Director Fees Update: Substantial Nexus and the Property Factor

By Garry Fujita

On August 27, 2010, we addressed the taxation of director fees in the article, Washington State B&O Tax on Director Fees.  In that post, we addressed the substantial nexus requirement that is necessary before Washington may extend its B&O tax to director fees.

We refer you to that August 2010 article for a more detailed discussion, but by way of a quick review, a director has substantial nexus if:

  1. the director is a Washington resident or is domiciled in Washington; or
  2. the director is a nonresident who has:
    1. more than $50,000 of property in the state;
    2. more than $50,000 of payroll in the state;
    3. more than $250,000 of receipts from the state; or
    4. at least 25% of his or her total property, total payroll, or total receipts in this state.

At that time, we raised a question regarding the property factor for a nonresident.  The question was whether “property” meant only business property or both business and nonbusiness property (e.g., vacation property).  Without guidance from the Washington Department of Revenue, we suggested that the safest course of action was to assume that the state would decide that both types of property should be considered.  In a recent query to the Taxpayer Services for the Washington Department of Revenue, we were told that, in fact, the agency has made the policy decision to include all property, although the question was admittedly a “close call.”

We have not seen any agency declaration of that position or seen any analysis supporting it, but there certainly is rational support for that position.  First, there is no limiting language in the statute.  On its face, “property” can include both business and nonbusiness property.  Second, to the extent that a court would likely assume that the legislature knew the difference between business and nonbusiness property, one could point to RCW 82.0.067(2)(e) to demonstrate that the legislature knows how to limit “property.”  In that section, the legislature specifically excluded “a person’s ownership of, or rights in, computer software as defined in RCW 82.04.215, including computer software used in providing a digital automated service; master copies of software; and digital goods and digital codes residing on servers located in this state.”  Thus, if the legislature found it appropriate to exclude software, digital goods and digital codes, then why did it not exclude nonbusiness property as well?

However, we do not believe that the analysis should end with a review of the statute alone.  As nexus is a constitutional concept for commerce clause purposes, we think that the commerce clause should be consulted too.  Under commerce clause analysis, nexus can be dissociated from the activity that the state seeks to tax if the nexus is unrelated to that activity.  According to the Department of Revenue:

Once nexus is established, the general rule is that all sales transactions are subject to B&O tax liability.  Put another way, nexus for one sale is nexus for all sales.  An exception to this general rule applies only to those particular sales where the seller can establish that the sale was not associated in any way with the in-state activity which created the nexus.  This burden of proof was addressed by the United States Supreme Court in Norton Co. v. Illinois, 340 US 534, at 537-538 (1951), where the court stated:

But when, as here, the corporation has gone into the state to do local business by state permission and has submitted itself to the taxing power of the state, it can avoid taxation on some Illinois sales only by showing that particular transactions are dissociated from the local business and interstate in nature.  The general rule, applicable here, is that a taxpayer claiming immunity from a tax has the burden of establishing his exemption.  This burden is never met by showing a fair difference of opinion which as an original matter might be decided differently. . . . (Emphasis added.)

Det. No. 87-69, 2 WTD 347, 350 (1987) (italics supplied, underline in original text).

In the context of director fees, a nonresident director with nonbusiness property in Washington could contend that the nexus created by the nonbusiness property is dissociated with the director fees earned.  The argument would be that the director fees “are not associated in any way with” the family beach property in the San Juan Islands or a condo at Crystal Mountain (assuming that no business entertainment occurs at the property).  For purposes of taxing the director fees, only the property related to generating the director fees should create the required nexus.  The nexus created by the nonbusiness property should be irrelevant.  However, until judicial scrutiny is given to this issue, the safest course of action for a nonresident director is to assume that Washington Department of Revenue will include the director’s  nonbusiness property located in Washington for the purpose of  establishing the required nexus.

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Double Down: Deal of a Lifetime

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Being The First Inventor No Longer Counts

By George Rondeau

The most significant change in U.S. patent law goes into effect on March 16, 2013 when for all patent applications filed on or after that date the U.S. switches to a “first-to-file” system. Under the America Invents Act (AIA) the first inventor to file a patent application for an invention will be awarded the patent even if another invented it first. In competitive industries, this creates pressure to file patent applications earlier than previously required since being first to make an invention no longer matters. One big exception is where an inventor makes a public disclosure of his invention before the first patent application is filed by another inventor.

Most of the significant changes flow from the revised definition of prior art, against which an invention is measured to determine patentability, and the stated exceptions to prior art. Under the AIA an invention is not novel if patented, described in a printed publication, in public use, on sale or otherwise available to the public anywhere in the world before the effective filing date of a patent application for the invention. A fairly straight forward concept without limitation to geography or who made the public disclosure.

