How 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.

hand holding a piece of paper with marijuana leaf shape cut out

The Impact of the Legalization of Recreational Cannabis in New Jersey

By: Jon Avidor and Ilana Faibish

On February 22, 2021, after years of failed legislative attempts, New Jersey’s Governor Phil Murphy signed three bills that together launch a marijuana industry in New Jersey and put an end to thousands of arrests. This comes after New Jersey voters approved in November with a 67% vote “New Jersey Public Question 1”, an amendment to the state constitution to legalize adult recreational use of cannabis. The amendment provides for the state to establish a regulated market for the cultivation, distribution, and sale of cannabis. As a result, New Jersey has joined the minority of states to fully legalize adult recreational cannabis use. 

As the guinea pig for recreational legalization in the tri-state area, other states in the northeast will likely look to the Garden State to address some of the hurdles that coincide with legalization, namely, decriminalizing marijuana possession as a matter of law, creating a regulatory commission, and finalizing a taxation plan which implements social equity. New Jersey’s approval is paving the way for New York and other northeastern states to legalize, as evinced in the New York governor’s announcement calling for statewide legalization of recreational marijuana shortly after New Jersey’s amendment to the state constitution.

Decriminalizing Marijuana Possession and Creating a Regulatory Commission 

The first aspect of legalization of adult recreational cannabis use and possession is reconciling legalization with criminal legislation and penalties already in place. For example, in New Jersey, the law currently imposes a maximum penalty of six months in prison and a $1,000 fine for marijuana possession of 50 grams or less. This reconciliation is addressed in three bills which New Jersey Governor Phil Murphy signed into law on February 22, 2021. As a result, possession of up to six ounces of marijuana by people age 21 or older is now legal. Moreover, the legislation eases penalties for minors for possession of marijuana. Importantly, distribution and growing cannabis without a license remain illegal.

Furthermore, this new legislation proposes a regulatory and licensing scheme, whereby the State will expand the duties of its existing Cannabis Regulatory Commission implemented for regulatory distribution of medical marijuana to additionally issue and cap the number of recreational marijuana licenses for merchants in six “marketplace” classes, including (i) growers; (ii) processors; (iii) wholesalers; (iv) distributors; (v) retailers; and (vi) delivery services. The cap is intended to support small businesses as the Commission sets aside 25% of licenses for “microbusinesses” and the issuance of licenses is intended to benefit “significantly involved” New Jersey residents. Additionally, the new legislation gives licensing preferences to residents of zones that reflect areas disparately impacted by prohibition with a goal that 30% of all issued licenses would be issued to minority, women’s, and disabled veterans businesses.

In New York, Governor Cuomo signed legislation to decriminalize the penalties for unlawful possession of marijuana, as well as a process to expunge records for non-violent convictions. Since then, Cuomo has been involved in discussions for legalizing adult-use cannabis. Recently, Cuomo released a proposal to create a new Office of Cannabis Management as part of a comprehensive system to oversee and regulate cannabis in New York, emulating the framework set by New Jersey. Similarly, in addition to rolling out a legalization plan that complies with national standards to promote responsible use, Governor Cuomo’s proposal also places a large focus on creating licensing opportunities and assistance to entrepreneurs in communities of color who have been disproportionately impacted by the war on drugs.

Finalizing a Taxation Plan

State executives and legislatures recognize that legalizing and regulating adult-use cannabis creates a path of opportunity to generate massive revenue. For instance, the tentative taxation plan proposed by New Jersey projects a state sales tax on marijuana sales at a rate of 6.6% generating nearly $2 billion in revenue annually once the market develops producing about $126 million in tax revenue. Additionally, localities have the option to charge up an extra 2% tax on sales.

Moreover, to address historical racial disparities and statistical evidence showing that Black Americans are at least 3.6 times more likely to be charged with marijuana possession, New Jersey legislation includes a “social equity” excise tax on cannabis purchases to fund communities impacted by prohibition. However, the excise fee is optional meaning that the Cannabis Regulatory Commission is free to reject it, and the bill does not specify communities entitled to the benefits of the excise tax. If the Commission implements the excise tax, then the funds would be distributed to social equity programs such as educational support, economic development, social support services, and legal aid. 

In New York, once the proposal to legalize recreational marijuana use is fully implemented, the marijuana industry is expected to generate more than $300 million in tax revenue, which according to Governor Cuomo is “much needed.”

Conclusion

Until New York decides to move forward with mere plans to fully legalize adult-use recreational marijuana, it is uncertain what New Jersey’s legalization means for cannabis use and possession in its easily accessible New York neighbor less than 10,000 feet across the Hudson River. Governor Cuomo’s proposal seemingly emulates many aspects of the framework implemented by New Jersey. It will be interesting to see where they might differ when the time comes.

graphic of a money tree

QSBS: Do I Really Have to Close My LLC and Open a Corp?

