Startup Company Blog

The Basics of Music Licensing in Digital Media

Davis Wright Tremaine — Wed, 10 Mar 2010 15:24:24 -0800

03.10.10

By David D. Oxenford and Robert J. Driscoll

Businesses that are involved in digital media use music in many ways—and most require some sort of license to make the use legal. Whether the music is used in an advertisement or a music video, on a Web site or delivered via another digital platform, licenses are usually required. Unfortunately, there are a variety of rights that may be needed, depending on how the music will be used, so knowing what you need to do to avoid liability is not always easy.

Making it even more complicated is that fact that the different rights are often obtained from different individuals or groups, and it is not always easy to determine where to go to get the necessary rights. This advisory provides a basic description of some of the rights necessary for some of the most common uses of music under United States laws and where to obtain such rights.

Current copyright laws

Before discussing where to get permission to use music, you must first understand the different rights that can be implicated by the use of music.

Under current United States copyright laws, songs and other creative works first published as long ago as 1923 could still be protected by copyright. Section 106 of the Copyright Act gives the owner of a copyrighted work a number of exclusive rights with respect to the work, including the right to reproduce the work, the right to distribute the work, the right to prepare “derivative works” based the work (e.g., a new arrangement of a song or a translation of its lyrics into another language) and, in many cases, the right to publicly perform and publicly display the copyrighted work. The copyright owner also has the right to authorize or refuse to authorize others to exercise any of these rights. As a result, permission from the copyright owner—i.e., a license—generally is required any time copyrighted music is used.

The particulars of the permission that is required depends on the nature of the use and which of the various exclusive rights under Section 106 of the Copyright Act are implicated. In most cases, licenses must be negotiated with the copyright owner, although, as set forth below, there are certain music rights that can be obtained through a “statutory license” (i.e., a license that all affected copyright owners are required by law to grant and for which a license fee is established by the government). For certain uses of music, various rights societies (which are sometimes subject to government antitrust review), also offer “blanket licenses.”

To make matters more complicated, for each piece of recorded music, there are two separate copyrights, which are often held by different owners. First, there is the copyright in the underlying musical composition (that is, the notes and lyrics as they might be written out on paper). Copyrights in popular songs are usually controlled by a music publishing company (and sometimes multiple publishing companies, if the song has multiple writers with different publishing arrangements). Second, there is the copyright in the particular recording of the song that is being used (i.e., the song as sung or performed by a particular recording artist and contained in a CD, digital file or other recorded medium). Such recordings are referred to in the Copyright Act as “sound recordings” and in the music business usually are referred to as master recordings. For most popular recordings, the copyright is held by the record company. However, in some circumstances, copyrights in musical compositions and sound recording may be controlled directly by the songwriter and/or recording artist, particularly in the case of recordings by independent artists of songs that they have written.

In certain instances, particularly with older classical music, the underlying musical composition may have entered the public domain, while the more recently produced sound recording is still be protected by copyright. Depending on the type of use, a license may be needed with respect to the musical composition, the master recording, or both.

Streaming audio

Rights to the musical compositions

As noted above, the owner of a copyrighted musical composition has the exclusive right to control its public performance. “Public performance” is not limited to a live performance of a song in a concert or similar setting. Rather, the Copyright Act defines a public performance as one that occurs in any place open to the public or that is transmitted or otherwise made available to many people, whether they receive it in one place or many, or at one time or different times. An example of a public performance of music in a traditional context would be the broadcast of music as part of a television or radio program. Similarly, in the digital world, a public performance of music occurs in an Internet radio stream or when individual songs are streamed on a Web site.

A digital public performance of music—such as the streaming of music on a Web site—will trigger an obligation to obtain a public performance license from the songwriter or publisher. In situations where one or a small number of musical compositions is being performed via a Web site or other digital service, the operator will typically license the compositions directly from the songwriter or publisher. When larger numbers of songs are being used, or when the particular song performed varies (as in an Internet radio operation), licensing is most commonly done through a “blanket license” from a performing rights organization (PRO) that provides the rights to use all the music in the catalog of the PRO, which it licenses on behalf of the copyright owners.

Songwriters and music publishers in the United States are typically affiliated with one of three PROs (ASCAP, BMI, SESAC), which are responsible for licensing nondramatic public performances (i.e., performances of songs other than in dramatic productions such as an opera or a musical where the song is a part of and carries forward the plot, although the right to publicly perform songs from such productions in a nondramatic fashion can be licensed from the PROs). ASCAP and BMI are governed by antitrust consent decrees, administered by the federal courts. By law, they are required to offer licenses to all who seek them, and they must set rates that are uniform for all similarly situated users. Where rates for a user category cannot be established by negotiation, they are set through a rate court hearing in the district courts. Many of the standard licenses for existing categories of music users (with information about the rates) are available on these organizations’ Web sites. SESAC, as the smallest of the PROs, is not subject to an antitrust decree, though a group of television stations recently brought an action to seek to compel antitrust review of their practices. SESAC, unlike ASCAP and BMI, is a for-profit company. Thus, many of their rates are not publicly available, and SESAC does have the ability to negotiate individually on the rates that they charge.

Some music users, to minimize costs, have considered trying to live without a SESAC license. However, SESAC licenses the music of some very important writers whose songs are covered in many music genres (including Bob Dylan, Neil Diamond, and even some of the production music from certain commercial production companies). Thus, it is difficult if not impossible to do without a SESAC license if one seeks to perform a broad range of popular songs.

