Archive for September, 2010

Licenses 2, Sales 0 in Eminem and Autodesk 9th Circuit Rulings

Wednesday, September 22nd, 2010

The growing popularity of licensing as a strategic business and legal tool is likely to grow even greater as a result of a pair of cases decided one week apart in the federal Ninth Circuit Court of Appeals that broadened the scope of and increased the powers of licenses.

The first Ninth Circuit decision, F.B.T. Productions vs. Aftermath Records, involved a dispute between rap artist Eminem and his record label Aftermath about whether Aftermath’s provision of Eminem’s songs to iTunes was a “sale” or “license” for purposes of a contract drafted in the pre-digital age. The difference was significant, because the agreement provided that the label would pay Eminem royalties of between 12% and 20% of the adjusted retail price of all “full price records sold in the United States… through normal retail channels,” but would pay 50% of its net receipts “[o]n Masters licensed by us… to others for the manufacture and sale of records or for any other uses.” The agreement was signed in 1998, before iTunes was established, and did not further define either “sale” or “license.”

The record label argued among other things that the custom in the recording industry was that the “masters licensed” provision applied only to “compilation records and incorporation into movies, TV shows, and commercials,” and furthermore, that the iTunes download was functionally no different than a purchase of a vinyl record or CD at a record store.

The court rejected that argument, and held that under copyright law, a license is, “an authorization by the copyright owner to enable another party to engage in behavior that would otherwise be the exclusive right of the copyright owner, but without transferring title in those rights.” Because the record label retained ownership of the copyrights for the Eminem songs as well as title to the digital music files that it made available to iTunes in exchange for periodic payments based on the volume of downloads, the transaction was a license, and the higher 50% royalty rate applied.

One week later, in the case of Vernor vs. Autodesk, Inc., the court ruled that most written license agreements will preserve the licensor’s right to prohibit resales not only under the license agreement, but also under the Copyright Act. There the issue was whether Timothy Vernor could sell on eBay outdated copies of Autodesk’s AutoCAD software for a few hundred dollars that normally sell for several thousand dollars per copy when new.

Copyright law confers several exclusive rights on copyright owners, including the exclusive right to reproduce their works and to distribute their works by sale or rental. An important exception to this exclusive right is the so-called “first sale doctrine” codified at Section 109 of the Copyright Act, which says that the, “owner of a particular copy or phonorecord… is entitled without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy or phonorecord.” So for example if a publisher sells a book to a bookstore, the bookstore is free to resell it to anyone, and the purchaser is in turn free to sell the same book to anyone on eBay.

Vernor had purchased the AutoCAD software from an architectural firm that had licensed it from Autodesk. The AutoCAD license agreement contained standard provisions prohibiting transfer to or use by any party other than the original licensee, however, it did not require the licensee to return old installation disks. Vernor argued that under prior case law in the Ninth Circuit, since the license did not require the architectural firm to return its copies of the install discs, the firm was an “owner of a particular copy,” which kicked in the first sale doctrine which exempted the firm and any of its purchasers from a copyright infringement claim arising out of resale of the discs. Although the architectural firm had violated its license agreement by reselling the discs, Vernor argued that he had not, because he had neither installed the software nor agreed to any online license agreement before the eBay sales.

After an extensive review of prior case law the appeals court disagreed with Vernor, and held that a software user is a licensee rather than an “owner of a copy” where the copyright owner: 1) specifies that the user is granted a license; 2) significantly restricts the user’s ability to transfer software; and 3) imposes notable use restrictions. Like most well-drafted software license agreements, the Autodesk agreement passed with flying colors, despite the absence of a requirement to return old install discs. Thus, because the architectural firm was a licensee, not an “owner,” then the first sale doctrine did not apply, and Vernor had infringed Autodesk’s exclusive distribution rights in violation of copyright law.

Takeaway: the Eminem case is not expected to have much of a practical impact on the recording industry, because since the time of that agreement, almost all record label agreements deem that provision of songs to iTunes will be treated as a “sale” at a 12% to 25% royalty rate. But when the nature of a copyright transaction is unclear, the Ninth Circuit will presume it is a license rather than a sale where the copyright owner retains control of the copyright, retains title to the media on which the content is delivered (CD, mp3 file, etc.), and receives periodic payments after the original transaction. Vernor says that when a standard license agreement is in place during the original transaction, the copyright owner can use both the license agreement and copyright law to prohibit later resale or disposition of the content. This will encourage copyright owners to cast transactions as licenses rather than sales, and with the proliferation of digital content that can be made easily subject to clickwrap license agreements even after the original point of sale, they will likely succeed in their efforts. So the purchaser of a hard copy of The Girl With the Dragon Tattoo will be able to resell it, because she (and the bookstore before her) took title to the media (book) on which the content was delivered. But she might not be able to resell her e-book version, if she purchases it subject to a standard license agreement at the time of download. One practical effect is that copyright owners will now be able to easily assert that resale of software, digital games, and many other kinds of digital content is a copyright infringement. Please note that these rulings only apply in the Ninth Circuit (California, Oregon, Washington, Nevada, Arizona, Idaho, Montana, Alaska, Hawaii, and Guam), and that other circuits may not follow them.