By: Steven Masur (with research and writing assistance from Maria Samson)

A great many entrepreneurs who believe they may one day sell their companies have been calling to ask whether they need to close their LLC and open a corporation in order to reduce or avoid capital gains tax on the sale of their company under Section 1202, QSBS (defined below), a new provision of the IRS Tax Code (the “Code”).  Here’s the answer.

Section 1202 of the Code (“Section 1202”), amended in 2017, now provides tax breaks for capital gains incurred from the sale or exchange of eligible small business, C corporation stocks. Specifically, owning qualified small business stock (“QSBS”) may excuse one from paying hefty federal capital gains tax. Congress passed Section 1202 to create incentives for individuals to either start businesses or invest in them. Because QSBS only applies to C corporations, it may make sense to disband an existing corporate structure to form a new C corporation. QSBS allows non-corporate investors to exclude up to 100% of federal capital gains tax incurred from selling their stake in the business. More people ought to know about QSBS due to recent changes in the regulation and the potential benefits of applying for it. 

To qualify for the QSBS exemption, first, the investor must be non-corporate. They must be a natural person, not a formed entity, and they must receive the QSBS at the time of issuance. This means the company must give the QSBS directly to the investor when they issue stock, not at any later date or through a resale. The total amount of the gain excludable depends on when the QSBS was issued. Importantly, the issuing company must be a C corporation, not a limited liability company (“LLC”) or a partnership. This is important for already established companies to contemplate if they wish to take advantage of QSBS. While there are advantages to having an LLC or other corporate structure, such as avoiding double taxation, benefiting from QSBS is not one of them. 

The company must also meet both the gross assets requirement and the active business requirement. To meet the gross assets test, the aggregate gross assets cannot exceed $50 million at the time of issuance. The value of the investor’s stake may increase later on, but it cannot be more than $50 million when the investor receives it. Moreover, to meet the active business test, the business must use at least 80% of its assets engaging in a “qualified trade or business.” The Code defines this by exemption. It is defined as any business that does not provide services in the fields of health, law, engineering, accounting, etc. QSBS is not available for any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees. Lastly, to get the tax benefits, one must hold on to the stock of the corporation for a period of 5 years. After the 5-year period, the investor may sell the QSBS tax-free.

Seemingly, it may be in an entrepreneur’s interest to consider whether they could benefit from QSBS and if they should restructure their current structure to apply for it. For an LLC, conversion to a C corporation could allow non-corporate partners or investors to qualify for QSBS. They could use the fair market value of the LLC interests at the time of conversion to calculate for the potential tax exclusion. The eligible gain exclusion is determined either by (i) the greater of $10 million or (ii) 10 times the original basis amount. For instance, if an investor’s LLC interest is valued at $2 million when they convert the LLC to a C corporation, the maximum QSBS gain exclusion amount can jump to $20 million if they hold the stock for 5 years.

Ultimately, if a business owner has any plans to later sell the business, planning for QSBS wouldn’t hurt. An investor owning QSBS could see the price of that stock eventually skyrocket and they can profit from that investment completely tax-free. For this reason, it may be worth dissolving an existing LLC to form a C corporation for QSBS.

man raising arm at esports event

Esports 2021: Business and Legal Issues to Watch

By: Robert Auritt

2020 was the year of the pandemic and the year that thrust esports into the limelight at a time when almost all traditional sports were ground to a halt.  As such, the world of esports experienced unprecedented growth last year, but even the esports industry, which was largely able to shift its events online, still took a major hit from the virus.  While still surprising to many people, the real bread and butter of the esports industry are in-person live tournaments and games.

Being in person is not just about building a fan base, ticket sales, merch, and food & beverage revenues.  The fact is that being in the same room, on the same local area network (LAN) is the only way to ensure that there is fairness in esports competitions.  Regardless, in 2020 that line of revenue dried up for the esports world just as quickly as it did in the traditional sports world, with the primary difference being that many esports ecosystems were able to almost immediately shift to online gameplay.  This flexibility allowed some revenue to start flowing again, but with reduced volume and excitement and increased questions about the integrity of games due to server issues, it is clear that the esports business is just as anxious to return to the brick-and-mortar world as the traditional sports business is to welcome fans back into its stadiums and arenas.  So, what are the big business and legal issues to watch for in the esports world for 2021?

Players and Talent

One area where esports and traditional sports diverge a bit is with respect to the utilization of talent. In the traditional sports world, until now, an athlete had basically one job – to play the game to the best of his or her ability.  In esports, where in addition to competing professionally athletes are expected to stream and create content for themselves or their organizations against which lucrative sponsorship deals can be sold, players are esports organizations are increasingly coming into conflict on control of exclusive sponsorship categories.