Rights to the sound recordings

Public performance licensing requirements are different for sound recordings. In the United States, until very recently, there has been no exclusive right to publicly perform a sound recording, and accordingly no public performance licenses have been required with respect to public performances of sound recordings in broadcast and other traditional media. However, in 1995, Congress created for the first time a public performance right in sound recordings, but limited that right to performances that are made by means of a “digital audio transmission.”

Unlike the public performance right in musical compositions, the sound recording performance right does not extend to performances made in over-the-air broadcasts, in retail establishments or in other brick-and-mortar businesses and public places. Nor does the digital performance right cover sound recordings used in “audio-visual” works (such as television programming or other audio-visual programming streamed online). Efforts are underway in Congress to extend public performance rights in sound recordings to cover some of these uses (in particular, over-the-air radio broadcasting), but at the moment no public performance royalty must be paid for the use of the sound recording outside of the limited context of digital audio transmissions.

Because of the digital public performance right in sound recordings, companies that stream recorded music digitally—such as Internet radio services and any company that streams recorded music on its Web site¹—must have licenses to digitally transmit those recordings to their listeners. For webcasters and other covered digital media companies, there is a statutory license available, which is administered on behalf of the record labels by a nonprofit company called SoundExchange. The royalties can be negotiated between groups of similarly situated users and SoundExchange. If these negotiations are unsuccessful, the royalties are set by a government body—the Copyright Royalty Board—usually for periods of five years.

Digital transmissions under this statutory license must be made within very specific limitations. Uses must not be part of an “interactive” service. (While the exact manner in which the statutory definition of “interactive” applies to various types of music services is still to be determined, a recent appeals court decision held that a certain degree of user influence is permitted without the service being classified as interactive.) Services operating under this statutory license also must limit the number of songs played from the same album or by the same artist in given periods of time, must show information about the song being played visually on the Web site, and must comply with other rules designed to limit digital music piracy.

For services that involve more interactivity—e.g., allowing on-demand streams where users know what music is coming up, or where they can select the artist or song that is to be played—the service provider must obtain public performance licenses in the sound recordings directly from the copyright holders. In most cases involving popular music, this will be the record company that released the recording.

Streaming videos and commercials

As noted above, a broadcast of music as part of a television program constitutes a public performance of the music. The same is generally true of the streaming of an audio-visual program including music via a Web site or other digital service. Accordingly, as in the brick-and-mortar world, those who transmit audio-visual programs generally need to obtain public performance licenses with respect to the musical compositions contained in those programs when streamed on a Web site or in another digital format.

The public performance license is not the only license that is necessary. When a composition is recorded in a production with spoken words or video, such as when music is included as part of the soundtrack of a film, television program or other similar video production, or is recorded as part of a commercial or other recorded promotional announcement, another license is needed. This type of reproduction of the musical composition is usually referred to in the music business as a “synchronization,” and a license known as a “synch” license must be obtained from the music publisher or songwriter that controls the composition. The producer of the video typically is responsible for obtaining the synch license.

The synch license issued by the publisher or songwriter relates only to the composition, and does not include the right to use any pre-existing master recording (i.e., the song as recorded by a particular artist). (If the licensor intends to create a new recording rather than using a pre-existing one, the right to do that should be granted in the synch license.) Accordingly, when a pre-existing master is synchronized with moving images in a film, television or other audiovisual production, or is recorded as part of a commercial or other recorded promotional announcement, a license must be obtained for the use of the master as well. This license is referred to as a “master use” license, and like the synch license, is usually obtained by the producer of the video.

With respect to major label recordings, the record label will usually issue the master use license. In most situations, the label and publisher will insist on “favored-nations” treatment (i.e., both will receive the same license fee).

For use in commercials, artists often have their own concerns about being associated with particular products, and thus each use of a master recording may be subject to a unique negotiation with the record company or artist management company representing that artist.

Downloads

Providing downloadable master recordings online involves a reproduction and distribution of the masters and underlying musical compositions. Thus, as with the other situations described above, rights to both the musical composition and the sound recording must be obtained. Typically, an online music store or other service that sells music will obtain the necessary rights from the record labels, which own the master recordings and are responsible for obtaining from the publishers or songwriters the right to reproduce and distribute the recorded composition.

However, where a site is not using major label recordings, but is instead transmitting recordings provided or made by a local or independent musical group, the site must be sure that the rights to the underlying musical compositions have been obtained even if the performers clear the use of the sound recording. For instance, a school may provide on its Web site the ability to download the spring choral concert. In doing so, although the school will own its recording of the concert, the school should be sure that it has also cleared the rights to the musical compositions performed in that concert. A radio station may want to post on its Web site for download recordings of bands that have performed in its studios. Even if a band has consented to the use of the recording of its performance, if the band does not also control the rights to the songs it performed, the radio station must make sure that it licenses the rights to those musical compositions.

Rights can be obtained from the publisher or songwriter through a statutory license, which is available for any musical work that has previously been recorded and requires prior notification to the copyright holder. In addition, these licenses—known as “mechanical” licenses—also can be obtained directly from the publishers or songwriters or, in many instances, through the Harry Fox Agency, which acts on behalf of many owners of musical compositions in connection with mechanical licensing. Unlike ASCAP, BMI and SESAC, Harry Fox does not provide rights to virtually all songs that a potential licensee would want to use, but it does have rights to an extensive catalog, and thus may be a convenient first stop in trying to obtain such licenses. There are a number of private companies that will also help to clear the underlying licenses to use the musical composition.