Which Is Better for My Startup, C Corporation or LLC?

Monday, September 13th, 2010

Photo Courtesy NASA’s Marshall Space Flight Center

Startup clients frequently ask– which is the better business entity, a C corporation or a limited liability company (LLC)?

Before answering that question, let’s quickly review the basic differences between C corporations and LLCs. (For more detailed treatment, see here.)

In a corporation, control is held by the shareholders, but they frequently delegate most major decisions to the board of directors and day-to-day control to the officers. The corporate entity shields shareholders from the corporation’s liability and income. But if the corporation’s income is distributed to the shareholders, for example as dividends, the income is effectively taxed twice, once at the corporate level, once at the shareholder level. The corporate entity is especially advantageous for allowing changes in ownership– in the absence of special provisions such as shareholder agreements, existing shareholders can buy and sell stock without restriction to new shareholders.

Pros

  • More “professional” image
  • More attractive to venture capital funding and more flexible for granting options and other incentive compensation
  • Easier to take public

Cons

  • More formalities such as required shareholder and directors meetings, capital maintenance, etc.
  • Income to shareholders is taxed twice

The LLC is a relatively recent creation, within the last 25 years in most states. It is based on the partnership model, where partners share all control, income, and liability personally. Like partners, LLC “members” share control and income, but like corporate shareholders, members are shielded from liability for the acts of the LLC. LLC income is taxed only once, but all profits (and losses as well) are attributed to the members, even if the LLC retains it and does not distribute it to the members, as frequently occurs in the startup stage. (Note that an LLC can make an election with the IRS to be taxed like a corporation, while a corporation can make an election with the IRS to be taxed like a partnership, as a so-called S corporation.) However, as with a partnership, an LLC does not easily release old members or admit new members– the default rule is that normally at least a majority of existing members must approve any change in membership.

Pros

  • Inexpensive and easy to set up and maintain
  • Income to members only taxed once (but all of it is taxed, even if not distributed)

Cons

  • More difficult for old members to leave, and new members to join (may be a pro for some startups)
  • Disfavored by venture capitalists and incentive recipients
  • Must be converted to a C corporation to take public

Bottom Line: if VC funding and/or publicly listed stock is part of your business plan, then a C corporation is your best startup entity. In almost all other cases, an LLC is cheaper, easier, and lower maintenance, but be sure to address your exit strategy, both for individual members and the company as a whole, in your LLC documents at the startup stage. To help you make the correct choice, please consult a knowledgeable business attorney and/or accountant.

Trademark Licensees Catch a Tax Break

Thursday, September 2nd, 2010

The federal Second Circuit Court of Appeals has ruled that trademark licensees can in certain circumstances immediately deduct royalty payments as current expenses, rather than capitalizing and deducting them over time.

Overruling both the IRS and the United States Tax Court, the Second Circuit ruled in Robinson Knife Manufacturing Company, Inc. vs. IRS that where the royalty payments: 1) are calculated as a percentage of sales revenue from inventory, and 2) are incurred only upon the sale of that inventory, such payments are immediately deductible.

Robinson Knife designs, manufactures, and markets kitchen tools such as spoons, soup ladles, spatulas, and cooking thermometers, and sells them to retail customers such as Wal-Mart and Target. Sometimes it sells the products under the store brand. In this case, Robinson Knife sold the goods under the Pyrex and Oneida trademarks, which it licensed from Corning and Oneida respectively. Both license agreements required payment of royalties as a percentage of sales revenue only on sale to the retailers, with no royalty advance payments or minimum guaranteed royalties.

IRS rules under Section 263A of the Internal Revenue Code require the capitalization of, “all direct costs and certain indirect costs properly allocable to property produced,” and include, “licensing and franchise costs” as examples of indirect costs, “that must be capitalized to the extent they are properly allocable to property produced.” Examples of indirect costs not allocable to property produced include, “marketing, selling, advertising, and distribution costs.”

Robinson Knife argued that because the famous trademarks were intended to boost sales of their products, the royalties were in the nature of advertising expenses and thus currently deductible. It was overruled by both the IRS and the Tax Court, which ruled that the royalty expenses must be capitalized under complex inventory accounting rules and deducted over time.

But the Second Circuit ultimately agreed with Robinson Knife, on the grounds that the obligation to pay royalties was not incurred unless and until a sale was made, thus royalties were not incurred by reason of production activities, and did not directly benefit such activities.

This is an important victory for licensees, but its scope is unclear. It remains to be seen whether: 1) the IRS follows this ruling outside of the Second Circuit (New York, Connecticut, and Vermont); and 2) it applies as well to royalties paid on copyright, patent, and other intellectual property licenses. Logically it should, because the ruling was based on the timing of the royalty payments, not on the nature of the intellectual property.

Takeaway: trademark licensees based in New York, Connecticut, or Vermont that pay royalties as a percentage of sales revenue of goods only upon sale of those goods can immediately deduct the royalties as current expenses. It remains to be seen whether the IRS allows analogous treatment for licensees based in other states, as well as licensees of patents, copyrights, and other intellectual property.