The AI Copyright Quandary: Originality, Creativity, and the Machine

By Lauren Mack, with the assistance of ChatGPT

Questions surrounding the protectability of output produced by artificial intelligence (AI) under copyright law are becoming increasingly significant for content creators and businesses alike. The current legal framework in the United States and many other countries requires that, in order to be eligible for copyright protection, a creative work must be created by a human. However, as AI technologies continue to advance and produce increasingly creative and original works, there is a growing debate about whether these works should also be eligible for copyright protection.

Who Should be the Author of AI-Created Works?

One of the key issues in the debate over whether AI-generated works should be copyrightable is the question of who should be considered the author of such works. Traditionally, the author of a work is the person who created it, and that person is entitled to the exclusive rights of copyright protection. However, in the case of AI-generated works, there is no clear person or group of people who can be considered the author of the work. Instead, the work is the result of a complex and often opaque set of algorithms and processes that may involve many different inputs and variables.

The most persuasive approach to resolving this issue in favor of technology is to consider the role of human input in the creation of AI-generated works. While AI systems may be capable of producing works that are original and creative, these systems generally still require significant input and direction from humans. For example, an artist may use an AI algorithm to create a painting, but the artist is still responsible for selecting the colors, composition, and other elements of the work. Similarly, a musician may use an AI system to generate a melody, but the musician is still responsible for arranging and producing the final song. This could be analogized to taking a photograph with a camera – while the camera creates the picture, it is the human behind the camera who selects the subject, angle, lighting, etc., and who is therefore the copyright owner in the ultimate photograph. Proponents of this approach argue that the human input and direction involved in the creation of AI-generated works is sufficient to satisfy the “human authorship” requirement under copyright law.

A less common argument is that the AI itself is the copyright owner. This argument appears destined to fail, as the US Copyright Office has consistently stated that only humans can author a copyrightable work, including in connection with a case where PETA brought an action claiming that the copyright in a selfie taken by a monkey named Naruto using a camera set up by a nature photographer was owned by the monkey (the lawsuit was ultimately settled). Others have argued that the AI program is the author, which creates the work on behalf of the AI creator as a “work made for hire” under the US Copyright Act, making the creator of the AI program the ultimate owner in the works it creates.

One such argument is being made by Stephen Thaler, who submitted an application to register a copyright in an AI-generated work of art titled A Recent Entrance to Paradise in 2018. He listed the author of the work as his Creative Machine system, known as DAUBUS, which he claimed “autonomously” created the work. He further listed himself as the copyright claimant under the “work made for hire” theory. The US Copyright Office rejected his application, stating that current copyright law only provides protection to “the fruits of intellectual labor” that “are founded in the creative powers of the mind”, and AI-generated works do not meet this requirement. Thaler appealed the decision to the US District Court in Washington, D.C., arguing that protecting AI-generated works under copyright law is necessary to promote the production of socially valuable content and is required under current legal frameworks. While the Copyright Office’s decision here is in line with its previous statements and court rulings, these novel arguments could result in disrupting current norms.

Further clarification from the Copyright Office has recently determined that works not created entirely by AI may have limited copyright protection. In September 2022, Kristina Kashtanova attempted to register the copyright in their comic book entitled Zarya of the Dawn. The story was written by Kashtanova themself, however they used the AI art generator Midjourney to create the illustrations. Although they described the time-intensive process of describing how each image should look to the AI platform in order to obtain their desired output, the Copyright Office was unpersuaded that it was enough human creativity to merit full copyright protection. As of this week, the Copyright Office has cancelled their copyright registration and reissued it to exclude protection for the Midjourney-created art, but provided protection for the text written by Kashtanova and for the comic as a “compilation due to her creative selection, coordination, and arrangement of the text and images”. Whether Kashtanova will also appeal this decision to federal court as Thaler did remains to be seen.

That’s Output, But What About Input?

Whether AI output is copyrightable is not the only question being posed to US courts. For AI to learn how to create text, art, sound, or other output, its algorithm needs to be fed a large amount of information to analyze, from which it learns how to create the desired output. In January 2023, three artists filed a lawsuit in California federal court against DeviantArt, Midjourney, and Stability AI for using their artwork to train AI generators and requested certification of a class action on behalf of similarly situated artists. The plaintiffs asserted that the defendants fed their art to the AI algorithm, thus using it to create new images that were unauthorized derivative works of their original artwork. They further allege that the defendants have profited from these infringing artworks and have used the artist’s names to sell their AI products and services by virtue of being able to copy their artistic styles. The outcome of this lawsuit could have a serious impact on evolving technologies and/or the ability for artists to continue to make a living.

This tension between artists and technology has been a hot button issue since the advent of the commercial Internet. Without large amounts of information to teach the AI algorithm, it could not produce useful output, however if AI output can be used to replace artists by consuming their art, then human artists may not be able to survive. Ultimately, the question of whether AI-generated works should be copyrightable and what permissions are needed to teach that AI, if any, is likely to remain a contentious and evolving area of the law throughout the next few years.

Attention ALL expats living in the U.S.: Important information for your next entry in the U.S.

By: Steve Masur

All expats know and share the struggle of dealing with U.S. administrative, fiscal, and immigration-related processes and issues. Do yourself a favor and request an ink stamp in your passport during your next entry in the U.S.

