Category Archives: Crowdfunding Laws

The New 20% Deduction in Crowdfunding Transactions

Taxes and Income - iStock-172441475 - small.jpg

Co-Authored By: Steve Poulathas & Mark Roderick

The new tax law added section 199A to the Internal Revenue Code, providing for a 20% deduction against some kinds of business income. Section 199A immediately assumes a place among the most complicated provisions in the Code, which is saying something.

I’m going to summarize just one piece of section 199A: how the deduction works for income recognized through a limited liability company or other pass-through entity. That means I’m not going to talk about lots of important things, including:

  • Dividends from REITS
  • Income from service businesses
  • Dividends from certain publicly-traded partnerships
  • Dividends from certain cooperatives
  • Non-U.S. income
  • Short taxable years
  • Limitations based on net capital gains

Where the Deduction Does and Doesn’t Help

Section 199A allows a deduction against an individual investor’s share of the taxable income generated by the entity. The calculation is done on an entity-by-entity basis.

That means you can’t use a deduction from one entity against income from a different entity. It also means that the deduction is valuable only if the entity itself is generating taxable income.

That’s important because most Crowdfunding investments and ICOs, whether for real estate projects or startups, don’t generate taxable income. Most real estate projects produce losses in the early years because of depreciation deductions, while most startups generate losses in the early years because, well, because they’re startups.

The section 199A deduction also doesn’t apply to income from capital gains, interest income, or dividends income. It applies only to ordinary business income, including rental income*. Thus, when the real estate project is sold or the startup achieves its exit, section 199A doesn’t provide any relief.

Finally, the deduction is available only to individuals and other pass-through entities, not to C corporations.

*Earlier drafts of section 199A didn’t include rental income. At the last minute rental income was included and Senator Bob Corker, who happens to own a lot of rental property, switched his vote from No to Yes. Go figure.

The Calculation

General Rule

The general rule is that the investor is entitled to deduct 20% of his income from the pass-through entity. Simple.

Deduction Limits

Alas, the 20% deduction is subject to limitations, which I refer to as the Deduction Limits. Specifically, the investor’s nominal 20% deduction cannot exceed the greater of:

  • The investor’s share of 50% of the wages paid by the entity; or
  • The sum of:
    • The investor’s share of 25% of the wages paid by the entity; plus
    • The investor’s share of 2.5% of the cost of the entity’s depreciable property.

Each of those clauses is subject to special rules and defined terms. For purposes of this summary, I’ll point out three things:

  • The term “wages” means W-2 wages, to employees. It doesn’t include amounts paid to independent contractors and reported on a Form 1099.
  • The cost of the entity’s depreciable property means just that: the cost of the property, not its tax basis, which is reduced by depreciation deductions.
  • Land is not depreciable property.
  • Once an asset reaches the end of its depreciable useful life or 10 years, whichever is later, you stop counting it. That means the “regular” useful life, not the accelerated life used to actually depreciate it.

Exception Based on Income

The nominal deduction and the Deduction Limits are not the end of the story.

If the investor’s personal taxable income is less than $157,500 ($315,000 for a married couple filing a joint return), then the Deduction Limits don’t apply and he can just deduct the flat 20%. And if his personal taxable income is less than $207,500 ($415,000 on a joint return) then the Deduction Limits are, in effect, phased out, depending on where in the spectrum his taxable income falls.

Those dollar limits are indexed for inflation.

ABC, LLC and XYZ, LLC

Bill Smith owns equity interests in two limited liability companies: a 3% interest in ABC, LLC; and a 2% interest in XYZ, LLC. Both generate taxable income. Bill’s share of the taxable income of ABC is $100 and his share of the taxable income of XYZ is $150.

ABC owns an older apartment building, while XYZ owns a string of restaurants.

Like most real estate companies, ABC doesn’t pay any wages as such. Instead, it pays a related management company, Manager, LLC, $500 per year as an independent contractor. All of its personal property has been fully depreciated. Its depreciable real estate, including all the additions and renovations over the years, cost $20,000.

