Entity Formation Basics: The Cooperative

Co-op (larger file size)

Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company (LLC), partnership, non-profit, or some other type of business entity.

This post is about one useful form of business entity that is frequently overlooked by business advisors and attorneys – the cooperative!

A cooperative or “co-op” is a type of legal entity that is distinguishable from standard, for-profit corporations, LLCs, and partnerships.  Co-ops offer a flexible business model that can be used by any group of people who are interested in creating a democratic decision-making company that benefits all members.  In other words, co-ops strive to be patron- or member-oriented, rather than investor-oriented like traditional corporations or LLCs.

At their core, co-ops are formed by a group of people who either work or shop there (a brewery co-op or a food co-op), use its services (a credit union or health insurance co-op), or product goods and items for it (a food producers co-op).  Co-op members are not to be held liable for any debt, obligation or liability of the co-op.

The International Cooperative Alliance, a global membership association of co-ops and co-op support organizations, has established Seven Cooperative Principles including Democratic Member Control and Concern for Community, among others.

The “common purpose” of individuals wishing to form a co-op can include a number of things, including employee-ownership, group marketing, or group purchasing.  Some of the most nationally well-known co-ops include Ace Hardware and REI, as well as dozens of successful agricultural co-ops such as Land-O-Lakes, Sunkist, and Ocean Spray.

Today, artist and freelancer co-ops are becoming more common due to the rise of the “sharing economy” and the realization of individual artists, photographers, software developers and other freelancers there can be great benefits to pooling resources, infrastructure or ideas.

Colorado Cooperatives

Colorado cooperative law has developed cumulatively over more than five decades.

Today, a standard co-op should be formed under Article 56 of Title 7 of the Colorado Revised Statutes.  Article 58 contains the “Colorado Uniform Limited Cooperative Association Act”, recently enacted in 2011.  Also, Article 33.5 of Title 38 is a special Colorado code section for housing co-ops.

Interestingly, Colorado law explicitly prohibits the ability to use the word “cooperative” or any abbreviation or derivation of as part of your business name, trade name, trademark or brand unless you are actually formed as a co-op under these statutes, so be careful if you are loosely using the term “co-op” or “cooperative” in your business!

Under Colorado law, co-op members and those on a co-op’s Board of Directors are protected from personal liability from the activities of the company, similar to corporations and LLCs.  Co-ops are also allowed to limit membership only to persons engaged in a particular business, persons who will use the goods or services of the co-op, and other membership conditions stated in the co-op’s Articles of Incorporation or Bylaws.  Because they are so member-oriented, Colorado law requires a co-op to keep detailed membership lists with contact info.

Limited Cooperatives

Under the newer Limited Cooperative Association Act, a co-op can have investor members who do not participate as much in the common purposes of the company.  This kind of co-op would have “patron members” who fully own and participate in the co-op and “investor members” who participate in the co-op on a more limited, financial basis.

Because the Article 58 was designed with maximum flexibility in mind, a co-op’s Bylaws and Membership Agreements can set forth all kinds of rules and arrangements for the patron members and investor members as far as how the company is run, how patron member votes versus investor member votes are counted towards certain decisions, and how allocation and distributions are made to these different kinds of members.

Cooperatives and Securities Laws

Both Articles 56 and 58 state that any unit or evidence of a membership interest in a co-op is exempt from the Colorado Securities Act or our state’s “Blue Sky” laws.  This means a co-op can offer and sell its membership interests without needing to registered as a broker-dealer, unlike the ownership in a corporation or an LLC.  This takes a lot of legal headache and expense away from co-ops who are looking to have dozens or even hundreds of members.

Nevertheless, if your co-op needs to raise a lot of capital and wants to do so by securing many membership fees or contributions, we strongly recommend this is done through a Regulation D private placement offering under the federal Securities and Exchange Commission’s (SEC) rules.

Worker Cooperatives

Worker co-ops (i.e., employee-owned companies) are gaining traction like never before as the socially-conscious business movement and sharing economy continue to gather momentum.

The common purpose of the worker co-op is each member’s livelihood – their job and income – as it relates to the success and sustainability of the company as a whole.  In a worker co-op, the employees democratically control the management and operations of the company, with each employee-owner having an equal vote.

Generally, this means that all employees, no matter their salary, job title, or years of employment, are entitled to one vote per person on all matters brought before the membership of the company.  However, this does not mean all employees have to be involved in every company decision.  A worker co-op should still have a Board of Directors, and can also have other officers (for example, a President or a CEO) to set policies, manage day-to-day operations of the company, and determine when important decisions should be put to the members.  Of course, the members vote for who is on the Board and can also vote for who the President or CEO is to be.

Taxation of Cooperatives

Co-ops have unique income tax structures governed by Subchapter T of the Internal Revenue Code.  This tax structure is similar to partnership taxation, but with some different terminology.  Profits of a co-op are called “net margins”.   The members of a co-op are deemed “patrons”.