As an expat in the U.S., it’s important to stay informed about the latest updates regarding immigration and entry procedures.

In the past year, U.S. Customs and Border Protection (CBP) has made changes to the arrival procedure entering the United States (notably via air): there is now a stamp-less entry for noncitizens, meaning that you will no longer automatically receive an ink stamp in your passport at entry.

However, you may request a stamp from the CBP officer during your entry interview, and we recommend that you do so.
As a reminder, if you are not a US citizen or permanent resident, it’s essential that you download your I-94 and your I-94 history from CBP’s website each and every time you enter the United States. The CBP’s online system is not always accurate and prone to glitches, so you need to make sure the information on record is accurate, and if not, promptly take the necessary action to correct it.

It’s important to note that the stamp-less entry applies to both nonimmigrant visa holders and permanent residents. Consider how physical stamps may come in handy:

  • Nonimmigrant visa holders may have to rely on passport ink stamps as evidence acceptable to the United States Citizenship & Immigration Services (USCIS), regarding subjects such as maintenance of status and recapturing time outside the U.S. for H/L visas holders.
  • Permanent residents applying for U.S. citizenship may have to rely on passport ink stamps for documenting absences outside the U.S. since the CBP’s website does not track their travel history. Without ink stamps, your only evidence of international travel would be airline emails, itineraries, and travel receipts.

Both nonimmigrant visa holders and permanent residents may find ink stamps helpful or even required in other situations, such as for determining fiscal residence (for U.S. tax purposes) or when dealing with the Social Security Agency or state DMVs.

Therefore, we highly recommend that you request an ink stamp from the CBP officer during each admission to the United States. This will help ensure that you have proper records and avoid any potential issues down the road.

DAOs are the Punk Rock of Corporate Law

By Steven Masur and Lydia Amamoo

There’s something new and amazing happening in corporate law. Decentralized Autonomous Organizations, or DAOs. DAOs represent an evolution of corporate law that moves at the exponential speed of technology.

What is a DAO?

In its simplest form, a DAO is a self-governing group of people who control a bank account. Blockchain technology enables the rules of engagement for the DAO to be coded into smart contracts such that all participants can see transactions, and no participant can act counter to the smart contracts without the approval of all participants. The smart contracts are coded onto coins, which individuals can purchase to participate in the DAO. Because most DAOs make use of blockchain technology, the smart contracts within them can be revised and updated upon a vote of the participants, and these revisions will be immutable and transparent to all.

 

How are DAOs Used?

These self-governing voting trusts can be used for almost anything. A common use of a DAO is people banding together to buy something of value, like an unreleased Wu-Tang Clan record, a Stradivarius violin, a building, or even a rare original copy of the U.S. Constitution for nearly $50 million dollars. Another common use of a DAO is as a basic governance structure. Examples range from CryptoMondays’ DAO, which decides when and where a monthly event will take place and what will be discussed, to DAOs controlling the operations of an entire institution, government, or company, like the Shapeshift DAO.

 

Why were DAOs Created?

The SEC’s accredited investor rules, which require a net worth of at least $1 million dollars or annual income in excess of $200,000 to qualify to invest in a private startup, left normal people behind during one of the biggest wealth creation cycles in U.S. history. Only the relatively rich could participate and risk their money on a new startup with new ideas, unless they had an in – if they were either a part of the startup, or the founders’ friends or family. For those starting companies, despite intense competition among law firms doing early-stage formations, the average cost of setting up even a simple company properly ranges from as low as a few hundred to upwards of $250,000. At the lower end of this range, mistakes and omissions in the corporate documents, improperly established management structures, missed state-regulated deadlines and tax payments, and outright exploitation by those more sophisticated in corporate law, have cost founders millions of dollars. So, in a very real way, DAOs are made by and for people frustrated and disenfranchised by the current state of corporate law.

 

How are DAOs Changing Corporate Law?

DAOs fly in the face of established corporate law because they allow participants to directly vote their interests, instead of investing their trust in a board of directors, which in turn delegates operational duties to officers who control an ever-expanding hierarchy of managers. Traditional corporations exist and must abide by the laws of a state or country and the regulations of any territory in which they do business. DAOs are empowered by the basic human right of freedom of association, and most DAOs currently exist outside the system of states or governments. As a result, they represent a technology-driven evolution in corporate law, transcending territorial government in the same way that all internet-technologies transcend territories. DAOs open a universe of possibilities for human self-governance, decision-making, and participatory wealth creation. Hundreds of DAOs have been created for an increasingly wide variety of purposes, experimenting with new and different voting mechanisms, including tiered voting, voting on specific areas of competency, or using defined voting roles. Any conceivable voting system can now be hard-coded into the smart contracts of a DAO, tested, and then manipulated until it works as desired. The exponential growth of DAOs, and the process of iterative evolution is changing corporate law, not at the speed of legal precedent or legislative process, but at the exponential speed of technology.

 

So… What’s the Problem?

One problem is limited liability. As a matter of law, a corporation or LLC can limit the liability of participants to just the amount they invested. While a DAO could include this limitation in its rules of engagement, under the law of most countries, if someone outside the DAO were to sue the DAO, each DAO participant could potentially be held equally responsible for paying the full amount of any judgments against the DAO.