Also, in esports, it is common for organizations to enter into contractual relationships with esports-related content creators who don’t actually play on the organization’s teams, but who focus entirely on producing game related content that is a kind of fusion between competitive gameplay and pure entertainment and which functions as a highly effective marketing platform for organizations that latch themselves to these popular personalities.  Some of the top content creators, with millions of followers and hundreds of millions of stream views, are capable of commanding very hefty salaries and generating their own sponsorship and endorsement deals.

“Gone are the days of esports organizations being able to fully dictate terms to their talent.”

One trend that will almost certainly continue to gather steam into 2021 and beyond is the increased reliance by athletes and content creators on professionals like agents and attorneys to assist them in their negotiations with esports organizations. Gone are the days of esports organizations being able to fully dictate terms to their talent. Now contract negotiations between esports athletes and content creators and the organizations that hire them very much resemble traditional sports contract negotiations, so the need for both sides to engage experienced counsel has never been higher.

Intellectual Property

Will 2021 finally be the year when game publishers begin to aggressively assert their intellectual property rights?  Up until now the evolution of the esports ecosystem has had at least the tacit support of the video game publishers.  For context, in traditional sports, nobody owns the intellectual property rights in the underlying games, which is to say that anyone with the resources to do so could start their own professional baseball, football, or basketball league using the same basic rules that already exist for any of those games and there would be nothing that MLB, the NFL or the NBA could do, at least from an intellectual property perspective, to stop it.  This is not necessarily the case in the world of esports, where the intellectual property rights to the games like Overwatch, Valorant, CS:GO, and Call of Duty are respectively owned by Blizzard Entertainment, Riot Games, Valve/ Hidden Path, and Activision the companies who publish the video games.

At this point, it is common for the organizations who sponsor esports tournaments to enter into licensing arrangements with the publishers to secure the necessary rights to use the games to do everything necessary to run a tournament, such as broadcast, display, and stream the games online.

At the same time, players and content creators typically use game footage in their Twitch streams for creating on-demand videos on platforms such as YouTube.  The use of this footage, if not explicitly authorized by game developers in their terms and conditions, has at least been tolerated by them on the theory that such uses have generally been good for promoting the ecosystem.  But just because things have been tolerated until now does not mean that will always be the case.

Enter Game+, one of many relatively new apps out for mobile gaming on the Android iOS app stores.  Game+ allows users to challenge one another to play popular video game titles like Call of Duty, Fortnite, and Madden, for money.  Or what sounds a lot like gambling (but which the app developers insist on calling a “skills-based competition app”).  Recent media reports suggest that not only did the app developers not get licenses from the game developers to allow them to use their copyrighted and trademarked intellectual property on the Game+ platform, but the game publishers are not at all pleased with being potentially associated with gambling.  This unauthorized use of the publisher’s IP looks as if it is sure to draw the publisher’s legal fire.  On the other hand, in light of the recent liberalization of sports betting regulations, might the publishers be tempted to grant licenses to Game+ in exchange for a piece of the action?  Stay tuned.

graphic of newzoo esports revenue growth
Image source: Newzoo

College Esports

2021 will see the continued expansion of collegiate esports activities not only in connection with competitive play and the development of academic, degree-based esports programs but in the race to exploit esports for potential sponsorship dollars the way traditional college athletic programs are able to exploit their multi-media rights for profit.

The move from clubs to sanctioned competitive play at the college level is on, but the rules of the road are still being written.  Schools are still struggling with how to treat esports. Some schools treat esports like a club sport, while others see them belonging in the athletic department. How a school deals with esports have implications for each school’s compliance with Title IX of the Education Amendments of 1972 – the federal law that protects against gender discrimination in schools that receive federal money.

There are questions about whether the NCAA or other esports-specific organizations such as the NACE (National Association of Collegiate Esports) will emerge as the de facto governing body of competitive collegiate esports, but in addition to navigating potentially thorny Title IX issues, any such body will need to grapple with the game publisher’s intellectual property rights discussed above, in order to sanction competitive tournaments.

As esports grows as a part of campus life and schools begin to feel pressure to attract students with new high tech esports facilities and venues, the need to fund this infrastructure is pushing colleges to explore opportunities that will allow them to sell naming and branding rights around esports in a manner similar to the opportunities that are exploited by schools in connection with big-time college sports.  Multimedia rights management organizations are in a rapid competition to sign deals with universities that will enable the schools to sell various esports related rights such as naming rights for esports arenas and tournaments.

In addition, with the emergence of esports as a billion-dollar industry, the proliferation of schools starting to offer academically rigorous esports and esports industry management degree programs seems likely to continue in 2021.  These programs suggest that the esports industry ecosystem will continue to professionalize as capital continues to flow in and esports become an increasingly normal part of the US sports scene at both the collegiate and professional levels.