Under Subchapter T, net margins are not taxed a the co-op level, but are instead allocated to the patrons on an annual basis similar to a partnership distribution.  Unlike a partnership distribution however, co-op allocations are based on a patrons use of the co-op rather than their investment.  For example, in an agricultural co-op, if Farmer A uses 3,000 acres of the co-op’s land and Farmer B uses 10,000 acres, Farmer B had more “patronage” of the co-op and should expect a larger allocation.

Subchapter T states at least 20% of the allocation to a co-op’s patrons must be in cash.  The remaining 80% can also be distributed in cash, or in can be retained on the books of the co-op as “patronage equity”, to be redeemed sometime in the future.  Consequently, patronage equity allows a member of a worker co-op to build personal assets and net worth by having an equity account that can be redeemed when he or she retires or leaves the company.

Each patron should receive a Form 1099-PATR from the co-op every year reporting the allocation (both cash and non-cash).  Then, each patron is responsible for paying his or her own income taxes based on the reported allocation.

If you would like to form a co-op or have a question related to an existing co-op, contact our offices today!

 

 

 

 

 

 

Colorado Legislative Watch: Encouraging Employee Ownership of Small Businesses

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UPDATE (4/21/2017):  House Bill 17-1214 passed both the House and the Senate and is on its way to Governor Hickenlooper’s desk for signature!

On February 27, 2017, House Bill 17-1214 was introduced in the Colorado House of Representatives.  The goals of the Bill are to educate state policy makers on the benefits of employee ownership and to create a revolving loan fund through the Office of Economic Development to assist existing small business with converting to employee ownership.

Nearly half of Colorado’s workforce is employed by small businesses, but this workforce is approaching a potential economic crisis:  About 66% of small businesses in the U.S. are owned by “Baby Boomers” who are going to be retiring in ever-increasing numbers over the next decade.  However, many of these Boomer business owners have no succession plan for their businesses upon retirement, and market analysts are predicting there aren’t going to be enough buyers for all these small companies hitting the market.  Thus, not having a concrete succession plan increases the risk that these companies will simply be liquidated – assets sold, accounts closed, and employees laid off.

A number of recent studies on employee ownership show that employee-owned companies are statistically better for the economy than traditional ownership models.  For example, employee-owned companies have lower rates of layoffs and lower rates of failure after 5 years of business.  Employee-owned companies also have better annual sales figures, and employees in an employee-owned company earn 5-12% more than their counterparts at other businesses.  These benefits are rooted in the fact that in a democratically-controlled, employee-owned company, the goals and motivations between management and the workforce are aligned.

So, the goal of H.B. 17-1214 is to convince and assist these retiring Boomer business owners “sell” their companies to their employees!

Fundamentally, employee-ownership could be a meaningful way to address the growing income- and earnings-inequality that is plaguing our country.  If H.B. 17-1214 passes, it will be an exciting development in Colorado and perhaps, a model for the rest of the country on the economic benefits employee ownership!

 

 

10 Legal Documents Every Startup Should Have

Legal Documents
  1. Bylaws / Operating Agreement

 A company’s Bylaws (in the case of a corporation) or Operating Agreement (in the case of an LLC) provide the legal backbone for how it operates.  If your company does not have bylaws in place, state statutes will control how the company is run.  However, these default rules might not be the best fit for your company, so it is much better to strategically think through how you would like your company to be run.

For example, if there is a major disagreement among the owners that “deadlocks” the company from being able to do anything, generally one of the only remedies under state statutes is that an owner can file a lawsuit asking the court to wind up and dissolve the company.   This is usually a lose-lose for everyone, especially if the company was doing well prior to the deadlock.  The owners could avoid this scenario by having certain dispute resolution provisions in the bylaws, or by having a limited, advisory-only member of the company who effectively acts as a tie-breaker, the process for which would be set forth in the bylaws.

  1. Insurance

After establishing a well-thought out corporate structure and executing governance documents, every company should make sure that they have good insurance coverage.  This may not come cheap, but it’s an important investment for any business to make.

Beyond a general commercial liability policy, insurance can cover anything from cyber liability to director/officer liability to life insurance for key founders.  Also, if you are selling any kind of product to the public, consulting with an attorney who specializes in products liability is advised, as they will be able to assist you in mapping out this additional exposure to risk and preparing any contracts or disclaimers to include with the sale of your product.

  1. Shareholders’ Agreement

This agreement, which also may be called a “Founders’ Agreement” or “Buy-Sell Agreement”, can help you govern the relationship between the owners of your company.  You and your business partners may be on the best of terms now, but running a company might put a strain on your relationship sooner than you think.  Interpersonal conflict between founders is one of the most common and predictable reasons for why companies fail.  Thus, a shareholders’ agreement goes a long way to protect your investment in the new business.

This type of agreement should contain vital information such as who can be a shareholder or serve on the board of directors, what happens in the case of a shareholder’s death or impairment, or what happens when a shareholder files for bankruptcy, resigns, retires or is fired.  It should also outline how much shares of stock are worth and who will be required to purchase the shares of the owner who is leaving.

  1. Non-Disclosure Agreement (NDA)

NDAs protect the confidential information of your business.  They are used when one or both parties in a relationship wish to disclose confidential information, but want to ensure that the person or organization who receives it does not disclose it to anyone without consent.  For example, if you are looking for a manufacturer to produce your company’s new widget on a mass scale, you should probably have each potential manufacturer you interview sign an NDA so that they can’t turn around and start making your widget anyways.