Another problem is a limited instruction set within a DAO for dealing with unforeseen problems. Corporations and LLCs can rely upon boilerplate protections built into their corporate documents, as well as laws and legal precedent specifically addressing the history of similar problems for prior corporations and LLCs. This lack of precedent leaves DAOs susceptible to legal claims, lacking a strong basis of guidance for what to do in the wide variety of situations that arise through normal human interactions, including business interactions.

A third problem is the potential for carelessness or outright exploitation at the hands of those programming the smart contracts. A malicious or sloppy programmer could build into the smart contracts the means to take or divert the money contained within the DAO, or even result in the DAO being hacked.

 

LLC-Wrapped DAOs

It is still very early, but a few states and countries are getting on the blockchain bandwagon and have adopted DAO legislation. These laws are intended to extend the concept of limited liability to DAOs.

 

  • Vermont was the first U.S. state to make corporate legislation tailored to companies utilizing blockchain-based technology. The Vermont Blockchain-Based LLC (BBLLC) isn’t specific to DAOs but applies standard LLC law to any company using blockchain-based technology for a material portion of their business activities. However, unlike the standard LLC, a BBLLC is required to make additional disclosures in its formation documents, such as including a mission statement and specifics on voting procedures and the blockchain technology that will be used. To determine and lock in these parameters at the outset of establishing the business may be incompatible with the innovative and ever-changing spirit of DAOs.

 

  • Wyoming was the first U.S. state to make legislation specifically addressing DAOs. The Wyoming DAO LLC applies the state’s standard LLC law and a few additional requirements, including specifying the extent to which management will be conducted algorithmically. Unlike the BBLLC, the Wyoming DAO LLC can propose its own definition of a quorum for voting purposes. This amendment to traditional LLC law goes with the fluidity of DAOs, where requiring a majority for all voting matters might stifle DAO member participation on a large scale. A notable deterrent to the Wyoming DAO LLC is that the DAO must take actions or approve proposals within the first year or it will be legally dissolved. Tennessee followed in Wyoming’s footsteps, creating a “decentralized organization” or DO LLC, which operates similarly to the Wyoming DAO LLC, but still requires the default 50% quorum requirements.

 

  • How are countries around the world doing things differently? Several countries, including Switzerland, Liechtenstein, Bermuda, Cayman Islands, the British Virgin Islands, and Singapore, are trying to become crypto-friendly hubs, but few have enacted DAO-specific legislation. Malta was the first country to introduce DAOs as a legal entity called a D corp, or decentralized corporation, but its legislation includes a hierarchical corporate governance structure that may be against the very nature of a DAO. The Republic of the Marshall Islands made its way into the crypto-arena back in 2018 when it first tried to launch a state-sponsored cryptocurrency as its legal tender. Now, the Marshall Islands have enacted a DAO regulation based on a mix of U.S. and English common law recognizing DAOs as legal entities similar to non-profit LLCs. The Marshall Islands’ statute provides for easy set-up, minimal KYC requirements, and member confidentiality, making it a highly desirable country to establish DAOs.

 

Conclusion: DAOs are Here to Stay

DAOs are considered by some to be a new fad that will pass by in the blowing wind. But DAOs are here to stay. The technology to implement them exists, is improving, and people will continue to use it, regardless of legality. Their motivation may be profit, or the desire to own things not otherwise accessible, or even to enjoy of the greater things in life, like smoothly operating community systems. But regardless of motivation, the old ways seem inaccessible, expensive, problematic, and difficult. People feel powerless. DAOs may be the early iteration of entirely new forms of human governance. Lawyers have a critical part in building this new infrastructure because of our knowledge of what went before and our experience with the tried-and-true methodologies that built the world in which we live today. But the world of tomorrow will be different.

Corporate Formalities: Protecting Your Business’ Assets

By: Steve Masur

Corporate formalities are steps that your business must take to ensure that your corporation remains legally distinct from its owners. The majority of these steps include keeping separate records for corporate activity, holding regular meetings for corporate directors, and maintaining a financial independent account for your corporation.

You should be careful to observe the proper corporate formalities so that your business will not be attacked by any governmental authority or other creditor as being no more than a sham entity created to give you tax benefits or to protect you from personal liability. The most important corporate formalities which should be observed are:

  • The timely filings of corporate forms
  • The writing of corporate minutes which reflect the various actions of the corporation and the annual meeting of stockholders or action by written consent in lieu of such meeting
  • Communicating with third parties in a manner that clearly indicates that they are doing business with your corporation and not an individual
  • Separate maintenance of all financial accounts

Your corporation must keep minutes of all meetings with stockholders, Board of Directors and any committee of the board. Also, your corporation should keep a stockholder list, including addresses. Transfer agents for the corporation are equipped to maintain the stockholder list and will periodically provide updates to the list. The minutes do not have to follow any sort of form but should include information such as the date, time and place of the meeting, those persons in attendance, and the actions taken and considered by the board in a clear fashion. It is strongly recommended that all minutes not drafted by your firm be reviewed periodically to ensure that all corporate business is properly authorized.

Another indication that your corporation is conducting business as a bona fide corporation will be the maintenance of proper books and records for your corporation. Stockholders and directors have the right during usual business hours to inspect your corporation’s stock ledger, stockholder list and any other books and records. The annual meeting of stockholders is significant in maintaining the on-going nature of your corporation and confirming that you and the other members of management are respecting the separate existence of the corporation. Your corporation should hold an annual meeting of stockholders to elect the Board of Directors, to ratify the appointment of accountants and to transact any other business properly brought before the stockholders and to conduct stockholder business.