While much remains unclear with respect to the development of esports, as the pandemic eventually comes to an end, 2021 is poised to be a significant year in the evolution of esports.

covid data privacy

The Balancing Test Between Data Privacy and Public Health in a Pandemic

By: Steven Masur and Maria Samson

The 2019 novel coronavirus “COVID” has disrupted seemingly every facet of daily life. From closing schools to altering the 9-to-5 workday, the pandemic has made us question constructs that have long been established as “the way it is,” and created a new construct; the way it is now, or “the new normal.” Organizations of all kinds have had to come up with unprecedented new solutions, such as imposing mandatory quarantines and creating contract tracing methods to flatten the curve. Unsurprisingly, governments have increased surveillance to control the spread of COVID, and have instituted tracking measures that make many people uncomfortable. How far should such surveillance go? Is your privacy at risk?

Pandemic outbreaks like COVID will likely occur again, and perhaps with more frequency.  Contact tracing practices and surveillance technology created in reaction to the current pandemic threaten individual privacy and may have long-term privacy implications.  As we shift to a new version of normal, we must find a balance between individual privacy and public health.

Companies, such as Apple and Google, are offering technology-assisted contact tracing solutions to help battle COVID. The Apple-Google solution is voluntary and allegedly anonymous, which aims to help control the spread of the virus by using Bluetooth technology. The Apple-Google solution records a user’s whereabouts, relationships, and activities. It is a good idea in theory, but in practice, such tracing technology is in its infancy and its efficacy is still in question. For instance, Norway temporarily suspended its nationwide contact tracing app due to security concerns.  The app was gathering more data than was necessary to track the virus. As a result, Norway decided to delete all data collected by the app because keeping it constituted a disproportionate intrusion in citizens’ privacy. Ultimately, because contact tracing gathers so much information about an individual’s day-to-day activities, critics say that its use at scale could roll back years of privacy protection efforts that were meant to protect sensitive location data and keep people safe from governmental as well as criminal and other potential threats.

Contact tracing apps are not narrowly tailored to only track one’s contact with COVID.  They record an individual’s location and movement, making it difficult to keep the data anonymous. The surveillance technology is more intrusive than necessary to achieve the narrow purpose of tracking the spread of COVID “hot spots”. While it may seem important to share this information now, proceeding down this slippery slope implicitly gives the government the actual data and could lead to unauthorized mass surveillance.  In addition, the data is stored in centralized and mirrored databases that are susceptible to security breaches and make it likely that the data could be obtained and used not only by the government but by criminals as well.

In time, contact tracing methods can be developed to both serve public health and protect individual privacy. While governments and institutions have yet to find a solution that successfully balances these interests, we must safeguard individual privacy and not turn a blind eye to the rise of inappropriate or illegal forms of surveillance.

woman with question marks around her head

Should Independent Contractors Form Loan-Out Companies, or Not?

By: Steven Masur and Danika Johnson

Recently, we wrote an article about Loan-Out companies in which we discussed the advantages for established and early-stage artists alike. However, our clients are reporting trouble getting gigs and getting paid through their loan-out companies.  It seems some agencies now want them to be employees — the same agencies that had previously required them to form loan-outs. Why the sudden change?  The reasons include: 1) the fact that IRS requires employers to pay back withholding taxes for individuals they believe should have been classified as employees, 2) the growing argument regarding who is an employee and who is an independent contractor, and 3) new tax rules that may reclassify who should pay employment taxes.  Loan-out company owners are getting whipsawed by their clients, and are struggling to work out how best to get paid. 

The IRS Cracks Down

As we discussed in our previous article, agencies and other employers had encouraged the idea of paying their workers through loan-out companies as independent contractors. Employers believed that by hiring people as independent contractors, they could avoid paying their share of social security and medical taxes, overtime pay, and other employee benefits such as vacation and sick pay, as well as avoiding workers’ compensation insurance and unemployment compensation taxes. The 2017 Tax Cuts and Jobs Act provided many advantages to classifying workers as independent contractors – it cut labor costs, made the workers’ checks look bigger because no taxes withheld, and even gave the workers a slew of pass-through deductions on their own taxes, for everything from equipment and supplies needed for work, to home offices, travel and entertainment costs, and even car repairs. Many employers looking to avoid paying employment taxes got wind of these advantages and began labeling workers as independent contractors.  The IRS saw both situations that amounted to potential tax fraud, and an opportunity to collect more taxes so it began to crack down on and re-classifying the same workers as employees, enabling it to collect the back taxes and levy fines and interest for the misclassification of these workers.  Facing these potential liabilities, many employers rushed to reclassify their workers as employees rather than independent contractors in order to avoid repercussions. 

Health Insurance

Because of the change, loan-out company owners are finding it more difficult to get new gigs, get paid by long term clients through their loan-out company, and are now encountering problems with their health insurance. If they accept a gig as an employee, the loan-out company owner may no longer be able to use their loan-out company’s insurance, and instead, have to rely on the agency for which they now work to provide medical insurance (if they even qualify).  Furthermore, the benefits are often not as good, and to add insult to injury, these expenses may no longer be deductible.  If the worker does not work enough union hours in the entertainment industry through their loan-out company, they can claim COBRA benefits. However, if they work for an agency that classifies them as employee, they will not qualify for COBRA. 