Restaurants pay lots of wages but don’t have much in the way of depreciable assets (I’m assuming XYZ leases its premises). XYZ paid $3,000 of wages and has $1,000 of depreciable assets, but half those assets are older than 10 years and beyond their depreciable useful life, leaving only $500.

Bill and his wife file a joint return and have taxable income of $365,000.

Bill’s Deductions

Calculation With Deduction Limits

Bill’s income from ABC was $100, so his maximum possible deduction is $20. The Deduction Limit is the greater of:

  • 3% of 50% of $0 = $0

OR

  • The sum of:
    • 3% of 25% of $0 = 0; plus
    • 3% of 2.5% of $20,000 = $15 = $15

Thus, ignoring his personal taxable income for the moment, Bill may deduct $15, not $20, against his $100 of income from ABC.

NOTE: If ABC ditches the management agreement and pays its own employees directly, it increases Bill’s deduction by 3% of 25% of $500, or $3.75.

Bill’s income from XYZ was $150, so his maximum possible deduction is $30. The Deduction Limit is the greater of:

  • 2% of 50% of $3,000 = $30

OR

  • The sum of:
    • 2% of 25% of $3,000 = 15; plus
    • 2% of 2.5% of $500 = $0.25 = $15.25

Thus, even ignoring his personal taxable income, Bill may deduct the whole $30 against his $150 of income from XYZ.

Calculation Based on Personal Taxable Income

Bill’s personal taxable income doesn’t affect the calculation for XYZ, because he was allowed the full 20% deduction even taking the Deduction Limits into account.

For ABC, Bill’s nominal 20% deduction was $20, but under the Deduction Limits it was reduced by $5, to $15.

If Bill and his wife had taxable income of $315,000 or less, they could ignore the Deduction Limits entirely and deduct the full $20. If they had taxable income of $415,000 or more, they would be limited to the $15. Because their taxable income is $365,000, halfway between $315,000 and $415,000, they are subject, in effect, to half the Deduction Limits, and can deduct $17.50 (and if their income were a quarter of the way they would be subject to a quarter of the Deduction Limits, etc.).

***

Because most real estate projects and startups generate losses in the early years, the effect of section 199A on the Crowdfunding and ICO markets might be muted. Nevertheless, I expect some changes:

  • Many real estate sponsors will at least explore doing away with management agreements in favor of employing staff on a project-by-project basis.
  • Every company anticipating taxable income should analyze whether investors will be entitled to a deduction.
  • Because lower-income investors aren’t subject to the Deduction Limits, maybe Title III offerings and Regulation A offerings to non-accredited investors become more attractive, relatively speaking.
  • I expect platforms and issuers to advertise “Eligible for 20% Deduction!” Maybe even with numbers.
  • The allocation of total cost between building and land, already important for depreciation, is now even more important, increasing employment for appraisers.
  • Now every business needs to keep track of wages and the cost of property, and report each investor’s share on Form K-1. So the cost of accounting will go up.

As for filing your tax return on a postcard? It better be a really big postcard.

Improving Legal Documents in Crowdfunding: Get Rid of the State Legends!

I see lots of offering documents like this, with pages of state “legends.” The good news is that in Crowdfunding offerings – Title II (Rule 506(c)), Title III (Regulation Crowdfunding), and Title IV (Regulation A) – you can and should get rid of them.

The legal case is pretty simple:

  • Before 1996, states were allowed to regulate private offerings. Every state allowed exemptions, but these exemptions often required legends, differing from state to state.
  • The National Securities Market Improvement Act of 1996 added section 18 to the Securities Act of 1933. Section 18 provides that no state shall “impose any conditions upon the use of. . . .any offering document that is prepared by or on behalf of the issuer. . . .” in connection with the sale of “covered securities.”
  • The securities sold under Title II, Title III, and Title IV are all “covered securities.”
  • Hence, section 18 prohibits states from imposing any conditions regarding the issuer’s offering documents, including a condition that requires the use of a state legend.