Keep in mind, NDAs are worthless unless they are actually signed by the party against whom you wish to enforce it.  No matter what verbal promises were made before or after information was disclosed, it is advised you get your NDA in writing and signed by both parties before any confidential information is shared.  This way, both parties clearly know their duties and privileges as they are receiving business information from the other.

  1. Intellectual Property Agreement

This document is mandatory if you wish to acquire, sell or license intellectual property (e.g. copyrights, trademarks, patents).

If you are giving or receiving all the rights to a certain piece of intellectual property, that is called an “assignment”.  If you are giving or receiving only a few rights related to the intellectual property (for example, the right to print and distribute someone’s copyrighted book), that is a “license.”

Whether you are just starting out or a well-established business, intellectual property or “IP” is often a significant piece of your business’s value.  An IP agreement protects this value.

A good IP agreement should be comprehensive, covering the financial compensation, date of the assignment/license, the rights and obligations of the Assignor and Assignee and timelines for payment, representations and warranties, indemnities, and more.

  1. Privacy Policy

A privacy policy is essential for online businesses because data privacy issues are being subject to more legal scrutiny than ever before.  Your privacy policy should outline how your business collects information on customers, what that information is used for, and how it is stored and managed.  It should also explain the rights and control of a customer’s personal information.

Currently, data privacy laws are a patchwork of various state laws and federal regulations.  Some industries, such as education and finance, are also subject to special rules.  Some states, such as California, have enacted laws for any business that targets customers in that state.  If you have concerns about whether you are following the law in this complex area, consulting with an attorney is strongly advised.

  1. Terms & Conditions

This item is essential if you conduct any business online.  Your website’s terms and conditions regulate the online transactions where you sell your products or services to clients.

Well drafted website “Terms and Conditions of Use” will deal with issues such as returns and refunds, consumer guarantees, deliveries, disclaimers and competitors.  They will also have the effect of limiting liability for any information and material that may be on your site in relation to third party information or content that is included on your site.

Additionally, it should lay down the rules for people visiting the website as well as explaining that any intellectual property on the website is protected.  Your website’s terms and conditions should be easy to read and accessible before a transaction takes place.

  1. Founders’ Assignment of Intellectual Property

Each and every person who works in any manner for the company, including the founders, should execute an agreement assigning their creations to the company.  A founder’s IP contributions could be anything from patents, software, logos and marketing materials, customer data, and more.

Especially during the startup phase of a company, almost all of the value of the venture will be tied up in the IP, so if the company cannot prove it actually has legal title to these assets, the company is essentially worthless.

  1. Employee Contracts or Offer Letters

 Having a easy to understand contract or offer and acceptance letter with employees is essential for setting forth expectations and ensuring the employee is tied into the team.  Topics that could be covered in an employee contract or offer letter include who the employee reports to, who will own the employee’s work product, basic expectations, required commitments, share vesting and all other “rules” the employee must abide by. This prevents misunderstandings and thus can go a long way to protect the company from HR-related disputes.

  1. Liability Release Forms

 Startup companies tend to have a variety of fun work events that may involve risk.  For example, maybe your company has an annual dodgeball tournament against an important vendor or maybe you want to organize a company “hiking day” for bonding and team-building.  If so, you should have all employees sign a liability release form so that your company doesn’t become liable for an unexpected accident.

Trademarks: A Primer for Colorado Business Owners

Trademark Primer

A “trademark” is any word, name, slogan, symbol, or combination thereof, including packaging, configuration of goods or other trade dress, which is adopted and used to identify goods or services, and to distinguish them from goods or services offered by others.

The primary goal of trademark law is not to establish an exclusive property right in the mark, but rather, to protect consumers from confusion in the marketplace.  Thus, your trademark rights are violated if someone else is using your mark (or a mark confusingly similar to yours) in a way that is likely to cause confusion to existing or potential customers.

Technically, “trademark” is the term to use for tangible goods and products and “service mark” or “servicemark” is for non-tangible services, but nearly everyone, even trademark attorneys, use “trademark” for both categories.

“Common Law” Trademark Rights

Many people believe you can only have a trademark if you file for a registration, but this is not true!

Trademark rights can be established under common law simply by being the first use a mark for a business endeavor.  Your common law trademark rights extend as far as the geographic area in which you use your mark.

For example, if Roger started a plumbing business called Roger’s Parts & Plumbing in 2002 and has continuously used the name “Roger’s Parts & Plumbing” in the Denver metro area ever since, he will have likely established a legal right to “Roger’s Parts & Plumbing” under common law in the Front Range.

If, in 2017, Judy tries to start a plumbing business in Denver called “Roger’s Parts & Plumbing”, Roger could use his trademark rights to legally stop Judy from doing so.  Consumers would be confused about which “Roger’s” business is which.  Plus, the new “Roger’s Parts & Plumbing” could unfairly take advantage of the goodwill and reputation Roger has established over more than 10 years of business.  These are the very problems trademark law was designed to address.