Other Problems

Deductions are also withheld differently, drastically affecting creative workers’ income. If the creative worker has multiple clients, they are stuck in a situation where they have to file a W-2 for some clients, and a 1099 for others, making it very difficult to accurately keep track of which expenses can be deducted, and which cannot.  This could also trigger an IRS audit. Even without the audit, this leads to increased accounting costs, as the owner will need a good accountant to keep track of the various nuances. 

Uber, Amazon, and the Studios

The state of California has been very vocal about employee rights. In its fight with Uber, California has shown an interest in classifying Uber drivers as employees instead of independent contractors. If Uber is ultimately required to classify its drivers as employees, Uber will be subject to health care, pension, workers compensation, and unemployment insurance obligations. 

Here we see a situation where drivers can set their own hours and use their own car, but in order to classify as an independent contractor, they must pass the ABC test in Assembly Bill 5 (a simplified version of the 20 part IRS test qualifying a worker as an independent contractor or an employee): A) the worker is free from the control and direction of the company in connection with performing the work, both in reality and under the terms of the contract; B) the worker performs work that is outside the usual course of the company’s business; and C) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work being performed for the company. 

It is likely that in California, the studios, as well as such companies as Amazon, or Disney may be scrutinized by tax authorities to evaluate where their workers are employees, or independent contractors. 

Conclusion

So what’s our advice if you are a creative worker?  We believe that if you have multiple clients in a single year, it is best to insist that a client pay you through your loan-out company unless the client makes clear that they will not hire you unless you become their employee. If they do insist that you become their employee, do your best to document that they insisted it, so you can defend yourself if the IRS or state tax officials raise any questions.  Ultimately, it is you being caught in the middle, and it is an instance in which you really should push the problem to the people responsible.

man handing paper to two women

Client Alert: Don’t Forget Your Year-End Corporate Due Digilence

By: Steven Masur

While 2020 is what we can only hope will be a unique year in many respects, in other ways it is just another year. The end of any year presents an opportunity for each of us to take stock of where we are and to resolve to make sure we are living healthy lives as we move into the new year.  The same principle should also be true for companies.  How has your business developed this past year? Have you kept pace with your company’s legal needs? MGA has prepared the below checklist as a tool for helping you assess the health of your business and encourages you to consider making any adjustments that might help your company to maintain its health and vitality as it enters the new year.

Corporate Compliance

  • Update state records to reflect corporate changes you made this year such as dissolutions, cancellations, name changes, or reinstatements.
  • Prepare to file Annual Reports and pay franchise taxes to your state of registration, often due during the first quarter and not on Tax Day. These franchise taxes are imposed on domestic corporations, limited liability companies, and partnerships in exchange for the privilege of doing business and existing as an entity in the state in which the entity is incorporated or organized. These payments are also often made in connection with a requirement for companies to concurrently file an annual report or registration document. These annual (or biennial) taxes are distinct from income taxes. Franchise taxes are calculated in different ways, depending on the state, but in the case of corporations, they are usually based on the corporation’s capitalization, and in the case of  LLCs and partnerships, they are usually payable in accordance with a flat fee schedule. Be warned that even if your company ceased business operations this year, these taxes will continue to accrue until the company files a document to officially terminate its existence with the state. Failure to file and pay by the specified deadline will result in a penalty fee and monthly interest, and if in arrears for several years, termination of existence by the state. See this resource from Wolters Kluwer for a full list of annual report due dates across the 50 states.
  • Comply with annual governance requirements, such as holding a shareholders meeting and updating your governance documents to reflect any major actions taken over the past year.

Intellectual Property

  • Confirm that you have a written agreement with any independent contractors assigning the rights in their work product to your company.
  • Ensure that your online terms of use and privacy policy still accurately reflect your website functionality and business practices and are up-to-date with changes in the law, especially any applicable privacy laws.
  • Consider how your brand has grown and developed, and whether you might have valuable trademarks that should be protected by registration in the United States or abroad.

Business Operations

  • Make sure you have the right agreements in place for all new hires.
  • Check that all essential business licenses are active and in good standing.
  • Determine whether there is a current and valid contract in place for each of your most important business relationships and revisit the terms of all contracts for any changes.

We wish you and your business a successful new year, and we look forward to serving your legal needs and supporting your business’ growth in 2021!

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For more information calculating and paying your annual business entity taxes, contact your tax advisor or MGA LLP at info@masur.com or (212) 209-5450.