Podcasts

Many companies are creating some form of “podcast,” i.e., an on-demand program that can be downloaded onto a digital device for later replay (and can usually be played immediately on someone’s computer as well). The use of music in a podcast will usually require specific permission for the inclusion of both the musical composition and the sound recording, just as is the case in a video or a download. Simply having public performance rights from the PROs or from SoundExchange will typically be insufficient to cover the use of music in a podcast.

Areas of controversy

While the simple distinctions outlined above may seem easy to apply, in practice, things frequently become less clear in situations involving new media and platforms, as the lines between different types of services often get blurred.

For instance, the question of when a digital use of music constitutes a public performance has been raised in a number of court cases and is still the subject of some dispute in the music industry. In the brick-and-mortar context, the definition of “public performance” is often relatively easy to apply—if a performance is to a number of people in a public setting, it is a public performance. A performance in a concert hall, or a stadium, or a bar or on the radio clearly fits within the definition. However, the application of the definition to certain digital music services is less clear. For example, when a webcasting service sends out one stream to hundreds of people, the webcaster is operating much like a radio service, so there would seem to be a public performance. But when the service is interactive, so that unique streams are served up to each customer, is that really a “public” performance? Likewise, has a “public” performance taken place when a particular song is streamed to a user at that user’s request and is not simultaneously transmitted to other users?

In a recent decision, the Copyright Royalty Judges established a royalty formula for the digital delivery of musical compositions via interactive streaming in which a baseline percentage of revenue royalty is paid for the reproduction and distribution of the musical compositions, but that amount is to be offset by public performance royalties paid to the PROs in connection with such streaming. However, the Copyright Royalty Judges did not definitively answer the question of whether, and under what circumstances, such streaming actually constitutes a public performance for which a payment to the PROs is required. Similarly, because of some ambiguity in the language of the Copyright Act, some PROs have asserted that a download of a recording involves a public performance of the underlying musical composition, and similar questions have been raised with respect to the delivery of compositions in the form of mobile phone ringtones.

When the copyright owner’s exclusive reproduction right is implicated is another area of dispute. In any digital transmission process, there are multiple “copies” of a work made in the course of the process. Typically, copies are made in the server of the transmitting entity, and on the servers through which any transmission passes as it makes its way through the Internet to the recipient. Copies are also made on the RAM of any computer, and sometimes in the hard drive as well. Some of these copies may exist for only seconds, while others may persist longer. Are any of these copies, even made in a pure, wholly noninteractive stream, “reproductions” for which compensation should be paid? The Copyright Office has wrestled with this question, and suggested that copies are being made. But the issue has also been argued in the courts, and there has been no definitive, final answer to this question.

These are but a few of the unresolved issues that remain to be decided in the digital world. Questions of liability for copyrighted works used in user-generated content supply an endless debate over who owes what duty to whom to weed out uses of copyrighted music for which no royalty has been paid. Look for these and other areas to be the subject of litigation over the coming years unless Congress steps into the process and provides clearer guidance—an unlikely prospect unless the major players in the debates can themselves reach a consensus that can be reflected in a legislative remedy.

“Fair use”

In addition to all of the licensing issues, many music users grapple with the potential application of the “fair use” doctrine to their uses of music. Under the doctrine of fair use, the use of limited portions of copyrighted material for purposes such as teaching, research, criticism, news reporting or parody is permitted without the authorization of the copyright owner. Unfortunately, the law does not clearly indicate exactly which uses constitute fair use and which do not. Rather, it provides a set of guidelines that are interpreted by the courts with reference to the facts of each situation. For that reason, it can be difficult to identify with precision the types of music uses that may be deemed fair use.

In general, when determining whether an unlicensed use of music or other copyright works should be permitted as a fair use, courts will consider four factors: (i) the nature of the use, including whether such use is for a commercial purpose or rather for an educational or nonprofit purpose; (ii) the type of copyrighted work being used (more latitude is given for the unlicensed use of purely factual material than creative material); (iii) the amount of the original work that is being used in relation to the whole (i.e., is it just a short excerpt, or a significant portion of the original); and (iv) the effect of the unlicensed use on the market for the original work. In general, in a commercial context, courts will be reluctant to permit unlicensed use of creative copyrighted works, particularly where, as in the case of music, there is an established licensing market.

Because of the fact-specific nature of the fair use analysis, for most commercial users of music it will make sense to rely on the fair use doctrine only in limited situations, where only a portion of a composition or a recording is being used, where some type of commentary on the song or recording or some other “transformative” activity (such as a parody²) is taking place, and where the use is not of a type for which licenses are generally obtained. For instance, using an excerpt of a song in a record review would probably constitute a fair use, but the use of a song in a commercial, even a funny version of the song (where the comedy comes from the commercial message—and not from making fun of underlying the song itself), probably would not be fair use.

The issues discussed above are only some of the myriad of copyright issues that come up in connection with the use of music in the digital world. Be familiar with these issues as improper use of music can lead to copyright violations, which can, in some cases, carry large monetary penalties. Enjoy your music carefully.