However, if Judy starts a plumbing business called “Roger’s Parts & Plumbing” in Durango, Colorado instead of Denver, nearly 350 miles away from where Roger operates, Roger might have trouble proving that his common law rights extend that far.  Similarly, if someone starts a punk band in Denver called “Rogerzz Plumbing”, Roger would have to prove his trademark rights extend beyond the plumbing industry in order to stop the punk band from using that name to promote music and live shows.

Federal Trademark Registration

Registering your trademark, even if you have established strong common law rights to the mark, is always advised.  This allows you to provide notice to the world that you are using the mark, and affords you certain statutory rights and protections as well.

The U.S. has a two-tiered system of trademark protection:  federal and state.  A federal registration issued by the U.S. Patent & Trademark Office (USPTO) give the registrant rights through the entire United States.  A state registration will grant rights within that state’s boundaries only.

Generally, in order to file for a registration with the USTPO, the trademark’s owner first must use or plan to use the mark in “interstate commerce.”  This means the mark is used on a product or service that crosses state lines or that affects commerce crossing such lines (for example, an Internet business that caters to interstate or international customers).

At first glance, registering a mark with the USPTO appears to be a relatively simple process. It requires a completed application, a specimen, and a statutory filing fee.

However, doing some research before spending the cash on the filing fee, which can range from $250 to $375 or more depending on the type of application submitted and how many class of goods or services you want to list for your mark, is strongly recommended.  This is because all applications will be examined by a USTPO Trademark Examiner for registrability under the Lanham Act (15 U.S.C. § 1051 et seq.).

Some things CANNOT be trademarked under the Lanham Act.  You are not allowed to claim the generic name of a product or a service itself as your trademark.  Roger cannot trademark “Plumbing” or “Plumber” for his plumbing business.

You cannot register “clearly descriptive” marks, which are those made of dictionary words which describe some important characteristic of your product or service (e.g., “Delicious Apples” if you have an apple orchard business).  You also cannot register “deceptively misdescriptive” marks (e.g., “Leather Shoes” for shoes that aren’t actually made of leather).

However, “suggestive” marks only give some vague idea about the products and services covered by the trademark, and are registrable.  Sometimes the boundary between unregistrable clearly descriptive marks and registrable suggestive marks isn’t very clear. This can result in long disputes between applicants and the USPTO.

There are many other rules for what is allowed for registration under this Act, and if your application is rejected, you do not get a refund of your application fees.  As such, consulting with a trademark attorney is advised before you begin the federal registration process.

If the Trademark Examiner determines your mark can be registered, it is then published in the USPTO Gazette, and if it is not challenged within 30 days of publishing, it will be registered. The total process can take 1 year at a minimum.  After registration, you can use the symbol ® after your mark to show it has been federally registered.

Colorado Trademark Registration

Trademark registration under Colorado law[1] is easier, faster and cheaper than federal trademark registration.  It is used to protect a trademark within the state.

A Colorado trademark registration allows for a standard character mark (expressed in ordinary English letters, Roman and Arabic numbers, or punctuation, without any stylization) and a special form trademark (logos, pictures, design elements, color or style of lettering).[2]

To file a Colorado trademark registration, you submit a Statement of Registration of Trademark electronically at the Colorado Secretary of State’s website with an attachment of your mark and the goods/services category your mark will be used in.  The current filing fee is $30.

Unlike the USPTO, there is no examiner who is going to look at your application to make sure you have completed it correctly and that the mark is appropriate for registration under state law.  Instead, when you file your application, you certify that in your good faith belief, you have the right to use the trademark in connection with the goods or services listed your application, and

your use does not infringe the rights of any other person in that trademark.

Colorado trademark registrations are effective for 5 years and may be renewed before expiration in successive 5-year terms.[3]  (Prior to May 29, 2007 however, Colorado trademarks were effective and renewed for 10 years.[4])

Obtaining a Colorado trademark registration does not authorize the use of the federal registration symbol ®.[5]  However you can use “TM” or “SM” (for a service mark) after your mark.

If you are interested in speaking with one of our attorneys about registering your trademark or stopping someone else from using your mark, give us a call.

[1] Section 7-70-101, et seq., C.R.S.

[2] Section 7-70-102(2)(f), (g), C.R.S.

[3] Sections 7-70-104(1)-(2), C.R.S.

[4] Section 7-70-109, C.R.S.

[5] Section 7-70-103(4), C.R.S.

B Corps vs. Benefit Corporations: What Are They & What’s the Difference?

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As socially conscious entrepreneurship becomes more visible and viable, you may keep hearing the terms “B Corp” and “Benefit Corporation” or “Public Benefit Corporation.”  What do these terms mean and how are they relevant to a Colorado small business owner?

Many use the terms “B Corp” and “Benefit Corporation” interchangeably, but they are in fact very different things!

B Corps

A B Corp is a for-profit entity that has obtained a voluntarily certification from a certain nonprofit organization headquartered in Wayne, Pennsylvania, called B Lab.