The law considers your corporation to be a separate person and therefore its financial affairs and all assets and funds should be kept separate from any individuals or other entities, assets, and funds. You should take care always to execute legal documents and take other actions on behalf of the corporation in a way that makes clear that your corporation is the party taking the action.

To reduce the risk that stockholders of your corporation will be liable for its debts and obligations, all officers, directors, and stockholders should observe the corporate procedures set forth in your state’s general corporation law and in the bylaws of your corporation. Also, you should do the following:

  • Carefully maintain written consents of directors and stockholders, stock records, bylaws, Certificate of Incorporation, and other corporate records
  • Hold meetings of directors and stockholders as necessary or appropriate and keep minutes of those meetings
  • Make it clear to third parties that they are transacting business with you corporation rather than any individual
  • Execute documents and instruments on behalf of and in the name of your corporation rather than in the name of any individual
  • Carefully segregate corporate assets and funds from personal assets and funds
  • Use corporate assets and funds only for corporate purposes not use personal assets or funds for corporate purposes
  • Carefully document all personal dealings with your corporation

Division of Responsibilities 

In addition to taking care to ensure that your corporation’s identity remains distinct from that of any individual, all persons associated with your corporation should take care that their different roles relative to the corporation remains distinct. The Board of Directors is ultimately responsible for the management of your corporation. The Board of Directors appoints and delegates authority to your corporation’s officers. The officers handle the corporation’s day-to-day affairs, including the execution of documents and instruments under the direction of the Board of Directors. The corporation’s bylaws generally describe the principal duties and responsibilities of the officers of your corporation. Each member of the Board of Directors is charged with a duty of care and a duty of loyalty to the corporation. As such, each director must act in good faith and in a manner such director believes to be in the best interests of your corporation. Directors must act with such care as an ordinarily prudent person in a like position would use under similar circumstances. In doing so, the directors may rely on the advice of independent experts, but they must make a reasonable inquiry into the facts on which such experts base their advice. Similarly, the director must not usurp an opportunity which properly belongs to your corporation. In this regard, a director must bear in mind that your corporation must first be offered an opportunity which falls within the realm of your corporation’s business prior to a director undertaking to benefit personally from such opportunity.

Depending on your state’s general corporation laws your Board of Directors may be required to approve certain corporate actions. To approve corporate actions, the Board of Directors typically adopts resolutions by unanimous written consent or by vote at a directors’ meeting. The bylaws of your corporation describe procedures for obtaining unanimous written consent and holding directors’ meetings; you should review your bylaws whenever you have a question concerning such procedures. Forms of actions by written consent should be kept in the minute book, with the other corporate records of your corporation. The Board of Directors generally may take action at a properly noticed meeting at which a majority of the authorized number of directors is present upon a vote by a majority of those present. Special rules apply where a director has an interest in the matter to be approved. Transactions involving directors will be evaluated to determine whether the transaction is fair to your corporation, and the material terms and director’s interest are fully disclosed to and ratified by stockholders or by non-interested directors acting in good faith.

Actions that generally require directors’ approval include:

  • Election of corporate officers
  • Amendments to and repeal of the bylaws
  • Election of directors to fill vacancies on the Board
  • Issuance, sale or transfer of shares of stock
  • Calling of meetings of stockholders
  • Declaration of dividends and other stockholder distributions
  • Amendments to the Certificate of Incorporation
  • Sale, lease, conveyance, exchange, transfer or other disposition of corporate property and assets
  • Corporate borrowing and lending
  • Designation of corporate banks and authorized signatories
  • Adoption of business policies and plans

Depending on your state’s general corporation laws, stockholders may be required to approve of certain fundamental corporate actions. To approve corporate action, the stockholders typically adopt resolutions by written consent or by vote at an annual or special meeting of stockholders. The bylaws also describe the procedures your corporation must follow for obtaining stockholder written consent and calling and holding annual and meetings of stockholders.

Actions that generally require stockholder approval include:

  • Certain amendments to the Certificate of Incorporation
  • Election or removal of directors
  • Sale of all or substantially all of your corporation’s property assets
  • Mergers, reorganizations or dissolution of the corporation

In simpler terms, it will not always be evident whether you and the other principals of your corporation should take action as officer, director or stockholder. The easiest solution, although it is not always the best solution, is to seek and document both Board and stockholder approval of any major action your corporation is considering taking.

The Importance of Investor Updates

By: Gabriel Goldenberg & Natasha Harris, with comments from Steven Masur

Leading angel investor Jason Calacanis’ Rule of Startups is “If your startup isn’t sending you monthly updates it’s going out of business.”  In other words, keeping your investors up to date on what you’re doing is crucial in generating investor engagement and building the relationships that contribute to a startup’s growth. For companies working toward going public, investor updates create a helpful foundation for the type of reporting required of public companies.  Investor updates also protect you from investors claiming that you did not share enough information with them about what you were doing with your company, and their money. So, even if you are a very early stage startup, if you expect to have investors, implement the habit now of writing a monthly investor update, so that you become proficient at sharing both good and bad news in the best way.