SEC Regulation A+ Recent Update

By: Jon Avidor, Jason Gershenson and Danika Johnson

Prior to the 1929 stock market crash, companies and retail investors could freely exchange stock and other securities due to minimal regulation. In the wake of the 1929 crash and resulting Great Depression, the Securities and Exchange Commission (“SEC”) was created to protect retail investors by limiting their investment choices to less sophisticated products, and by requiring companies to follow specific rules and regulations in order to be eligible to sell securities to retail investors. These new protections made it more difficult for smaller companies to raise enough funds to sell its securities publicly in an initial public offering (“IPO”) or privately among retail investors that did not meet the new SEC classification of “accredited investor”. The new SEC rules distinguished accredited investors as financially sophisticated, thus having a reduced need for the protection provided by regulatory disclosure filings. Today, the two most commonly cited criteria to determine whether an individual investor is “accredited” are an individual’s net worth of at least $1 million or an individual’s income of at least $200,000 for each of the past two calendar years. On the other hand, a non-accredited investor does not meet SEC accredited investor requirements.

In 2015, the JOBS Act opened up opportunities for non-accredited investors and small companies. It included Title IV, or Regulation A (informally, Regulation A+), creating a “mini-IPO” for small-capitalization U.S. and Canadian companies that want to raise capital and for investors looking for new access to pre-IPO investment deals. Regulation A+ creates two tiers of offerings: Tier 1 for offerings up to $20 million in a 12-month period and Tier 2 for offerings up to $50 million in a 12-month period. For offerings up to $20 million, companies can elect to fall under either Tier 1 or Tier 2. Tier 1 offerings must adhere to state blue sky laws and qualification requirements. Tier 2 offerings are more stringent, requiring a company to provide audited financial statements, ongoing financial reporting, and other updates to ensure a continuous flow of information to investors and markets.

Under Regulation A, the investment capital creates a new class of stock that may be eligible for exchange on a secondary market. Since the inception of Regulation A, $9.095 billion were sought across 382 offerings qualified by the SEC. Specifically, $859 million were sought across 105 Tier 1 offerings and $8.336 billion were sought across 277 Tier 2 offerings. It is reported that 183 issuers have raised $2.446 billion, which is $230 million under Tier 1 and $2.216 billion under Tier 2. The SEC attributes the popularity of Tier 2 to the federal preemption of state blue sky laws, making it easier to follow a single set of rules. Additionally, the SEC reports that issuances of securities by companies in the real estate industry accounted for the largest share of proceeds reportedly raise in Regulation A offerings, an estimated 69% of reported proceeds in ongoing and completed offerings. Furthermore, in 2017, the SEC began to allow reporting companies to raise capital through an online offer.

Since June 2019, The SEC has collected various comments from individuals and organizations regarding the Concept Release on Harmonization of Security Exemptions. Commenters indicate that they are interested in an expansion of the regulation, requesting the extension of Regulation A eligibility to issuers organized and with a principal place of business outside the U.S. or Canada, to business development companies, and to investment companies advised by registered investment advisers. Additionally, commenters requested that Regulation A ensures inclusion of evolving financial products, such as certain digital securities that are not strictly equity, debt, or convertible debt.

Digital, Social Media, OTT Players Should Play the Long Game, and Stop Unnecessarily Exploiting Content Creators

By: Steven Masur and Ilana Faibish

Significant revenue is driven by artists, entertainers, and content creators who become recognizable personalities in their own right. But most of the time, these talented people do not actually own the rights to the content they create. Just like the early 1950s rock-n-rollers assigning the rights to their music for the price of a Cadillac, or the WFF owning the rights to WFF character names, the content creator exploitation game has once again become the standard modus operandi for digital media, social media, and OTT platforms, with new ad-supported media companies offering shiny baubles to content creator/brand personalities in exchange for their rights, including audience platform, studio resources, recognition, and stability in exchange for ownership of the content and personalities these talented people create.

Exploiting the Talent

Many new content creators are young, unrepresented, lack experience negotiating contracts, and have little to no leverage.  As a result, they are susceptible to being exploited.  For the most part, they just take what they are handed, and in many cases are afraid to engage counsel for fear of losing their positions. Vlogs, podcasts, social media, Youtube, and digital platform channels are relatively new opportunities in the media business.  There is little to no regulatory oversight. So as a whole, these companies negotiate such opportunities through general employment or independent contractor agreements in which ownership and exclusivity over licensing, platforms, and the overall intellectual property is presented as non-negotiable. For example, in 2016, a slew of Buzzfeed Video employees left the company to become full-time YouTubers, primarily because they felt exploited and disposable, without any path toward career growth.  Their employment contracts included stringent career restrictions on the content they could create, the ownership of that content, the ability to engage in other career-defining work, or even the ability to mention their involvement in developing their own work.  So having left Buzzfeed, these content creators had to start from scratch, after already having created substantial content, followings, and in some cases fully-fledged brands for BuzzFeed.  BuzzFeed employees caught helping them were summarily fired.  In these new-age sweatshops, the bargaining power from the beginning of employment is inherently, and systemically unequal.  However, if content creators were treated as talent, and contracts were negotiated through the lens of talent agreements, more sustainable, long term, mutually beneficial relationships could be created. 