If the capitalized legends just take up space, why not include them anyway just to be safe? Take Pennsylvania’s legend as an example:

These securities have not been registered under the Pennsylvania Securities Act of 1972 in reliance upon an exemption therefrom. any sale made pursuant to such exemption is voidable by a Pennsylvania purchaser within two business days from the date of receipt by the issuer of his or her written binding contract of purchase or, in the case of a transaction in which there is not a written binding contract of purchase, within two business days after he or she makes the initial payment for the shares being offered.

If you include the Pennsylvania legend “just to be safe,” you’ve given Pennsylvania investors a right of rescission they wouldn’t have had otherwise!

Two qualifications.

First, the North American Securities Administrators Association –the trade group of state securities regulators – suggests including uniform legend on offering documents. I include this or something similar as a matter of course:

IN MAKING AN INVESTMENT DECISION INVESTORS MUST RELY ON THEIR OWN EXAMINATION OF THE COMPANY AND THE TERMS OF THE OFFERING, INCLUDING THE MERITS AND RISKS INVOLVED. THESE SECURITIES HAVE NOT BEEN RECOMMENDED BY ANY FEDERAL OR STATE SECURITIES COMMISSION OR REGULATORY AUTHORITY. FURTHERMORE, THE FOREGOING AUTHORITIES HAVE NOT CONFIRMED THE ACCURACY OR DETERMINED THE ADEQUACY OF THIS DOCUMENT. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THESE SECURITIES ARE SUBJECT TO RESTRICTIONS ON TRANSFERABILITY AND RESALE AND MAY NOT BE TRANSFERRED OR RESOLD EXCEPT AS PERMITTED UNDER THE ACT, AND THE APPLICABLE STATE SECURITIES LAWS, PURSUANT TO REGISTRATION OR EXEMPTION THEREFROM. INVESTORS SHOULD BE AWARE THAT THEY WILL BE REQUIRED TO BEAR THE FINANCIAL RISKS OF THIS INVESTMENT FOR AN INDEFINITE PERIOD OF TIME.

Second, some states, including Florida, require a legend to appear on the face of the offering document to avoid broker-dealer registration. Because Section 18 of the Securities Act doesn’t prohibit states from regulating broker-dealers, some lawyers recommend including those legends, while others believe those requirements are an improper “back door” way for states to avoid the Federal rule. I come out in the latter camp, but opinions differ.

Questions? Let me know.

Can A Crowdfunding Issuer Sell Its Own Securities?

Securities Cash  Register

Some states, including Texas, require all securities to be sold through licensed brokers. Do these state laws mean that Crowdfunding issuers can’t sell their own securities? Do they have to use a “clearing broker” instead?

For Title III the answer is easy. Securities under Title III may be offered and sold only through a licensed broker or a licensed funding portal. If you’re selling through a licensed broker then you’re complying with the state law, and section 15(i)(2)(A) of the Securities and Exchange Act of 1934 prohibits states from regulating funding portals in their businesses as such.

For Title II (Rule 506(c)) and Title IV (Regulation A), the answer is less clear. The issue is especially acute under Title IV, just because of the number of investors.

Section 18(a)(1) of Securities Act

Added to the law in 1996, section 18(a)(1) of the Securities Act of 1933 provides that:

Except as otherwise provided in this section, no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security.

Because the term “covered security” includes securities offered under Rule 506(c) and Regulation A (also Title III, for that matter), the law clearly prohibits states from requiring the registration of a Crowdfunding offering. But does it also prohibit states from regulating who sells the securities?

Here’s the statute again, with extra words removed:

No law requiring registration or qualification of securities transactions shall apply to a covered security.