However, a big exception is provided for a disclosure by the inventor of his own invention (or by another who has derived the information disclosed from the inventor), and for a disclosure by a third party at a date after an earlier disclosure was made by the inventor of his own invention (or by another who has derived the information disclosed from the inventor). To take advantage of this exception the inventor must file a patent application for the invention disclosed within one year from the date of the first disclosure covered by the exception. Unlike under prior U.S. patent law, the one-year grace period does not apply to all public disclosures (e.g., it does not apply to an independent disclosure by a third-party before the inventor publicly discloses his own invention, even if the inventor can prove he invented his invention before the disclosure and filed his patent application within one year after the disclosure, unlike was the case under prior U.S. patent law).

Summary of New One-Year Grace Periods and Other “Prior Art” Rules

While the one-year grace period under prior U.S. patent law no longer exists for new patent applications, the AIA effectively creates a number of new one-year grace periods and other new rules on what constitutes prior art. These are, in hopefully plain English, summarized below:

1. If a disclosure was made by the inventor, or someone obtaining the information from the inventor, it will not be prior art against the inventor for one year after the disclosure (i.e., a one year grace period for his own disclosures and disclosures of information obtained from the inventor). This exception applies to an inventor who makes the first disclosure of the invention. (Note that if before the inventor makes a disclosure of his invention and before he files an application for the invention, another person who independently arrived at the invention makes a disclosure by way of a printed publication, public use, on sale or otherwise makes the invention available to the public anywhere in the world, that disclosure by the other person will be prior art against the inventor – there is no exception applicable to that situation.)

2. If the inventor, or someone obtaining the information from the inventor, made the first public disclosure, a subsequent disclosure by another inventor of the same subject matter will not be prior art for one year after the disclosure by the other inventor (i.e., a one year grace period for disclosures by other inventors if the inventor or someone obtaining the subject matter disclosed from the inventor was first to make a public disclosure of the invention). However, the public disclosure by the inventor will be prior art against his own application if filed more than one year after that public disclosure.

3. If the subject matter of a patent application or patent by another was obtained from an inventor, then the patent application/patent will not be prior art against the true inventor (i.e., the other person copied the invention from the true inventor). Presumably the publication or issuance will be a disclosure that triggers the one year grace period first mentioned since derived from the inventor.

4. If the inventor, or someone obtaining the information from the inventor, made a public disclosure of the invention, and before the inventor files his application, another inventor files an application, the application by the other inventor will not be prior art. Being first to publicly disclose blocks subsequent patent applications filed by others from being prior art against the later filed application of the first inventor to publicly disclose his invention. However, the public disclosure by the inventor will be prior art against his own application if filed more than one year after that public disclosure.

5. If the patent application by the inventor and another are owned by the same person (or subject to an obligation to assign to the same person) no later than the filing date of the second application, then the first application is not prior against the second filed application. Note that other type public disclosures, such as a publication, public use or sale prior to the effective filing date of the inventor’s effective filing date, will be prior art.

While being “first to invent” no longer has any role in determining who obtains a valid patent in the U.S., the first inventor to make his invention public assures himself that no other inventor can patent the invention and that public disclosures and patent applications by the other inventor will not be prior art against him. Effectively, by making the first public disclosure of an invention, the first-to-disclose inventor gets a one year grace period in which to file his application without his own public disclosure being prior art against himself and without another inventor being able to block him by filing the first application on the invention or making a subsequent public disclosure of the invention. Thus, the U.S. has created two paths to winning the patent race, one, be the first to file a patent application (assuming nobody makes a public disclosure of the invention before you file the application), or two, be the first to publicly disclose the invention (assuming nobody files an application on the invention before your public disclosure).

One downside to using this “first-to-disclose” approach is its impact on foreign patent rights. In most countries a public disclosure before filing a patent application immediately results in loss of patent rights, most times without regard to where the public disclosure occurred.

Significant Unknowns

It is unknown if the court-made “experimental use” exception will survive. In the past, a public disclosure or offer for sale by an inventor was given special treatment if for an appropriate experimental purpose and would not start the one-year grace period running. Under the AIA the experimental nature of these activities may be irrelevant. Also, it is unknown how a sale subject to a confidentiality requirement will be treated. Will a sale which does not make the invention available to the public still be considered prior art?

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A Tale of Two Exemptions

There is a fair amount of confusion about equity-based crowdfunding, how it will work once it is legal, how the crowdfunding exemption will interact with other securities law exemptions, and in general what the future holds. This is natural and to be expected in light of the dramatic nature of the two new laws Congress passed.

In case you had forgotten, Congress did two things in the JOBS Act which dramatically altered the securities law legal landscape.