As of the date of this posting, there are 1,925 certified B Corps in 50 different countries spanning 130 different industries.  Some nationally-recognized Colorado B Corps include New Belgium Brewing Co. and Bhakti Chai.

Obtaining a B Corp certification requires passing the B Lab Impact Assessment, which analyzes a company’s operations and provides a score based on meeting higher standards of transparency, accountability, performance and impact on the community.  Passing the assessment test requires a score of at least 80 out of 200 points.  There are many workshops and boot camps available in the Front Range area for business owners looking to hit the Impact Assessment’s various benchmarks.  After passing the assessment, B Corps must pay a membership fee based on annual revenues.

Obtaining B Corp certification allows a business to join a community dedicated to creating a more just and conscious economy yet still driven by profit motives.  B Corps organize various gatherings around the world, including an annual retreat, and such events provide opportunities to network and support other like-minded business owners.

Benefit Corporations

A Benefit Corporation is a type of business entity (i.e., a special kind of corporation) that is authorized by state law.  As of the date of this posting, 31 states  – including, as of April 4, 2014, Colorado – have recently enacted legislation to allow for these entities.   This legislation allows socially conscious entrepreneurs another entity option when starting a business.

The Benefit Corporation movement, largely spearheaded by B Lab, was to fix what many saw to be a major limitation in standard corporate law.

As you may know, the business and affairs of any for-profit corporation must be managed by a board of directors.  Traditionally, the individuals on the board of directors have a legal duty to manage the affairs of the corporation in the company’s best interest.  If they do not follow this duty, they could be liable to the corporation’s shareholders for breach of their duties.

So…what does “in the company’s best interest” actually mean?  Some perceived it to mean only the maximization of shareholder value.  This would severely limit the goals and the general ethos of the socially-conscious business/B Corp assessment movement.  If a board of directors was trying to decide between two options, with Option 1 promising high profits but harm to the environment and Option 2 resulting in lower profits but no harm to the environment, the maximization of shareholder value theory would require the board of directors to pick Option 1.

Benefit Corporation legislation has thus been enacted to address this limitation in traditional corporate law.

Beyond corporate doctrine, however, forming a business as a Benefit Corporation may be important for reasons of marketability, relaying a message to current and potential employees and customers, and signaling participation in the socially-conscious business movement.

Colorado Public Benefit Corporations

The Public Benefit Corporation Act of Colorado (“PBCA”)[1] contains the relevant provisions for those electing to operate their corporations as a Public Benefit Corporation (a “PBC”).  A Colorado PBC is a for-profit corporation that is “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”[2]

What would be considered a “public benefit”?  The PBCA defines public benefit as “one or more positive effects or reduction of negative effects on one or more categories of persons, entities, communities, or interests other than shareholders in their capacities as shareholders, including effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific, or technological nature.”[3]

A key thing to realize is that PBCs are still subject to the rules and requirements contained in the regular corporate statutes, including the Colorado Business Corporations Act and the Colorado Corporations and Associations Act.  The PBCA merely imposes “additional or different requirements, in which case such additional or different requirements apply.”[4]  The primary differences are:

  • A PBC’s Articles of Incorporation must list one or more public benefit which the company must strive to achieve.[5]
  • A PBC’s name must contain the words “public benefit corporation” or the abbreviation “PBC” or “P.B.C.”[6]
  • A PBC’s board of directors must manage the company to balance (1) the pecuniary interest of the shareholders; (2) the best interest of those affected by the company’s conduct, and (3) the public benefit(s) listed in the Articles of Incorporation.[7]
  • A PBC must prepare an annual benefit report with (1) a description of how the company promoted the benefits listed in the Articles of Incorporation and any obstacles the company faced in promoting those public benefits and (2) an assessment of the overall social and environmental performance of the company against a third-party standard.[8] This annual report must be provided to each shareholder of the PBC and posted on its website.[9]
  • Any share certificates of the PBC must consciously state the company is a public benefit corporation.[10]

A PBC is formed the same was a traditional Colorado corporation would be formed – by filing Articles of Incorporation with the Colorado Secretary of State.  Thereafter, all other documentation used to organize a PBC is extremely similar as what is used to organize a traditional Colorado corporation.

The PBCA specifically protects directors of a PBC from lawsuits by third parties who are interested in the public benefits listed in the Articles of Incorporation and by people who may be affected by the PBC’s conduct.[11]

This section is meant to be a general summary of the PBCA and if you are thinking of creating such an entity or converting your current corporation to a PBC, consulting with an attorney is strongly advised.


[1] Section 7-101-501 et cet., C.R.S. Added by Laws 2013, Ch. 230, § 1, eff. April 1, 2014.

[2] Section 7-101-503(1), C.R.S.

[3] Section 7-101-503(2), C.R.S.

[4] Section 7-101-502, C.R.S.

[5] Section 7-101-503(1)(a)-(b), C.R.S.

[6] Section 7-101-503(4), C.R.S.

[7] Section 7-101-506(1), C.R.S.

[8] Section 7-101-507(1)(a)-(b), C.R.S.

[9] Section 7-101-507(4), C.R.S.

[10] Section 7-101-505, C.R.S.

[11] Section 7-101-506(2), C.R.S.