 

What Are Investor Updates 

Investor updates are communications that share key qualitative and quantitative data with investors. The information that a private company discloses to investors is governed by the company’s governing documents and in some states, by statute. But, since private companies raise money from private investors and not the investing public, they are not subject to the same disclosure laws as public companies. Thus, the level and frequency of disclosures is much less for private companies than for public companies. Even so, private investors do have a right to information about their investment. Information reports can include financial data, upcoming business decisions, any press or media updates, and ways that investors can get involved. If you are doing this correctly, it should be easy for you to write, easy for investors to read, and you should receive good feedback. You can find an example of an investor update in the Resources section.

 

Why Is It Important 

Companies that regularly communicate with their investors are twice as likely to raise follow-on funding, and are much less likely to get into trouble with investors because they failed to keep investor expectations in line with the realities the companies face in the market.  Underlying Jason’s Rule of Startups is the principle that if a company does not communicate with investors, it is because there is nothing noteworthy to communicate – a terrible sign for business. Investors have a right to know both good and bad developments in company affairs as it affects their investment in your company.  In fact, consistent communication with investors, no matter the nature of the update, instills a sense of confidence that the business is running effectively, even if it is facing difficult times, and allows insight into the business’s overall health.

Maintaining trust with your investors is critical.  Notably, your updates should not solely focus on the company’s ‘wins.’ Highlighting only the good news can lead to doubt about whether the business is being forthcoming with crucial information, which can damage an investors’ trust, which can lead to a myriad of problems.  Instead, it is most helpful, and leads to better relationships with investors, to share a holistic view of the company’s status, including both the good, and bad news. It is important to note that investors who trust you can be helpful to the business beyond their capital. They often have knowledge, experience, and networks that startups can leverage in a growing the business. Founders who send regular updates are in a better position to ask for and receive help, contacts, and even new investments.

Investors are less likely to make introductions with their valuable contacts if they do not know what is going on in a company. With more information, they can gauge how beneficial an introduction would be for both parties and not tarnish their relationships by making perceivably wasteful introductions.

 

Things to Consider When Drafting an Update 

In drafting investor updates, consider the acronym STAT.

Structure

  • Beauty, Format, and Style: The style of the update should be tailored to the nature of the brand and investors. Whatever the chosen style, be sure to divide the information into digestible sections for easy reading. Also, once you have developed a good format, stick with it, so that it is easy for you to draft the next update, and easy for investors to read it quickly.
  • Frequency: Updates should be scheduled so that there is enough time to make progress and provide substantive updates as a result.  If monthly updates feel too often, provide quarterly updates.  Once you decide upon the frequency, it is important to ensure the updates are delivered consistently at those times. Consistency signals reliability and increases the level of trust investors have.
  • Disclaimer: It would be prudent to add a disclaimer in updates that confirms that the information is strictly confidential, and provided as a courtesy; It is not intended to establish a course of future conduct and should not be construed as varying the terms expressed in the Company’s definitive agreements; and the update should not be construed as a guarantee of future performance and undue reliance should not be placed on it.
  • Brevity: The point is to have consistent contact, so there is no need for lengthy updates. It lessens the work required to draft the update and makes it more likely that investors actually read it.

Topics

  • Include short narratives about how things have changed for the better or any setbacks experienced.
  • Create helpful metrics that will help investors understand how growth is measured. As the values change, include brief blurbs with insightful context.
  • Highlight any added traction that the business has been getting, whether through profitability, revenues, publicity, partnerships, or other engagement.

Asks

  • Leverage investor expertise and point out how they can become further involved.
  • Make thoughtful asks and avoid creating a laundry list of to-do items.

Thanks

  • Consider placing a spotlight on investors who have helped the business recently. It is an effective way to show appreciation and can prompt other investors to be more involved.

Resources

 

What to Do To Qualify For QSBS Exemption

By: Steven Masur, Tim Fisher, and Danielle Cerniello

We recently analyzed whether entrepreneurs should close their LLC and open a corporation (more specifically, C-Corp) to reduce or avoid capital gains tax on the sale of their company under Section 1202 QSBS (qualified small business stock). In response, this article will take a deeper dive into QTB (qualified trade or business); discussing the relative merits of states in which to incorporate; and describing the limitations to exclusion rates anticipated under the Biden Administration.

What is Section 1202 QSBS and How Do I Qualify?

In the event your business qualifies under Section 1202, then upon the sale of your business, instead of owing your capital gains tax to the IRS, some or all of the capital gains will be excluded from federal tax. This exclusion applies to non-corporate taxpayers, meaning individuals, partnerships, limited liabilities taxed as partnerships, and trusts. Moreover, based on a change in the law in 2010, if you acquired the small business stock after September 27, 2010, then you can exclude 100% of the capital gains. Lastly, you can exclude up to the greater of $10 million or 10 times the adjusted basis of the gain. However, if all of the capital gains are not excluded, the taxable portion has an assessment at a maximum tax rate of 28%.

In order to qualify, there is a minimum holding period of five years. This means that if today, you changed your business form from an LLC to a corporation for tax purposes (either by conversion, by merger, by electing to be taxed as a corporation, or by dissolving the LLC and forming a corporation) and sold stock or sold the entire company a year from today, you would not qualify for Section 1202 QSBS tax benefits. However, if the sale instead occurred five or more years after becoming a corporation, then you may qualify for Section 1202 QSBS tax benefits. The key is that Section 1202 should be used as a strategic planning mechanism if you are likely to sell your business in five or more years. It is not as simple as switching from an LLC to a corporation and then realizing benefits the following tax year.