First, it passed a statute stating that the SEC shall issue rules which will allow general solicitation and general advertising in all accredited investor offerings. This is dramatic; at odds with decades of law. Soon, issuers will be able to run ads in newspapers advertising their private securities offerings. This is a totally new, totally radical approach to securities offerings.

Second, it passed an equity crowdfunding exemption. Again, this is totally new. There is no precedent for it. The SEC has yet to issue rules. And so we have no idea what the exact parameters of this exemption will look like until the rules are issued.

Keep in mind that neither of these two helpful changes to the law is yet legal. We are still waiting on SEC regulations.

Below is a table comparing the current most commonly used federal exemption from the registration requirements for early stage equity financing of emerging businesses and the new equity crowdfunding exemption, which I hope you will find helpful.

Rule 506 Crowdfunding
Limitation on Offering Size None $1M during any 12 month period (including amounts raised in any other private securities offering in the same period).
Limitation on number of investors Not if all investors are accredited. Not technically, but there is a some outside limit by virtue of the the offering size limit.
Advertising allowed Yes – once the rules are final. No, companies cannot advertise; they can only refer people to portals.
Specific Disclosure Requirements None required by the rules; but subject to anti-fraud requirements. Yes, very specific, detailed disclosure requirements, the complete details of which have yet to be finally determined. Also subject to anti-fraud requirements.
Third party intermediary required No Yes; companies have to go through a broker-dealer or registered funding portal.
Ongoing SEC reporting No Yes, but exactly what is required here is not yet defined.


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What’s Crowdfunding Without Advertising?

crowdfunding and advertisingCrowdfunding for equity is one of those ideas that appeals to a lot of people. It has “crowd” appeal, you could say.  Why not allow a great number of individuals (thousands) to each invest a little bit of money to fund projects that would otherwise not get funded?  Especially projects like rooftop solar projects or similar ventures which improve society as a whole?  Isn’t this a great idea?

Kickstarter now raises more money for the arts than the National Endowment for the Arts. Clearly, crowdfunding is the future we have all been waiting to be evenly distributed.  (As William Gibson famously said, “The future is here, it’s just not evenly distributed yet.”)

But hold on a minute. We have a little snag we have to deal with first. That snag being state and federal securities laws.  These laws were put in place in the aftermath of the stock market crashes that preceded the Great Depression, and  strictly regulate the business of selling securities. These laws prohibit the crowdfunding future we thought was just about to be evenly distributed. Under these laws you can’t sell even $10 worth of securities without first going through an expensive process with state and federal regulators. There is no “de minimis” exception to the securities laws.

Under state and federal law, before you can sell any security, you must first either register the security with the securities regulators (which costs a ton) or find an exemption under which the security can be sold without registration. Most private company stock offerings proceed according to an exemption simply because the cost of registration is so great.

The problem for our crowdfunding future?  Exemptions are limited in number and are typically subject to a number of conditions and limitations.  There is currently in place no “crowdfunding” exemption.

Take my example, the company that wants to sell equity to build a rooftop solar or wind project by selling shares at the local coffee shop (just drop that $100 off while you pay for your coffee).  The company would find it very hard (impossible actually) to find a securities law exemption that would allow it to proceed in the manner described.

The JOBS Act crowdfunding provisions are supposed to resolve the above dilemma, and allow ordinary Americans to invest.  (By the way, right now ordinary Americans are cut out of the private securities market almost entirely because almost all private securities offerings are “accredited investor” only offerings.  Accredited investors are generally individuals with a $1M net worth, excluding their home equity, or incomes of at least $200,000 a year for the last 2 years with the expectation of the same in the year of investment, or $300,000 with their spouses.)

The trouble?  The very concept of crowdfunding is at odds with the  structure of the federal securities law.  The most commonly used federal securities law exemption, Rule 506, is a safe harbor under Section 4(a)(2) of the Securities Act. Section 4(a)(2) exempts “transactions by an issuer not involving any public offering.”

How can crowdfunding be reconciled with this very fundamental no-public-offering concept that has been a part of the securities laws since the 1930s?

Aren’t companies that are crowdfunding going to be able to generally advertise that they are raising money?  The answer, oddly enough, is no.  All companies are going to be able to do under a crowdfunding offering is give “notices which direct investors to the funding portal or broker.”  The JOBS Act specifically disallows issuers of crowdfunding offerings from advertising:  “an issuer who offers or sells securities shall . . . not advertise the terms of the offering, except for notices which direct investors to the funding or portal.”

If issuer can’t generally solicit, is it still crowdfunding?  Well, it is still crowdfunding, at least according to the JOBS Act.

Contrast this with Section II of the JOBS Act. Under Title II, issuers in all accredited offerings are going to be able to put up billboards along the highway if they want, advertising “Buy Our Stock!” But that is for a different blog post.


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