A sale of a security is definitely a “securities transaction.” So here’s the question:  does a state law that requires the sale to be effected through a licensed broker amount to requiring “registration or qualification” of the sale? Many smart people conclude that it does, making any such law unenforceable. That’s why you can go online today and find issuers offering securities directly to investors, despite state laws saying otherwise.

But there’s plenty of room for doubt. When a state says that all securities must be sold through licensed brokers, maybe it’s not requiring “registration or qualification” of the transaction; maybe it’s not regulating the sale at all. Maybe, instead, the state is regulating the person making the sale. Because section 18(a)(1) of the Securities Act doesn’t prohibit states from regulating brokers, the way section 15(i)(2)(A) of the Exchange Act prohibits them from regulating funding portals, maybe these laws aren’t affected.

For good measure, I’ve read academic articles arguing that the 1996 law amending section 18(a)(1), and stripping states of their historic regulatory authority over most securities offerings, was an unconstitutional extension of the Commerce Clause of the U.S. Constitution.

What’s At Stake

If an issuer violates a state law by selling securities directly to investors, the issuer could be subject to state enforcement action, i.e., fines and penalties.

The greater risk, in my opinion, is the risk of claims from investors. If a widow in Texas loses money she might not accept her loss graciously. She (or her heirs, or the trustee in her Chapter 7 bankruptcy case) might look for a way to recoup her loss. And if she can show that the issuer violated Texas law, the court may find a right of rescission, i.e., the right to get her money back. The court might even extend that right against the principals of the issuer personally, especially if they were engaged in selling activities.

I imagine the widow on the stand, asking for recourse against the New York based issuer, backed by an amicus curiae brief filed by the Texas Board of Securities and the National Association of State Securities Administrators. Given the room for ambiguity in the statute, I’m not thrilled with my odds.

And even if you win, there’s the time and cost of defending yourself, and the sleeping-well-at-night factor, also.

What To Do

The simplest solution is to sell through a clearing broker licensed in every state.

Another solution is to sell through a clearing broker only in states that require it (I don’t have a list, but maybe a reader does and can share it).

If an issuer doesn’t want to spend the money on a clearing broker, it might decide not to sell securities in any state that requires use of a broker, although that includes some big states.

Or an issuer, guided by counsel, might reasonably decide to live with the uncertainty in the law and sell securities anyway. Just make sure your insurance would cover the widow’s claims.

__________________________________________________________________________________________

My thanks to Jillian Sidoti, Esq. and Anthony Zeoli, Esq., who provided valuable insight.

Questions? Let me know.

Crowdfunding Legal Resources

I really appreciate the time you spend on my blog. To make the blog more useful, I’ve added a Legal Links button, up there to the right. To start, you’ll find links to:

I plan to add more links in the future and welcome your suggestions.

Questions? Let me know.

Crowdfunding Is Just the Internet

red mouse with money and comment

Fortunately for me, there are a lot of complicated legal issues around Crowdfunding, including:

  • The differences among Title II, Title III, and Title IV
  • The differences between Rule 506(b) offerings and Rule 506(c) offerings
  • The differences between accredited investors and non-accredited investors
  • The Trust Indenture Act of 1939
  • The Investment Company Act of 1940
  • Applying broker-dealer and investment adviser laws to Crowdfunding portals

But at a higher level Crowdfunding isn’t complicated at all. Crowdfunding is just the Internet coming to the capital formation industry.

What happens when the Internet comes to an industry? Look at the publishing industry and the travel industry and the music industry and, increasingly, the entire retail industry:

  • Buyer and sellers connect directly
  • Middlemen are displaced
  • Prices decrease as the industry becomes more efficient
  • The middlemen being displaced are sure it won’t happen as it’s happening
  • In the end, the industry looks completely different and we all take it for granted

In Crowdfunding, the “sellers” are entrepreneurs and real estate developers seeking capital and the “buyers” are investors. The middlemen are the lawyers, bankers, finders, brokers, venture capital funds, investment advisors, and all the others who for the last 80 years have played an indispensable part in connecting entrepreneurs with investors. Today, for the first time, entrepreneurs and investors can connect directly, via the Internet. The middlemen have already started to be pushed to the side. The picture in my mind is an ice field slowly breaking apart as temperatures warm.