FOOTNOTES

1 Satellite radio and digital cable radio also pay these royalties. The Internet radio royalties, in most cases, currently cover streaming of noninteractive music streams to mobile phone platforms. While background music services do not pay a public performance royalty, the Copyright Act does require that the services themselves (as opposed to the retail establishments that may use these services) pay for the “ephemeral copies” of sound recordings made in the digital transmission process, i.e., the server and buffer copies made in the digital transmission process. Effectively, this acts much like a public performance royalty for the sound recordings used by these “business establishment services.”

2 A “parody” in a copyright context has a very specific meaning. While some might think that a re-recording of the tune of a familiar song, with different funny lyrics is a parody, the law finds a parody only where the comedic use is making fun of the original musical work—not where it has some independent comedic value. This is an important distinction, as many times advertisers have sought to use the tune of a familiar song as the basis for a commercial message—and in virtually all advertising contexts, this will not be a “fair use,” and thus permission from the copyright holder will be necessary for this derivative work.

Related Files

Disclaimer

This advisory is a publication of Davis Wright Tremaine LLP. Our purpose in publishing this advisory is to inform our clients and friends of recent legal developments. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

Storm Clouds on the Horizon: An Uncertain Future for Taxation of Carried Interests

Davis Wright Tremaine — Mon, 22 Feb 2010 13:55:37 -0800

Check out this informative presentation by DWT partner Jim Wreggelsworth on carried interest: STORM CLOUDS ON THE HORIZON: AN UNCERTAIN FUTURE FOR TAXATION OF CARRIED INTERESTS (PPP).

Washington Technology Industry Association's February Finance Community Meeting

Davis Wright Tremaine — Wed, 10 Feb 2010 15:48:29 -0800

Time to get back in the game?

February Finance Community Meeting

2/18/2010
5:00pm to 7:00pm
Davis Wright Tremaine, LLP (Davis Center)

The Washington Technology Industry Association has assembled a diverse panel of speakers from financial institutions, money managers and industry executives to discuss current trends and the current options and strategies to meet your needs. Whether you have a lot of cash, or only a little, an update on the current investment and corporate cash management environment will prove interesting.

Panel:
Chad Cohen, Zillow.com
Rob Derry, Silicon Valley Bank Asset Management
George Taylor, Moss-Adams Weath Advisors, LLC

Moderator:
Glenn Walcott, former CFO, Big Fish Games

Join the meeting for happy hour, networking and further discussion. Attendance is being limited to 50 participants. Click here for more information or to register.

Obama Shout Out To Zeroing Out Capital Gains On QSB Stock

Joseph M. Wallin — Thu, 28 Jan 2010 09:58:22 -0800

We've written about this before. The President has proposed to reduce the capital gains tax rate on qualified small business stock to zero.

He said it again last night in his State of the Union speech.

You can view the video below. The President's comment is at minute 6:50. He says:

"While we're at it, let's also eliminate all capital gains taxes on small business investment."

Reducing the capital gains tax rate to zero on qualified small business stock would be extremely beneficial to businesses that qualify for the QSB tax benefit, and would probably create a flood of investment in that direction.

Also see this article on pehub.

Text of Draft Economic Nexus Bill

Joseph M. Wallin — Wed, 27 Jan 2010 22:27:42 -0800

Please provide comments on this preliminary draft bill.

Economic Nexus Bill Being Considered In Olympia

Joseph M. Wallin — Wed, 27 Jan 2010 16:06:03 -0800

by Garry Fujita

In an effort to expand the tax base, the legislature may consider legislatively enacting an economic nexus standard for taxpayers that sell services and other similar intangibles. There is no bill formally introduced in the legislature at this time. The preliminary bill draft contemplates using three factors to determine if economic nexus exists:

>25% of a taxpayer's total property or $50,000 of property is in the state, or

>25% of a taxpayer's total payroll or $50,000 of payroll is in the state, or

>25% of a taxpayer's total receipts or $500,000 of receipts is from this state.

The state understands that the U.S. Supreme Court has not expressly ruled on whether economic nexus can be applied in light of Quill, but the state believes that 30 states have used an economic nexus standard. The state feels that the U.S. Supreme Court has declined several petitions to review the issue, and that fact signals that the high court accepts the notion that economic nexus can exist outside the Quill fact pattern. The state understands that it may be taking a risk that the Court will strike down economic nexus or that Congress might legislate permissible nexus upon which a state's taxing authority attached, so the bill contains language that the state believes will put the taxpayers back to the status quo in that event.

There are other important and unattractive aspects to this approach. First, if this was enacted, then the state would be constitutionally required to apply the same standards to instate companies engaged in interstate commerce. The statute would apply a single factor sales apportion formula (making rules like WAC 458-20-194 and 458-20-14601 dispensable), which means that it is really an allocation of income to only one state. This is good news for instate businesses that sell services in interstate commerce and have been reporting income on an apportioned basis. Under this new approach, for instate businesses, this would likely mean that their income will be allocated to the buyer's out of state locations, resulting in tax on 0% of its out-of-state sales. For out-of-state businesses, this would likely mean that their income will be allocated to the buyer's instate location, resulting in tax on !00% of its Washington sales. Second, this allocation theory (described as apportionment) raises concerns as to whether this is really an unapportioned gross receipts tax on services and royalties and whether it is constitutional. This method effectively transfers the tax burden from the instate businesses selling out of state to the out-of-state taxpayers selling into Washington.

