2009.

“It’s a three-year audit that went to trial,” said Robinson. “When we won it and won all three years, they didn’t get to impose any penalty or any tax. It’s a total, complete victory, and when you go look at some of the cases that are reported, there aren’t that many complete, total taxpayer victories, so this is very satisfying.”

He credits the amicus briefs that were filed in the case by the International Documentary Association and other filmmaking groups, along with testimony from executive producer Jack Lechner. “He came out and testified,” said Robinson. “Because of his resume and his expertise, it helped bolster the credibility of Lee Storey, who accessed really good editors, assistant editors and Mr. Lechner himself to make sure she was doing the right things.”

Robinson also credited Storey for her tenacity in securing rights to every piece of footage and music in the movie, even from the National Football League. “She was told she would never get permission from the NFL to put any of their footage in,” said Robinson. “She negotiated that too. Jack Lechner said she was absolutely brilliant how she negotiated all the rights.”

Storey believes the case could serve as a good precedent for future filmmakers and their accountants in how they can claim expenses.

“I think maybe that is a good area for future discussion among the film community, when to take elections, how to take elections, making sure that they’re prepared, along with probably a great deal more education on the nine-factor test for the hobby loss rule,” she said. “That’s good for everyone to know. You essentially have to meet these nine criteria that help the IRS determine that it’s more of a business than a hobby.”

This is the first time the Tax Court has directly addressed the question of the hobby loss rule for documentary filmmaking. The amicus brief filed by the International Documentary Association helped lay the groundwork for the recognition that documentary filmmaking should be considered a for-profit activity.

“It’s not the first time it’s addressed the hobby law, but it’s the first time it’s addressed it so squarely and pointedly for documentary filmmaking, recognizing that in some businesses like the arts, it can take longer to show a profit or even bring your product to market,” said Storey. “It’s also the first time the court has been asked to review this election under Section 181, and I am sure that accountants would probably be very interested in better understanding the court’s ruling for future documentary filmmakers.”

“Smile ’Til It Hurts” is Storey’s first documentary and it has already won several awards after playing at several festivals, including the Sundance Conference and the Tribeca Film Festival. The film received a Special Jury Prize at Michael Moore’s Traverse City Film Festival and the best director award at the First Glance Film Festival in 2009. It was also among 18 films selected by the International Documentary Association for qualification for Academy Awards consideration in 2010. Nevertheless, that has not yet translated into commercial success.

“Unfortunately, the film hit the market at a time when the entire industry went flat,” said Storey. “With the economy, no-one was buying any films, and in some ways it fell through the cracks. It’s been difficult because of the market, but I’m still hopeful. I own all the rights, and they’re available for sale, along with the DVDs.”

Storey is currently planning her next project, about Peter Asher, a longtime music producer who worked for Apple Records and produced songs recorded by James Taylor and Linda Ronstadt. Her co-producer on the film, CC Goldwater, has since made a documentary about her grandfather, former Republican presidential candidate Barry Goldwater, called “Mr. Conservative: Goldwater on Goldwater.”

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