As long as content creators are treated as at-will employees rather than talent, tension between media companies and content creators will continue and will escalate.

The Best Talent will be Attracted to the Companies that Offer the Best Incentives for Success

By definition, once a content creator is successful in building subscribers and a following, bargaining power will shift toward that creator.  If the content creator’s incentives are not clearly laid out upfront, it will create unnecessary tension each and every time a show is successful.  For example, Alexandra Cooper and Sofia Franklyn’s “Call Her Daddy” contract with Barstool Sports began with $70,000 each, plus bonuses.  Not bad pay for two previously unknown creators. But the podcast garnered over two million downloads in just two months and catapulted the co-hosts to fame, allowing them to accumulate close to a million followers on each of their individual Instagram accounts.  Needless to say, given their at-will relationships with Barstool,  this created tension between Barstool and the two co-hosts as they learned that from a talent perspective, they were being grossly undervalued and could not leave Barstool without also leaving behind “Call Her Daddy,” the primary reason for their fame on Instagram.  To its credit, Barstool was willing to offer the co-hosts a guaranteed $500,000 each, increase in merchandise profits and bonuses, and shorten their three-year contract by six months. Barstool was even willing to give them the intellectual property rights to “Call Her Daddy,” after their contract with Barstool expired.  The offer was generous, given what Barstool might otherwise have offered, and what most other companies would have offered, under the terms of the original boilerplate signed by Ms. Cooper and Ms. Franklin.  The example shows what media companies should be doing in order to attract top talent. Although there was disagreement between the co-hosts as to whether to accept this deal, the offer happened because of the shift in bargaining power as a result of social capital accumulated, from the hard work of the talent.  The disruptive, expensive, and difficult negotiation could have been avoided if, earlier in the relationship, the co-hosts had been able to enter into a co-hosting agreement with each other, and a talent agreement with Barstool laying out potential payouts if they created a successful show.  So instead of starting from a pointlessly exploitative place, if Barstool’s starting point were an agreement that acknowledged the direct relationship between the talent’s social capital and the show’s success, Barstool would attract the best talent to itself from the beginning, and also spend less money paying lawyers to sort out the mess, every time a show is successful.  Alexandra Cooper’s full video describing the negotiation is highly entertaining and instructive to anyone in the process of negotiating a talent deal.

Media Companies Should get Ahead of the Game 

Currently, media company lawyers draft overly exploitative agreements with talent because they figure that starting from the most aggressive bargaining position will get the best deal for their client, the media company.  But in actuality, fair negotiations with talent may actually be mutually beneficial. The inevitable increase of followers and subscribers some brand personalities will experience should be perceived as valuable social capital considering how easily this audience can be monetized. Furthermore, the deal a media company could get early in the artist’s career is much better than they will get once the artist develops a huge following. Finally, media companies would benefit by creating longer, less disruptive, and more loyal relationships with their talent, who, regardless of who owns the content, ultimately control their following.  The inevitable tension between content creators and media companies is foreseeable, so media companies should get ahead of the game, and strive for better equity earlier in the relationship. Otherwise, the revolving door of talent will continue, and media companies will continue to sacrifice highly valuable audience and brand loyalty. Brands like Saturday Night Live and The Tonight Show created giant audiences and enormous lasting value for shareholders, celebrities, and lower-level content creators alike, while post-internet media brands go down with alarming regularity and are quickly forgotten. As new media properties move past adolescence and into maturity, they should take better note of the lessons to be learned from those who went before.

* Steven Masur is one of the first digital media attorneys and has spent the last 25 years negotiating agreements in the entertainment and digital technology arenas.  He has negotiated a wide variety of talent agreements in music, film, television, OTT, social media, eGaming, and professional sports.  In addition, Steve has helped a wide variety of early and contemporary digital media, mobile, AdTech, and network effect companies develop their licensing and business models and build substantial businesses. 

Epic Games vs. Apple: A Battle for Control of a New Space

By: Robert Auritt and Ilana Faibish

It would be an error to view Apple’s current fight with Epic Games as a mere dust-up about commission rates or antitrust issues, though it is also surely both of those things.  This is a fight about who will be able to control, and of course profit from, new virtual spaces where an increasing amount of online activity is taking place as we move deeper into the 21st century.  In addition to offering gaming activity of various kinds (simulating war,  upgrading your house, and building stuff, for example) game titles like Fortnite, Animal Crossing, and Minecraft are increasingly using their virtual shared geographies as places for users to meet, socialize, watch movies, attend concerts, attend professional conferences and of course, make additional “in-world” purchases. 