People sometimes ask whether Crowdfunding will last. I respond “When was the last time you planned a vacation through a bricks-and-mortar agency?” The Internet is here to stay!

The capital formation industry is enormous – far, far bigger than the book selling industry or the travel industry. And the middlemen in the capital formation industry enjoy far greater political power than Barnes & Noble. But in the end, resistance is futile.

As you’re planning and managing your own portal, or any other Crowdfunding business, pause every now and then and remember that for all the legal complexity, for all the nuts-and-bolts, day-to-day grind of generating cash flow, Crowdfunding is nothing more or less than the Internet come to the capital formation industry.

Questions? Contact Mark Roderick.

Can A Crowdfunding Portal Avoid Broker-Dealer Registration by Registering as an Investment Adviser?

No.

In early 2013 the SEC issued no-action letters concluding that FundersClub and AngelList were not required to register as broker-dealers. Both companies were “venture capital fund advisers,” a special flavor of investment adviser, and some people read into the no-action letters a cause-and-effect, concluding that if a Crowdfunding portal registers as an investment adviser, which is relatively easy, then it doesn’t have to register as a broker-dealer, which is very hard.

When the SEC issues no-action letters, it doesn’t explain its reasoning. It provides the facts and the legal conclusion and leaves it to readers to figure out what was important and wapples and orangeshat wasn’t.

It’s possible that as the SEC weighed the requests by FundersClub and AngelList, a regulator thought “This is a close call, and because they’re already regulated as investment advisers we’ll give them a pass on broker-dealer registration.” But that’s just speculation, not a legal argument. A portal operating exactly in the manner described in the no-action letters might take comfort. Others, including any real estate portal, should not.

Under the securities laws, investment advisers are one thing and broker-dealers are something complete different – different functions, different rules, different risks. If you want to give investment advice, register as an investment adviser. If you’re in the portal business and think you need a broker-dealer, then either register yourself or use a provider like WealthForge or FundAmerica.

Questions? Contact Mark Roderick.

Do the Officers of a Crowdfunding Issuer Have to Register as Broker-Dealers?

thinking woman in jarToday, the most challenging legal question in Title II Crowdfunding is who is required to be a broker-dealer and under what circumstances. The question is most acute for the officers of an issuer, those who direct the issuer’s activities and put the offerings together.

Section 3(a)(4)(A) of the Securities and Exchange Act 1934 generally defines “broker” to mean “any person engaged in the business of effecting transactions in securities for others.” Section 15(a)(1) of the Exchange Act makes it illegal for any “broker. . . .to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless registered with the SEC.

Simply put, anybody in the business of effecting securities transactions for others must be registered. There is a lot of law around what it means to be “engaged in the business of effecting securities transactions for others.” Based on decided cases and SEC announcements, important factors include:

  • The frequency of the transactions.
  • Whether the individual‘s responsibilities include structuring the transaction, identifying and soliciting potential investors, advising investors on the merits of the investment, participating in the order-taking process, and other services critical to the offering.
  • Whether the individual receives commissions or other transaction-based compensation for her efforts.

Perhaps the most important rule is that the issuer itself – the entity that actually issues the stock – does not have to register as a broker-dealer. The logic is that the issuer is effecting the transaction for itself, not for others.

But what about the President of the issuer, and the Vice President, and all the other employees who send the mailings and put the deal on the website and answer questions from prospective investors? Are they required to register as – or, more accurately, become affiliated with – broker-dealers?

The answer is complicated.