Further, to be considered QSBS, the stock must be that of a domestic (US) C-Corp.. As a practical matter, once a corporation is an S-Corp it cannot qualify for Section 1202 QSBS tax benefits by changing to a C-Corp.  Moreover, the gross-asset tests must be met, meaning the company’s gross assets cannot exceed $50 million.

You Must Be A QTB To Qualify

The company must be a qualified trade or business (QTB) for substantially the entire five-year holding period. Essentially, Section 1202 does not consider a business to be a QTB if it offers value to customers primarily in the form of services. This is likely the case if the business’ principal asset is the reputation or skill of one or more of its employees.

For example, a QTB does not include performing services in fields such as: health, law, engineering, architecture, accounting, performing arts, consulting, athletics, financial services, brokerage services, etc. The law’s QTB definition also excludes businesses in banking, insurance, financing, leasing, investing, farming, and any motel, hotel, or restaurant. However, it does include industries such as manufacturing, technology, research and development, and software.

Importantly, just because your business may offer value in the form of services does not mean you will automatically not qualify as a QTB. For example, if you are in the business of architecture and primarily provide customers with tangible goods tools and equipment rather than services, then it remains possible to qualify as a QTB for the purpose of realizing benefits under Section 1202. Moreover, at least 80% of the company’s assets must be used for the QTB activities. Lastly, even if your business predominately provides services, because QTB requirement is based on the holding period and not on the entire history of the company, you may still qualify by restructuring to a business model that would qualify for the QSBS as you consider changing from an LLC to a C-Corp.

Consider the State of Incorporation

Generally, the State of Delaware is the most popular state to incorporate due to the bi-partisan political consensus to keep the corporation statute modern, and the quality of Delaware courts and judges. However, each state brings its own set of corporate laws and tax breaks which may be favorable to you and worth looking into. For example, other states that have enacted favorable laws for corporations are: Nevada, Wyoming, South Dakota, Alaska, Florida, Montana, to name a few. With your lawyer and tax advisor you should assess the laws of various states and your business objectives.

Importantly, if you decide to switch to a corporation, it is not an overnight process. Depending on the company’s complexity, the amount of equity holders, and other considerations, the process can take approximately a month or more.

Plot Twist: The Biden Administration Seeks to Limit QSBS’ Exclusion Rate

The 2010 amendment to Section 1202 allows for a 100% exclusion. In the proposed Build Back Better Act the current Administration sought to reinstate Section 1202 to its original 1993 version. If this proposed change goes through, then for taxpayers with an adjusted gross income (AGI) equal to or greater than $400,000, the capital gain exclusion would be limited to 50% (instead of 100%). Also, under the proposed changes, the gain that would not be excluded would then be subject to half the applicable capital gain tax rate of 28% and 7% of the excluded gain would constitute alternate minimum taxable income; therefore, any gain not excluded would be taxed at an effective rate of 14%, plus a possible alternate minimum tax on 3.5% of the gain.

Conclusion

Taxes as it relates to the law can become murky and complicated, and changes happen relatively quickly, so a decision made one day, may not serve you quite as well years later. This QSBS exclusion is the perfect example as to why we must thoroughly consider all information available to us, and hire excellent tax professionals who stay up on changes in the law. Changing from an LLC to a corporation takes time, effort, and money, especially if you have a lot of investors. Most often, it is necessary to replace all of your corporate documents, and reissue equity to your equity holders, and change the nature of the equity rights (e.g., a profits interest in an LLC does not translate well in a corporate environment.)  Regarding the uncertainty of proposed changes to Section 1202, you should consider the complexity of your current business structure and whether the efforts necessary to change to a corporation would be worth the limited exclusion rate. Alternatively, you should consider whether you would be happy to qualify for only a 50% exclusion if the proposed changes go through, remembering that it only applies to capital gains, not regular income, and your corporation would be subject to corporate taxation on its income earned during the holding period.   If you are unlikely to sell your stock, making the change is unlikely to benefit you.

Regardless of the potential changes, it’s important to remember that this QSBS exclusion is for those planning for the future. If you would qualify for QSBS, waiting at least five years to realize these benefits might be a perfect exit strategy.

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Protecting Your Business from Intellectual Property Theft

By: Steven Masur

Intellectual property refers to the original creations of the mind. Such creations can include inventions, artwork, product names, written works, website content, computer programs, to name a few. Unfortunately, intellectual property is often plagiarized, and can be done so in many forms. For instance, one can pass-off the ideas or words of another as their own; one can use another’s production without crediting the source; one can disguise a new and original idea or product that in fact is derived from an existing source. With the help of an intellectual property lawyer, you can prevent theft of your original creations or ideas. Here are some tips to help you in the process:

Carefully Guard Information

It is in your best interest to keep your original creations or ideas to yourself until you have secured legal protection. Importantly, a mere idea – as opposed to a work fixed in a tangible medium of expression – is not copyrightable. This means additional steps must be taken to protect an idea if you plan to discuss the idea with another individual. The best way to do so is to avoid having the discussion in public, and to require anyone you discuss it with to sign a non-disclosure agreement. This may seem overly cautious, but this is the best way to prevent your idea from being repackaged by others. 