Good Idea: Yes, Let's Eliminate the Personal Property Tax

Joseph M. Wallin — Sun, 24 Jan 2010 09:55:03 -0800

Another bill being considered now in Olympia is Senate Bill 6723. It is not a long bill. In full, it says:

"Sec. 1. (1) The legislature finds that the administration of the property tax on personal property is inefficient for government and business. The legislature concludes that a study is necessary to identify methods to best accomplish the elimination of the personal property tax.

(2) The department of revenue must conduct a study on alternatives for eliminating the property tax on personal property. In conducting the study, the department must examine the cost of administering the tax, savings to government and taxpayers by eliminating the tax, the effect on property tax rates, and property tax shifts.

(3) The department of revenue must seek the advice and input of local officials administering the property tax.

(4) The department of revenue must present a final report of its findings and alternatives, including a legislative draft proposal, to the ways and means committee in the senate and the finance committee in the house of representatives by October 31, 2011."

It would certainly be good for tax simplicity to do away with this tax. In my experience, many entrepreneurs are surprised there is such a thing as the personal property tax. Granted, as you learn in law school, ignorance of the law is no excuse, but that aphorism made a lot more sense when the laws we lived under were not so voluminous.

The views expressed here are my own.

Reminder From the Washington State Legislature: Director Fees Are Taxable For B&O Tax Purposes

Joseph M. Wallin — Sat, 23 Jan 2010 14:50:36 -0800

One of the many tax bills being considered in Olympia right now is House Bill 2972. One of the aims of HB 2972 (see Part III) is to make clear that director fees are taxable for business and occupation tax purposes in Washington State.

HB 2972 states as follows:

"(3) The legislature finds that corporate directors are not employees or servants of the corporation whose board they serve on and therefore are not entitled to a business and occupation tax exemption under RCW 82.04.360. The legislature further finds that there are no business and occupation tax exemptions for compensation received for serving as a member of a corporation's board of directors.

(4) The legislature also finds that there is a widespread misunderstanding among corporate directors that the business and occupation tax does not apply to the compensation they receive for serving as a director of a corporation. It is the legislature's expectation that the department of revenue will take appropriate measures to ensure that corporate directors understand and comply with their business and occupation tax obligations with respect to their director compensation. However, because of the widespread misunderstanding by corporate directors of their liability for business and occupation tax on director compensation, the legislature finds that it is appropriate in this unique situation to provide limited relief against the retroactive assessment of business and occupation taxes on corporate director compensation.

(5) The legislature also reaffirms its intent that all income of all independent contractors is subject to business and occupation tax unless specifically exempt under the Constitution or laws of this state or the United States.

Tax Bill Introduced In Olympia To Codify Economic Substance

Joseph M. Wallin — Wed, 20 Jan 2010 08:53:28 -0800

A bill has been introduced in Olympia to codify economic substance as the prevailing theory in reviewing potentially abusive tax avoidance transactions. This bill would substantially change Washington tax law.

Under the proposed bill, the Department of Revenue "must disregard, for tax purposes, abusive tax avoidance transactions."

An "abusive tax avoidance transaction means the avoidance of any tax collected by the department under the provisions of this chapter by means of a transaction, plan, or arrangement that lacks economic substance." (Our emphasis.)

A transaction, plan or arrangement will be considered as having economic substance only if:

the transaction, plan or arrangement changes in a meaningful way, apart from its tax effect, the taxpayer's economic position;
the taxpayer has a substantial nontax purpose for entering into the transaction, plan or arrangement; and
the transaction, plan or arrangement is an objectively reasonable means of accomplishing the substantial nontax purpose.

"A transaction, plan, or arrangement that carries some risk of loss and profit potential may nevertheless be found to lack economic substance if the economic risks and profit potential are so insignificant when compared to the tax benefits that a reasonable person would conclude that the taxpayer would not have engaged in the transaction, plan, or arrangement absent its tax effects."

"An objective of achieving favorable financial accounting benefits arising from tax savings is not deemed to be a substantial nontax purpose for entering into a transaction, plan or arrangement."

The burden is on the taxpayer to establish that a transaction, plan or arrangement has economic substance.

In addition, deficiencies resulting from engaging in abusive tax avoidance transaction are to be assessed 35% penalties of the additional tax found due, and there will be no statute of limitations for assessments of additional taxes, penalties, or interests on abusive tax avoidance transactions.

In disregarding an abusive tax avoidance transaction, the Department is empowered to do any of the following:

recharacterize the nature of income;
disregard the form of a corporate or other entity, even when legal formalities have been observed;
treat the tax effects of the transaction, plan or arrangement accordance to its substance rather than form;
treat a series of formally separate steps as a single transaction;
impute income to a taxpayer that provides services to a related person and the consideration does not reflect FMV; and
take any other reasonable steps necessary to deny the tax benefit that would otherwise arise as a result of the abusive tax avoidance transaction.

This bill has been referred to the Washington State House Committee on Finance. Hat tip to Lewis McMurran of the Washington Technology Industry Association. For information on related topics, visit Lew McMurran's Government Affairs blog.

Northwest Entrepreneur Network's "Legalities for Founders" Workshop: January 27, 2010

Davis Wright Tremaine — Tue, 19 Jan 2010 09:20:57 -0800

The Northwest Entrepreneur Network will conduct an interactive workshop that highlights key legal issues faced by early-stage start-up companies. Davis Wright Tremaine attorneys Joe Whitford, Ryan York and Kraig Baker will present along with Alexander Hutton Venture Partners’ Kent Johnson. The agenda will focus on:

Choice of legal entity
Corporate formation
Issuance of founders stock
Employment agreements
Option and restricted stock plans
Friends and family/angel financings

The workshop will be held at the Seattle office of Davis Wright Tremaine on January 27, 2010 from 8:00 am – Noon. Click here for more information or to register.