SEC Rule 3a4-1, issued under the Exchange Act, provides a “safe harbor” from registration. Under Rule 3a4-1, an employee of an issuer will not have to register if she is not compensated by commissions, and EITHER:

Her duties are limited to:

  • Preparing any written communication or delivering such communication through the mails or other means that does not involve oral solicitation of a potential purchaser, as long as the content of all such communications are approved by a partner, officer or director of the issuer; or
  • Responding to inquiries of a potential purchaser in a communication initiated by the potential purchaser, as long as her response is limited to providing information contained in an offering statement; or
  • Performing ministerial and clerical work.

OR

  • She performs substantial services other than in connection with offerings; and
  • She has not been a broker-dealer within the preceding 12 months; and
  • She does not participate in more than one offering per year, except for offerings where her duties are limited as described above.

Consider the President of the typical Title II portal offering borrower-dependent notes to accredited investors. Her duties are certainly not limited as described above, and she might participate in – actually direct – dozens of offerings per year. Does that mean she has to register as a broker-dealer?

Not necessarily. Rule 3a4-1 is only a safe harbor. If you satisfy the requirements of Rule 3a4-1 then you are automatically okay, i.e., you don’t have to register. But if you don’t satisfy the requirements of Rule 3a4-1, it doesn’t automatically mean you are required to register. Instead, it means your obligation to register will be determined under the large body of law developed by the SEC and courts over the last 80 years.

Courts and the SEC have identified these primary factors among others:

  • The duties of the employee before she became affiliated with the issuer. Was she a broker-dealer?
  • Whether she was hired for the specific purpose of participating in the offerings.
  • Whether she has substantial duties other than participating in the offerings.
  • How she is paid, and in particular whether she receives commission for raising capital.
  • Whether she intends to remain employed by the portal when the offering is finished.

Within the last couple years, a high-ranking lawyer in the SEC spoke publicly but informally about broker-dealer registration in the context of private funds, an area similar to Crowdfunding in some respects. He expressed concern at the way that some funds market interests to investors and suggested that some in-house marketing personnel might be required to register. At the same time, he suggested that an “investor relations” group within a private fund – individuals who spend some of their time soliciting investors – wouldn’t necessarily be required to register if the individuals spend the majority of their time on activities that do not involve solicitation. On one point he was quite clear: the SEC believes that if an individual receives commissions for capital raised, he or she should probably be registered.

Whether an officer or other employee of a Crowdfunding issuer must register as a broker-dealer will be highly sensitive to the facts; change the facts a little and you might get a different answer. With that caveat, I offer these general guidelines:

  • If an employee receives commissions, he has to register no matter what.
  • If an employee performs solely clerical functions, he does not have to register.
  • If an employee participates in only a handful of offerings, he does not have to register.
  • If an employee spends only a small portion of his time soliciting investors, he does not have to register.
  • If an employee advises investors on the merits of an investment, he’s walking close to the line. Describing facts, especially facts that are already available in an offering document or online, in response to an investor inquiry, doesn’t count as advising investors on the merits of an investment.

Here are two corollaries to those guidelines.

  • As long as he’s not paying himself commissions, the Founder and CEO of an issuer that is a bona fide operating company (not merely a shell to raise money) doesn’t have to register.
  • If the CEO hires Janet to solicit investors, and that’s all Janet does, and she speaks regularly with investors over the phone and helps them decide between Project A and Project B, the SEC is probably going to want Janet to be registered.

Of course, the most conservative approach for Crowdfunding issuers to run every transaction through a licensed broker-dealer. However, that adds cost and most issuers are trying to keep costs down.

This area is ripe for guidance from the SEC, and maybe even a new exemption for bona fide employees of small issuers. Stay tuned.

NOTE: I want to give a shout-out to Rich Weintraub, Esq. of Weintraub Law Group in San Diego. He and I had several very stimulating and thought-provoking conversations on this topic. If there are mistakes in the post, they’re all mine.

Questions? Contact Mark Roderick.

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