Artists and the Hobby Loss Rule

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Individuals who are engaged in creative pursuits often maintain other employment to supplement their income.  For example, a painter might work full-time as an art teacher or college professor, or may moonlight as a theater stagehand.  Many artists also slog away in professions completely unrelated to their creative endeavors.  Nevertheless, they may devote evenings, weekends and summers to making, promoting and selling their art, thus running a business enterprise apart from their “day job.”

However, these individuals may find themselves owing thousands of dollars to the IRS should their creative business pursuits be classified as merely a “hobby.”

This happened to Susan Crile, a painter and multimedia arts whose works have been displayed in top museums like the Metropolitan Museum of Art and the Guggenheim.  Susan’s art business came into question with the IRS because she is also a tenured professor of studio art at Hunter College.  

Since well before obtaining her teaching position, Susan devoted a substantial amount of time and money earning a living primarily as an artist.  In addition to the costs of supplies and studio space, it took a great deal of promotional efforts to have her pieces noticed by curators and art dealers and to be displayed all over the world.  Through such efforts over 40-plus years, Susan was able sell 356 works to art collectors and buyers, including a number of large corporations like AT&T, Exxon-Mobile, Bank of America and Charles Schwaab.  These successes sustained her business to some degree, but not enough to provide for Susan’s living expenses entirely.  Her teaching career filled that need, but as a dedicated artist, she has always continued to put in the time at her business.

Like countless artists before her, Susan wrote off expenses related to her making and selling art on her personal income tax returns.  Such expenses included supplies, travel, the costs of reaching out and maintaining communications with galleries and collectors, and hiring assistants to help with social media.

Unfortunately, in 2010 the IRS accused Susan of underpaying her taxes by more than $81,000 from 2004 to 2009 because it claimed her efforts as an artist were not a separate profession or business, and not something she intended to make money from, but something she did as part of her job at Hunter.  

To make this argument, the IRS invoked a set of tax code provisions often called the “Hobby Loss Rule.”  Under Section 162 of the Internal Revenue Code, a taxpayer is allowed deduct all of the ordinary and necessary expenses of carrying on a “trade or business.”  However, the taxpayer must show that he or she is engaged in the activity with an actual and honest objective of making a profit.  If an activity is not engaged in for profit, it is a “hobby” under the meaning of Section 183.  

The kicker of the Hobby Loss Rule is actually when a taxpayer loses money.  Taxpayers can deduct expenses of a “trade or business” in excess of earnings, thus allowing them to claim a net loss.  A “hobby” may only deduct its expenses to the extent of the profits of the activity, and cannot generate a net loss.  In other words, net losses from a hobby may not be used to offset income from other sources, like a professor’s salary, but net losses from a trade or business can.  

Susan’s 2004 through 2009 tax returns reported earnings from sales of her artworks on her Schedule C, but also reported a number of expenses that ultimately resulted in large overall losses for her art business, which she then used to offset other income.

When the IRS looks at whether a taxpayer’s enterprises is a “trade or business” or a “hobby,” a number of factors are considered:

  1. The manner in which activities were carried on;
  2. The expertise of taxpayer or her advisers;
  3. The time and effort the taxpayer expended on the activities;
  4. The expectation that assets may appreciate in value;
  5. The taxpayer’s success in carrying on other similar or dissimilar activities;
  6. The taxpayer’s history of income or loss; and
  7. The taxpayer’s personal motives.

Accordingly, Susan’s attorney stated that her goal was to show the tax court that “art is not a business like other businesses.” During trial, she called a number of art industry experts, including the dean of the Yale School of Art, Robert Storr, and a 40-year curator, gallery director, and art dealer, Renato Danese.  

These experts explained that an art career, and the prices for which an artist can sell his or her work, can be highly volatile.  They explained it is not uncommon for artists to make no money for years at a time, and so it is reasonable for artists to have other jobs or careers apart from their own art businesses.   

In October 2014, the Tax Court Judge finally made a determination, and it was hailed as a victory to artists everywhere.  Judge Albert G. Lauber held that Susan had met her burden of proving that her activities as an artist carried her actual and honest objective of making a profit, and therefore under tax law, should be considered a professional artist entitled to report her full losses on her Schedule Cs.

Despite Susan’s success, artists and creators are wise to still be wary when it comes to the Hobby Loss Rule.  Under Sections 162 and 163, there remains a fuzzy line between a hobby and a business venture, especially when taking all the 7 factors outlined above into consideration of a particular creative industry.  A tax advisor or attorney familiar with these nuances can help you distinguish between the two and ensure you are compliant with tax laws.  If the IRS initially disagrees, a tax professional can also help you work with the IRS to support and substantiate your positions.

Playing Music at Your Small Business under Copyright Law

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Today, music is cheap, easy, and everywhere.  

Sound recordings can be instantaneously accessed via terrestrial, Internet or satellite radio, YouTube, online streaming, or downloading.  Nearly all of us carry around a mobile device that gives us access, whenever we desire, to vast catalogs of recordings. We play our music in the car, at home, and at work, and when we go out, it’s played for us at coffee shops, bars, gyms, stores and restaurants.