Officers and Managers Risk Personal Liability for Knowingly Withholding Wages

Stuart Campbell — Wed, 13 Jan 2010 11:34:16 -0800

In these challenging economic times company officers and managers should be reminded that under applicable federal and state law they can be personally liable if they knowingly fail to pay employee wages. If making payroll becomes challenging, companies should consider other alternatives to reduce expenses, including salary or hour reductions, rather than not paying employee wages. See a more detailed discussion here.

What Every Employer Should Know about Social Networking Sites

Stuart Campbell — Wed, 13 Jan 2010 11:34:16 -0800

DWT's San Francisco and Los Angeles offices are hosting a program entitled: "The Complete Tweet: Developments in Social Networking and Employment Law". Attendees will have an opportunity to learn about what every employer should know with regards to social networking sites, as well recent changes to California and Federal employment laws.

The program will include a keynote speech by Neal Schaffer, author of the new book Windmill Networking: Understanding, Leveraging & Maximizing LinkedIn, which will be presented over lunch. All attendees will receive a copy of Neal's book.

The event will be held in San Francisco on January 21st and in Los Angeles on January 26th. To learn more and register for these events, please visit the following pages:

San Francisco: http://www.dwt.com/Events?find=167508
Los Angeles: http://www.dwt.com/Events?find=167510

DWT clients or their colleagues should contact mollyklein@dwt.com for special registration accommodation.

''Incorporation Transparency and Law Enforcement Assistance Act''

Joseph M. Wallin — Tue, 12 Jan 2010 11:01:02 -0800

For a copy of this proposed federal bill, see here.

This bill would require states to collect beneficial ownership information from applicants forming corporations or limited liability companies. The beneficial ownership information would have to: 1) identify each beneficial owner by name and current address, and 2) if the beneficial owner exercises control over the corporation or limited liability company through another legal entity, it would have to identify each such legal entity and each such beneficial owner who will use that entity to exercise control over the corporation or limited liability company.

States would also be required to collect updates of the list of beneficial owners in annual filings, or require disclosure each time a change is made in beneficial ownership. I have installed a tracker from govtrack.us to track the progress of this bill through Congress. Click on "Bills and Resolutions" and search "S.569."

Sure, You've Heard of 1031 Exchanges, But What About 1045 Exchanges?

Joseph M. Wallin — Wed, 30 Dec 2009 09:56:04 -0800

By Michael Gentile

The Internal Revenue Code contains a number of preferential tax treatment provisions for small businesses. One that is often overlooked is Section 1045, which generally permits a non-corporate taxpayer to elect to defer recognizing gain on the sale of qualified small business (QSB) stock held for more than six months to the extent the proceeds are reinvested in other QSB stock during a 60-day period beginning on the date of the sale.

With certain exceptions, QSB stock means any stock acquired on original issuance by the taxpayer from a domestic C corporation after August 10, 1993 that meets the following requirements: (1) the aggregate gross assets of the corporation must not have exceeded $50 million at the time of and immediately after the issuance of the stock; and (2) at least 80% of the value of the corporation's assets must have been used in an active trade or business. IRC Section 1202.

Section 1045 permits founders and angel investors to move money from one business venture to the next without having to pay tax on appreciation in the first business venture. Because the benefit of Section 1045 applies only to stock in C corporations, it should be taken into consideration by entrepreneurs in choosing the form of their business ventures.

If you form as an S corporation, you will not be able to access the benefits of Section 1202 or Section 1045 with respect to your founders' stock.

Public Policy Concerns For Startups in 2010

Joseph M. Wallin — Thu, 24 Dec 2009 13:20:38 -0800

There are at least two significant public policy items of concern for startups as we move into 2010.

Senator Dodd's proposal to repeal federal preemption of state regulation of all accredited investor securities offerings. If this proposal becomes law it will significantly increase the cost of raising capital for startups. For more detail on this proposal, see this attached letter.
Senator Dodd's proposal to increase the financial thresholds to qualify as an accredited investor. If this proposal becomes law, it will also make it more difficult for startups to raise capital. Bill Carleton has written about this proposal, and you can find one of his blog posts on this here.

Let's hope that 2010 turns out to be a good year for startups. Let's hope that legal and regulatory changes won't make life any more difficult for this important part of the economy.

What Is the Difference Between Warrants and Options?

Joseph M. Wallin — Wed, 16 Dec 2009 16:08:08 -0800

I am frequently asked the following question: Can a service provider receive a warrant in connection with the provision of services?

The short answer is yes, but it is important to keep in mind that a warrant received in connection with the performance of services will be taxed just like a compensatory stock option.

In other words, unless the warrant qualifies under the incentive stock option rules (which it likely would not) the following apply:

to avoid adverse tax consequences under Section 409A, the warrant would generally must have an exercise price equal to the fair market value of the underlying stock on the date of grant;
upon exercise, the excess of the fair market value of the shares received over the exercise price would be taxed as ordinary compensation income;
if the recipient was an employee, upon exercise income and employment tax withholding would be required; and
if the service provider was an independent contractor and not an employee, the income, although not subject to income and employment tax withholding, would probably have to be reported to the IRS on a Form 1099.