Thoroughly Document Your Ideas

Starting from the onset of developing your idea, be sure to document and continue as the process evolves. These records will help you when you apply for legal protection, such as a trademark or a copyright. They will also serve as evidence if you have to file a lawsuit against another party for a trademark or copyright infringement. 

Apply for Legal Protection of Your Ideas 

Apply for legal protection of your original ideas that you plan to pursue. The longer you wait, the greater the risk that your idea is pursued by another. If you are an artist, musician, writer, or any other type of artist or entrepreneur, you can apply for copyright registration with the United States Copyright Office. You can also apply for trademark registration with the United States Patent and Trademark Office to protect your business name, logo, slogans, or any other part of your business identity. While the USPTO does not require an applicant to be represented by a licensed attorney, the trademark registration process can be tricky. As such, hiring an attorney may save you time and money because an attorney will know how to best advise you on the registrability of your mark, formally prepare your application to the USPTO’s liking, and respond to the USPTO on various issues that oftentimes arise during the application process.

Include Legal Protection for Existing Intellectual Property

If you have existing intellectual property, it is important to seek legal protection for that as well to avoid the risk of another individual claiming your intellectual property as their own without legal ramifications. You can do so by obtaining registration with the United States Patent and Trademark Office or the United States Copyright Office which will provide you with federal protection over your intellectual property.

Foreign Qualification and How To Do Business in Other States

By: Steve Masur

If your company plans on doing business out of the state of formation, then you must register to do so. This process is known as foreign qualification and it’s pretty straightforward, but nearly always requires filing documents and paying fees. When forming a corporation or LLC, many people are confused about the term foreign qualification. Most of us, when we hear the word “foreign,” think of international affairs; however, in the world of U.S. corporations and LLCs, foreign qualifying a company means that you are registering it to do business in a state other than your state of formation. When you are applying to foreign qualify a business, you have to register for a certificate of authority in the state where your company will be transacting business and pay the necessary state fees. After completing this, the state knows that a foreign corporation or LLC is conducting business within its borders.

When evaluating whether to form your business as a corporation or LLC in a state other than one where you are doing business, keep in mind that your business will be subject to ongoing reporting requirements, fees and taxes in both your state of formation and state of foreign qualification. If your business is expanding into new states and you need to qualify it as a part of this growth, these initial fees should be considered a necessary part of doing business. Many factors are used to determine whether a company is transacting business in a state, and therefore needs to foreign qualify. Some of the criteria evaluated include whether a company has a physical presence in the state, has employees in the state, and accepts orders in the state.

Consequences of Avoiding Foreign Qualification

While you may think the extra fees and reporting requirements to be troublesome, the consequences of not foreign qualifying your business could be much worse. First of all, you might lose the right to bring a lawsuit in state court. Thus, you would not be able to sue to recover damages or to reinforce a contract. In most cases, you can foreign qualify and then bring the lawsuit, but you will lose valuable time before you can enforce your rights.

Also, your company could be subject to fines, penalties and back taxes for the period of time in which your company transacted business in that state.

The Foreign Qualification Process 

As part of the foreign qualification process, a name availability search must be conducted in the state of qualification. This ensures that the name of your business is not already in use in that state by another domestic or foreign corporation or LLC, or that its name is not similar to another name already in use. Next, you’ll have to elect a registered agent to represent your entity in that state. The registered agent will serve as an in-state liaison for your out-of-state business. Then, you must register for a certificate of authority in that state. This process is similar to filing articles of incorporation or articles of organization. The appropriate documents must be prepared and filed, and the appropriate state fees paid.

Each state has different requirements for the information to be included in this document. Common information includes:

  • Company name
  • Date and state of incorporation
  • Principal or legal address of the business
  • Name and address of registered agent in the state of qualification
  • Name and addresses of officers (for corporations) or members (for LLC’s)
  • Number of authorized shares and a listing of the different classifications of stock (for corporations)
  • Type of management (for LLCs)
  • Signature of a corporate officer, often the president (for corporations), or of a member (for LLCs)

Before granting approval for the certificate of authority, many states want to make sure your company is in good standing within the state of formation. In order to do this, they require submission of a certificate of good standing which states that your company has met all the necessary requirements for corporations or LLCs. Failing to file your annual statements, or failing to pay your annual statement fees and franchise taxes could cause your company to be in bad standing with the state. Being in bad standing will most likely cause the indented state of qualification not to grant you a certificate of authority. The prepared certificate of authority, the certificate of good standing or certified copy of your formation documents must be submitted to the appropriate state agency and the necessary state filing fees paid. Turn-around time for receiving state approval for a foreign qualification should typically allow six to eight weeks. Most states will allow you to expedite the filing for an additional charge which will reduce the turn-around time to two to four weeks.

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NFTs: Boon or Burden for Artists and Investors?

By: Lauren Mack and Ilana Faibish

NFTs (or Non-Fungible Tokens) are the latest blockchain-based craze to take over the Internet. Memes, tweets, sports highlights, Charmin toilet paper GIFs, and yes, even quarantine flatulence recordings have been minted into NFTs and sold. But while some artists may be making millions selling NFTs, many questions still remain as to their veracity, profitability, and longevity.