Perhaps because music has become so ubiquitous, many have a hard time understanding when and why anyone would have to actually pay for it.

Public Performance Licenses

A growing number of small businesses and nonprofits are thus unpleasantly surprised when they receive a letter, phone call, or even a personal visit from a performing rights organization (“PRO”) agent warning that they are playing music without the proper license and are thus participating in copyright infringement.  

These business owners may be hostile to the idea of paying for something that they perceive to be free or to already own. Music sales among American record labels have plummeted since the early 2000s and in 2008, 40 billion songs were downloaded illegally.  It is also estimated that 95 percent of music tracks are downloaded without payment to the artist or music company that produced them.  

Nevertheless, under U.S. copyright law, owners of copyrights in sounds recordings have the exclusive right to reproduce, adapt, distribute and publicly perform the recordings.  This means that under the law, purchasing a copy of a sound recording, whether an entire album or downloading one digital track from iTunes, does not permit the purchaser to further reproduce, distribute or perform the recording in public.  

Performing Rights Organizations

PROs are responsible for licensing the music of the songwriters and music publishers they represent, collecting royalties whenever that music is played in a public setting, and distributing quarterly royalty checks to the copyright holders of their catalogs.  

There are three PROs in the U.S.:  (1) the American Society of Composers, Authors and Publishers (ASCAP); (2) the Broadcast Music, Inc. (BMI); and (3) Society of European Stage Authors and Composers (SESAC).   A copyright holder can only sign up with one of the three PROs, which means each PRO holds rights to completely different catalogs of musical works.

PROs spend much of their time negotiating with television and radio broadcasters and large entertainment companies who operate stadiums, clubs and theaters.  However, a not-insignificant amount of time is also spent educating small business owners all across the country that they are legally required to pay for the music they use.  

Today, researching small businesses has never been easier for PROs thanks to the Internet.  PRO agents watch for small businesses who advertise live music, karaoke or dancing, but under the law, any business that plays music is likely responsible for paying PRO licensing fees, including grocery stores, hair salons, sports venues, retirements homes, and funeral parlors.  

Although “education” is the key word as far as how PROs view their work with small businesses, individuals who get a visit or phone call may remain resistant to the idea of paying fees to play music.  Some small business may find PRO’s license fees to be cost-prohibitive.  However, many simply believe that playing music is free or that we should be able to do whatever we want with the music we already own.  

As an example of such resistance, the owner of Roscoe’s House of Chicken and Waffles ignored ASCAP for seven years before they finally sued him for copyright infringement The 9th Circuit Court of Appeals eventually found Herbert Hudson and his corporation liable for nearly $200,000 in damages and attorney’s fees for playing eight unlicensed songs that were held by ASCAP!

This risk of lawsuit is real.  ASCAP files between 250 and 300 copyright infringement lawsuits annually and BMI files between 100 and 200 lawsuits annually.  

Do I Need a License?

Any store or other small business playing musical recordings through a playback device or radio receiver is engaged in a performance under the Copyright Act.  Those who “participate in, or are responsible for, performances of music are legally responsible” for obtaining permission from music copyright holders.  The law applies very broadly, so it is safer to assume you do need a license than don’t!

If a PRO is bringing a charge of copyright infringement against a business owner, generally there are two defenses:

  1.   Section 110(5) Exemption (the “Homestyle Exemption”)

The Copyright Act provides an exemption for the reception of radio or television broadcasts in an establishment open to the public for business.  This means a business can switch on the radio or TV and play broadcasted music performances without paying for a license.  This exemption does have more nuanced rules that consider gross square footage, number of loudspeakers, number of devices, etc., and does not explicitly include Internet radio or streaming serves like Pandora.

  1.   No “Public Performance”

Under current copyright law, a “public performance” occurs when music is played “in a place open to the public or at any place where a substantial number of persons outside of a normal circle of a family and its social acquaintances is gathered.”  

This means that playing music from a purchased CD at your 500-attendee family reunion is not a public performance, but playing the CD for just 2 patrons sitting in your bar on a Wednesday afternoon is.  Courts have ruled public performance occurs even where the customers are not directly charged for listening to the music.  Gray areas are “semi-public” places such as factories or condominium common rooms.  The legislative history of the 1976 Copyright Act makes it clear “semi-public” performances are to be treated as “public performances” under the statute, but this language did not actually make its way into the final law.  

As such, arguably music being placed for relatively-small work staff, say, the kitchen employees at a restaurant, that is not distinguishable to customers is likely not a public performance.

How to Avoid Copyright Violations for Playing Music

  1. Play music broadcasted from radio or television only.

As stated above, this could fall under the Homestyle Exemption, but care must be taken that your performance falls within the boundaries of the exemption rules.  If your location is more than 3,750 square feet for a food or drinking establishment or 2,000 feet for any other type of business, you may be subject to additional rules that impact whether you need a license or not.

  1. Pay the annual PRO fees.

Licenses can range from $200-$500 up to $8,000 annually, depending on the type and size of business, how many speakers or playback devices are in the establishment, and the prominence of the music to business operations.  Again, because there are three different PROs, businesses must either obtain three separate licenses or be carefully selective of the music played to ensure only one PRO’s catalog is used.