A warrant received in connection with an investment, or a loan, and not in connection with the provision of services, is not taxed as described above. There is generally no tax owed as a result of the exercise of a non-compensatory warrant. However, depending on the circumstances in which the warrant is received, there can be tax owed before the warrant is exercised. For example, a warrant issued in connection with a note will be considered to give rise to original issue discount , which is generally required to be taken into income over the term of the note. You should consult with a tax advisor about any warrants received in connection with an investment to determine the correct tax treatment.

House Votes To Tax Carried Interest As Ordinary Income

Joseph M. Wallin — Wed, 09 Dec 2009 17:54:20 -0800

The US House of Representatives today voted to subject the carried interest to tax as ordinary income and employment taxes.

This will result in venture capitalists and general partners of real estate investment partnerships paying a substantially higher rate of tax on their "carry", which is currently taxed as capital gain and a 15% tax rate. Ordinary income tax rates are as high at 35% (but that rate will increase to 39.6% when the Bush tax cuts expire), and employment taxes can be an additional 15.3%.

Employers Must Begin Reporting ISO Option Exercises To IRS

Joseph M. Wallin — Sat, 21 Nov 2009 22:05:40 -0800

Historically, the Internal Revenue Code of 1986, as amended (the “Code”) required corporations to provide an annual informational statement to each employee acquiring stock pursuant to the exercise of an incentive stock option (“ISO”) or under an employee stock purchase plan (“ESPP”). Congress changed this rule back in 2006 to also require employers to file an information return with the IRS. (Specifically, the Tax Relief and Health Care Act of 2006 amended Section 6039(a) of the Code.)

In connection with issuing proposed regulations in 2008, the IRS waived the requirement to file a report with the IRS for 2007 and 2008, but did not waive the requirement to provide employees with an informational statement. A few weeks ago, the IRS finalized the regulations under Code Section 6039(a) and waived the requirement to file a report with the IRS for 2009, but affirmed the requirement to provide affected employees with an informational disclosure statement in connection with ISO and ESPP exercises in 2009.

You can find a link to the final IRS regulations here.

For employers, the important point is that informational disclosure statements must be provided to affected employees by January 31, 2010, with respect to ISO or ESPP exercises or transfers that occurred in 2009. Following the close of 2010, employers will need to both provide affected employees with an informational disclosure statement and also file an associated return with the IRS.

For employees who exercised options in 2009, the most important thing to realize is that the exercise of an ISO or an option under an ESPP can trigger complicated tax consequences. For example, the exercise of an ISO does not give rise to ordinary income tax, but the spread on exercise is an alternative minimum tax adjustment, which could cause considerable federal tax to be owed.

Common Mistakes In Starting A Company & How To Avoid Them

Joseph M. Wallin — Sat, 21 Nov 2009 13:00:03 -0800

I frequently meet with entrepreneurs after they have created their business entity and put some of the initial legal documentation in place. I frequently see the following mistakes, which can be easily avoided and save time and money for entrepreneurs later.

Forming a Washington limited liability company and indicating in the Certificate of Formation that it is member managed. This means that any member has the apparent authority to bind the company to contracts, even passive, non-actively involved investors. You want to indicate, if you form a limited liability company, that the entity will be manager manged. This signals to the world that the management is centralized and that all members do not have the apparent authority to bind the company. RCW 25.15.150.
- Keep in mind that the Certificate of Formation on the Washington Secretary of State's web site, which you can find here, does not allow you to indicate whether the LLC will be manager or member managed. It defaults you to member managed, which is typically not desirable. I would recommend you use this example certificate of formation.
Forming a Washington corporation using the Articles of Incorporation form from the Washington Secretary of State's web site. If you do this, your corporation will have the following characteristics, which you generally want to avoid:
- You will have cumulative voting. RCW 23B.07.280.
- You will have statutory preemptive rights. RCW 23B.06.300.
- You will not have the ability for the shareholders to act by less than unanimous written consent. RCW 23B.07.040(ii).
- You will not have released the directors from personal liability to the maximum extent permitted by law. RCW 23B.08.320 ("The articles of incorporation may contain provisions not inconsistent with law that eliminate or limit the personal liability of a director to the corporation or its shareholders for monetary damages for conduct as a director, provided that such provisions shall not eliminate or limit the liability of a director for acts or omissions that involve intentional misconduct by a director or a knowing violation of law by a director, for conduct violating RCW 23B.08.310, or for any transaction from which the director will personally receive a benefit in money, property, or services to which the director is not legally entitled.").
- You will not have provided indemnification to directors to the maximum extent permitted by law. RCW 23B.08.560.
If you intend for your corporation to have maximum flexibility to move forward to raise capital from third parties, you will want your Washington articles of incorporation to specifically state (i) no cumulative voting, (ii) no statutory preemptive rights, (iii) shareholders can act by less than unanimous written consent, and (iv) maximum protection for directors.
Not obtaining from the founders a clear assignment of intellectual property to the company.
Executing initial founder agreements which require unanimous consent of all of the parties to amend them, allowing one founder to veto the ability of the company to move forward.
Making equity arrangements with service providers without written documentation clearly defining the terms of the arrangement and services to be provided, over what time and what milestones are required.
Not imposing vesting on founders whose continued service is a condition to their receipt of their founder shares.
Attempting to form an S corporation and not having spouses in community property states execute the Form 2553 (a spouse in a community property state has to execute the S election form if the stock in the S corporation is community property, even if the stock is titled in the name of the other spouse; see the Instructions to Form 2553, and see Rev. Proc. 2004-35).