What Exactly is an NFT?

Essentially, an NFT is a record that shows who owns a unique piece of digital content. It is similar to a deed to a house, except instead of a piece of paper being stored in a government building basement, the record of sale is placed on a blockchain that creates a digital and irreversible record of who owns that digital content. A blockchain is a secure network of computer systems that record and provide proof of transactions, such as the purchase and sale of NFTs. Any digital work can be minted into an NFT.

While NFTs show great promise for the monetization of digital art, they have drastically warped – and perhaps exploited – the art sale and investment landscape by creating complex and novel markets and opportunities for artists, brands, collectors, and investors. 

What Can I Do With an NFT?

The primary benefit of owning an NFT is that you have the right to exclude others from claiming ownership of the digital work evidenced by the NFT. NFTs typically do not grant copyright ownership in the art itself, however. This mirrors the ownership of physical art. When you buy a painting (or a book or a song) from an artist, you own the physical version, but the artist still owns the copyright to the work and has the right to recreate and sell it as many times as the artist wants.

That said, it is possible to be granted exclusive ownership of the copyright in the work if the author expressly conveys the copyright to you in a signed writing. Due to the nature of blockchain technology, it is unclear whether recordation on a blockchain alone is the equivalent to a “signed writing” within the context of the United States Copyright Act. When assignment of the copyright is intended, it is therefore advisable to have a written agreement accompanying the NFT that clearly transfers ownership of the copyright in the work.

Even when there is no transfer of copyright ownership, a written agreement is critical to understanding and preserving each party’s rights, including by describing how purchasers may use their digital assets and what benefits the artist receives. These agreements are often structured as a non-exclusive license to the underlying work. Depending on the circumstances, the license terms may state that others may be able to download, view, or listen to the work that was minted into the NFT, or that the buyer cannot profit from the use of the underlying work.

How is This Benefiting Artists?

Aside from the current fervor to purchase anything at all as an NFT, NFTs can be used to generate a new type of revenue for the creator. When an artist sells a physical painting, the artist is compensated only once when the painting is first sold. When the purchaser resells the painting – which may have increased in value if the artist has become more well-known – the artist does not have any say in the transaction and cannot claim any portion of the purchase price, despite being the owner of the copyright in the artwork. This is known under US copyright law as the “first sale doctrine”, and it is a limitation on a copyright owner’s exclusive right to distribute their works. When art is sold as an NFT on a blockchain, however, a commission can be attached that will automatically send payment to the copyright owner every time the NFT is resold, allowing the artist to share in the increased value of the work.

So What Are the Downsides?

The burgeoning NFT market is not without its risks and unknowns. Both the Copyright Office and the courts have determined that the first sale doctrine does not apply to digital files. This is because the first sale doctrine only applies to the distribution of a single copy. When a file is transferred through the Internet, a copy of that file is made, meaning that any digital sale necessarily includes a reproduction that the artist still has the right to control. Unless this technicality is addressed in a written license agreement accompanying the NFT, purchasers may find that they do not have the right to sell the NFT without the cooperation of the copyright owner, potentially negating any investment benefits.

There have also been several instances where an artist’s work has been minted into an NFT and offered for sale without the copyright owner’s permission, including a Jean-Michel Basquiat drawing where the eventual purchaser was given the option to destroy the physical artwork. Purchasers must be wary of fraudulent listings and do their due diligence in determining whether a seller is the rightful owner of the ability to provide a license or assign the copyright in the NFT, as the case may be. Some markets have identified this risk and will only allow verified works, or in other instances, it is clear to purchasers that the digital asset originates from the copyright owner and NFT creator. For example, purchasers can be confident that NFTs purchased from NBA Top Shot, the NFT collectible marketplace for NBA game highlights, are owned by the NBA and are being purchased from its proprietary blockchain.

Artists whose works are minted into an NFT without their permission are left having to navigate the limited number of ways in which they can protect their intellectual property and legacy in today’s digitally driven world. They can file a DMCA takedown notice or otherwise notify the NFT marketplace of the fraudulent listing, but if a takedown request is unsuccessful then creators will likely have to turn to litigation to protect their rights and artwork. And in the case of original works being destroyed after being minted into NFT, by then it may be too late.

Conclusion

Are NFTs a bubble ready to burst, or a new business model for artists? Perhaps both, but either way we’ll be watching closely as to how NFT sale terms develop, as well as other upcoming opportunities in the blockchain space.

The Art & Evaluation of NFTs: Virtual Panel Discussion at Digital Hollywood Spring (5/18/21)

On May 18th, 2021 Steven Masur moderated a virtual panel at Digital Hollywood Spring 2021 discussing the topic “The Art & Evaluation of NFT”.

NFT as a significant category of “Collectable Art,” while still in an “Arguable” stage of development, has nonetheless quickly established itself as the next real thing. It is hard to argue with the $69.3 Million sale at Christie’s of “Beeple’s” “EVERYDAYS.” Or the $7.5 Million for “CryptoPunk #7804” or the $6.66 Million for “CROSSROAD.” This panel includes a cutting-edge group of experts in the field of NFT Art. As a group, they have been a part of the explosion and impact of NFT Art from both the artistic and creative as well as NFT as a flourishing sector of the “Art Market.” Watch the full panel discussion on Vimeo here.

Moderator

Steven Masur

Speakers