One of the great promises of the early days of the open internet was that anyone could publish anything, anyone could build a website and have a voice. With the advent of the iPhone and the “appification” of the internet, Apple (and Google) became the main gatekeepers of online content, building the virtual highway through which most of the mobile internet flows, and charging a hefty toll to those who seek to profit from their app store infrastructure.  Now, companies like Epic Games and Mojang Studios are building entirely new worlds that can be accessed through their mobile apps (among other access points).  From a certain point of view, these worlds can be seen as another layer of the internet in that all the various kinds of commercial activities that take place in the real world, or online, can take place in these collective virtual spaces. The builders of these worlds increasingly want to be able to profit from the commercial activity taking place in them without paying the toll to Apple.

On August 13, 2020, in what clearly seems to have been a premeditated maneuver, while updating its hit game Fortnite, Epic Games attempted to circumvent Apple’s 30% commission rule for in-app payments. Within hours, as Epic surely knew would happen, Apple removed Fortnite from the App Store for violating the guidelines provided in Apple’s “Developer Program License Agreement” (“PLA”). Almost immediately Epic filed a federal lawsuit against Apple, accusing the company of violating antitrust laws by forcing developers to implement Apple’s payment systems. In the complaint, Epic described Apple’s removal of Fortnite as yet another example of Apple flexing its monopoly power over the market for in-app payments on Apple devices.  At almost the exact same time, Epic released Nineteen Eighty-Fortnite, a commercial that savagely mocks Apple by spoofing the very same imagery used by Apple in its groundbreaking 1984 commercial for the Macintosh. 

In retaliation, Apple threatened to revoke Epic’s access to developer tools and iOS support for the Unreal Engine, a game engine developed by Epic Games that provides a suite of creation tools for game development and other real-time applications. Epic describes Apple’s retaliation as overreaching and unnecessarily punitive, and Judge Yvonne Gonzalez Rogers of the United States District Court of the Northern District of California agreed. Judge Rogers stated that the ban on Unreal Engine “looks retaliatory,” but let the App Store ban on Fortnite stand. While it makes sense for Apple to impose a reasonable commission for purchases made for and within applications in the App Store, the breadth of Apple’s attempted retaliation certainly raises some serious antitrust concerns. In a world where most developers and consumers are reliant on the App Store, developers feel they are being strong-armed into forfeiting a seemingly excessive and non-negotiable 30% commission to Apple, and are often left with no choice other than to inflate game prices and in-app fees to offset the difference

Apple urged the court to deny Epic’s motion, arguing that when developers find ways to avoid its digital checkout, as Epic did, “it is the same as if a customer leaves an Apple retail store without paying for a shoplifted product: Apple does not get paid.” Tim Cook, the chief executive of Apple, argues that Apple is actually doing developers a favor. Cook suggested to Congress last month that when software was still sold in brick-and-mortar stores, 50% to 70% of the retail price went to intermediaries.  For perspective, PayPal, Square, and other electronic payment companies manage to charge merchants a more modest 3% fee, as do credit card companies like MasterCard and Visa. When tech giants such as Apple and Google, which are together worth more than $3 trillion, also make the software that backs virtually all of the world’s smartphones, and those smartphones provide businesses access to reach millions of people, those businesses are left to ask: “does Apple really need one-third of my sales?” The question is, is Apple abusing its dominance?

Epic is not alone in this battle, and nor is the fight limited to control of new virtual spaces. Recently, Facebook planned to launch a new tool in its app that lets online influencers and other businesses host paid online events as a way to recoup revenue lost during COVID-19. In an effort to maximize proceeds for small businesses, Facebook asked Apple to reduce the 30% fee that would normally be owed from in-app purchases. Apple declined. Facebook then attempted to add a disclaimer at the point of sale in an effort to inform consumers that 30% of proceeds would not actually benefit small businesses but would rather be diverted to Apple. Apple removed the disclaimer. 

In another instance, WordPress let it be known that Apple had cut off its developers from making updates to the WordPress iOS app unless WordPress enabled users to buy domain names within the app. This required WordPress to integrate Apple’s payment systems for purchases, and enabled Apple to take its 30% cut for all domain names sold in-app. WordPress agreed to the change. 

Similarly, Spotify complained to the EU last year that it was anticompetitive of Apple to impose the 30%  fee on Spotify since Apple’s own competing Apple Music service is of course not forced to reduce its profits by 30% just to gain access to the app store.

Indeed, the Epic Games suit is not even the only antitrust action currently pending against Apple.  In 2019, the Supreme Court allowed another antitrust lawsuit against Apple to proceed. That case concerns a group of iPhone users who accused Apple of driving up the price of apps by charging third-party app developers a 30% commission. However, the case is likely to end in a settlement before the district court has an opportunity to rule on whether Apple violated antitrust laws. 

As for this preliminary battle between Epic and Apple for control of increasingly vital virtual spaces, we will have to wait and see. Judge Rogers seemed uncertain as to which party would prevail on the merits, noting that “this is not something that is a slam dunk for Apple or for Epic Games.”  Whoever wins is likely to come out well-positioned for the future as digital life increasingly migrates into virtual worlds.