What to do if you are an entrepreneur and want to get off on the right foot? Call and ask for an example form of Certificate of Formation or Articles of Incorporation and a free consultation. You can reach me at 206-757-8184 or my partner Stuart Campbell at 206-757-8017.

Washington State's New Digital Goods Tax

Joseph M. Wallin — Fri, 23 Oct 2009 10:54:22 -0800

By Michele Radosevich

In the 2009 session, the Washington Legislature mandated big changes in the way that goods and services are taxed if those goods and services are delivered digitally. Under the new law, the notion that the sales and use tax primarily applies to tangible personal property is only a memory. On July 26, 2009, many sellers of internet-based products had to begin collecting sales tax from their customers. However, there is benefit. At the same time, some of these sellers’ business & occupation tax rate was cut by two-thirds, and their basis for apportioning income changed dramatically.

The Department of Revenue is still in the process of writing rules to flesh out the new statute and many details are still unknown. With the exception of digital books, music and videos, the Department recognizes that uncertainty in most situations is the common denominator. Consquently, the Department has said that in the early phases of implementation, it will help businesses comply rather than brow beat them for guessing wrong. Nonetheless, some of the biggest changes are clear.

Many Companies That Formerly Were Considered Service Providers Are Now Retailers and Must Collect Retail Sales Tax.

1. Digital Goods Providers. The quintessential digital goods are audio and video that is accessed electronically. A frequently cited rationale for the legislation was that when such goods were downloaded, a sales tax applied, whereas when they were merely streamed, no taxable transfer had occurred. This difference was eliminated. However, the legislation applies to far more than audio and video.

Under prior law, the provision of information in digital form was generally considered to be a service. Now sellers of database information, online legal research, financial information, and similar information will be considered retailers, though some sales are exempt from sales tax.

2. Digital Service Providers.

Providers of search engines, online gaming, and other services that are performed electronically using one or more software applications are now considered retailers

3. Providers of Web-based Software. Providers of web-based software applications, sometimes called “cloud computing” and called “remote access software” in this bill, will also become retailers under the new law. The fact that the provider does not transfer possession of the software does not change the analysis.

4. Exceptions. The new law is written broadly, but it also contains many exceptions. These can broadly be categorized as (1) exceptions to the definition of digital goods and digital automated services that maintain the current tax classifications for certain businesses, (2) sales tax exemptions that parallel existing law, and (3) sales tax exemptions unique to the new law.

The first category preserves existing tax treatment for certain goods and services. These include telecommunications, online classified advertising, internet access, electronic funds transfer and other automated financial transactions, online educational programs, travel agency services, data processing services, and payment processing services. Charges for allowing another person or entity to sell things on a website are also excluded from retailing, though the underlying sale is not.

Professional services, involving primarily human effort and performed pursuant to a customer request, are excluded from retailing, even if delivered electronically. Examples would include appraisal reports, legal research, and customer website development.

The second category parallels existing sales tax exemptions:

a. If a purchaser incorporates a digital good or service in goods or services that the purchaser markets or otherwise resells, the purchaser is entitled to use a resale certificate or, after January 1, 2010, a reseller’s permit, to avoid the sales tax.

b. If an entity makes digital goods or services available for free, no sales tax applies.

c. Goods created for a noncommercial purpose or internal use, such as e-mail, are not subject to tax.

d. Digital goods may qualify for the manufacturing and equipment exemption from sales tax under the same criteria as any other kind of goods.

The third category exempts certain digital goods and services from sales tax, despite their categorization as retail for B&O purposes:

a. Sales of data that is reported in a standardized format and for a business purpose, such as daily reports of stock prices for investment companies, are exempt. The business purpose must be documented with an exemption certificate.

b. Sales of electronic versions of newspapers are exempt if the electronic versions share content with the printed newspaper.

c. Radio and TV broadcasting is exempt except for pay-per-view programs.

d. Sales to entities that will use the digital goods or services both inside and outside Washington are exempt from sales tax, but the purchaser will be liable for use tax on value of the goods or services used in Washington.

The Change in Classification May Reduce B&O Tax for Washington-based Companies.

For the companies that are now reclassified as retailers rather than service providers, the B&O rate will decline from 1.5 percent to 0.471 percent. Just as importantly, the basis for apportioning income for B&O tax will also change from apportionment based on costs to apportionment based on sales. Cost-based apportionment tends to result in a larger amount apportioned to Washington for companies headquartered here. For digital goods and services providers that sell primarily outside the state, the amount of receipts subject to tax in Washington may decline significantly.

The New Law Will Affect Business Transactions.

The new law simply amends the current business and occupation and sales and use tax chapters, rather than creating a new chapter. As part of that existing architecture, there is no hint that business transactions involving digital goods or services would be analyzed any differently than those involving tangible personal property. Superimposing the existing analytical structure on digital goods is likely warranted. Although this sounds simple, there will undoubtedly be problems requiring further guidance from the Department.

Expect Further Changes in the 2010 Session.

The taxation of digital goods and services is a sweeping change that was enacted very quickly. The Department has already identified ambiguities and unintended consequences. Expect a technical corrections bill in 2010.