  1. Use music licensed from the Creative Commons.

Music publically performed from the Creative Commons typically still requires a license, but costs significantly less than the PRO fees.  However, music under this license includes primarily less well-known songs from independent and emerging artists.

  1. Play only original content.

A business can host live bands and musicians, but generally the performers must be instructed that they cannot play cover songs unless the performer has already formally obtained permission from the original songwriter to play it.  

A business owner can also write his or her own original compositions to be played at the establishment.

  1. Enroll with a music service provider.

Music services providers like PlayNetwork or SiriusXM for Business do the dirty work.  They charge service fees that include the public performance licenses from all the necessary PROs.

Have you received a letter from ASCAP, BMI or SESAC?  Are you opening a new business and need help navigating the licensing process or rules?  Contact the Law Offices of Daniel T. Goodwin today to speak with an attorney.

Creative Entrepreneurship

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The stereotype of the starving artist, one who endures a life of poverty for a labor of love, is a common cultural conception. Indeed, many creative individuals ultimately choose to forgo any professional pursuit of their creative endeavors because of a perceived uphill battle of “making a living” in the arts.

However, today a growing “do-it-yourself” mindset is allowing artists, designers, engineers, architects, and other creators to invent jobs for themselves that didn’t exist a decade ago.  More now than ever, business- and technology-savvy individuals are branding, marketing and networking their way into successful creative careers.

Creative Industry Companies

Brian De Herrera-Schnering is the founder of Colorado-based video production company, Pinto Pictures.  Prior to moving to Colorado in 2007, he was employed full-time as a video editor at a company that produced healthcare education films, but was unable to find similar full-time work upon relocating to Colorado.  Nevertheless, upon establishing his own business he found Denver housed a robust, collaborative community of film, animation, and video design professionals, and his business has thrived ever since.  His company now specializes in a wide range of film-based projects and has worked with a number of local companies and nonprofits in Colorado, as well as national major entertainment brands like Discovery Channel, TLC, Root Sports, and Dish Network.

Another success story is LA-based entrepreneur KamranV, who has mashed technology, marketing and music to build a diverse creative industries company called CyKiK.  CyKiK has successfully undertaken a wide range of creative business endeavors, including developing Interscope Records’ mobile business; designing POP-AUT, a payment system for music, games art and other creative projects; producing DVD-Audio projects for artists like Beck and Nine Inch Nails, and taking over the production of Moogfest.  KamranV is also one of the founders of Bedrock.LA, a converted manufacturing building that houses music rehearsal and showcase rooms, recording studios, and an equipment rental and repair shop.

As these two examples show, there are many opportunities to thrive as a creative entrepreneur, whether pursuing film, music or technology and a mash-up of multiple mediums.

Career Entrepreneurship

The emergence of the “creative entrepreneurship” movement has been fueled by several factors.  By far the biggest is the emergence of technologies that unbundled creators from the traditional hold of studios, book publishers, concert promoters, record companies and museums.   Artists today have the ability to distribute and make money from their works in ways that were never available to prior generations.

New, web-based technologies have also generated innovative ways of project collaboration.  One clear example of this is crowdfunding.  Sites like KickStarter and IndieGogo have made the process of raising capital significantly easier for artists and startups.

Finally, the national economic slump that began in 2009 led to a lack of good-paying employment opportunities for millions of young people and recent college grads, and also resulted in layoffs for other workers who had been working their way up the traditional career ladder.  A number of these individuals realized they could no longer rely on an employer or a large established company to train and mentor them towards their dream career.  

 Business Planning and Awareness of Legal Issues

Today, designers, artists and creators mix artistic expression with business skills in order to thrive and sustain their endeavors. These individuals recognize they can utilize new resources and platforms to form their own businesses that contribute to media, arts and culture.  However, there are many legal pitfalls that could take a fledgling creative-industries business owner by surprise. 

One of these is the unfortunate receipt of a Cease and Desist Letter for either trademark or copyright infringement.  When forming a new business, people may spend a lot of time and energy coming up with a great brand name, designing a great new logo, and planning an interactive website, only to learn, after a large investment has already been made, that the name is being used by another company.  This happened to Judith Mendez, an entertainer who went by the name Dita de Leon.  Ms. Mendez decided to expand her business by offering jewelry, clothing and leather goods featuring her stage name “Dita”, but was sued for trademark infringement by luxury sunglasses brand, Dita, Inc.

Another pitfall for new businesses is improper business planning or the incorrect reporting or calculation of taxes.  This topic certainly isn’t very exciting or sexy, but extremely important.  For example, running a business a certain way, especially if there are two or more owners, or misunderstanding the filing and deposit requirements from having employees can have huge financial repercussions.  Even if you acknowledge your mistake to the taxing authorities and try to work something out to resolve it, the impacts of not knowing the intricacies or administrative rules of the tax system can be devastating and shutter an emerging business altogether.

Do you need help starting a new creative business or dealing with a tax problem under your current enterprise?  Contact us today to schedule a consultation with an attorney.