Arbitration – not boilerplate, and not necessarily quick, easy, or inexpensive!

If you have basic familiarity with contracts, you’ve likely heard the term “boilerplate,” which is often used to mean standard language that the contract writer uses in many of its contracts or even that you may find in contracts across the board.  Of course, just because language might be “standard,” that does not mean that it is innocuous or that you can safely ignore it!

So-called boilerplate language, it it exists, is often found near the end of the contract.  Some contracts stipulate that if a dispute arises from the contract the parties agree to submit the dispute to binding arbitration.  While this clause may be brief and, coming at the end of a contract, may appear almost like an afterthought, it is important to understand that agreeing to arbitrate has very real consequences.

Arbitration clauses are most often seen by consumers in credit card agreements and service agreements with large companies (e.g., “Any dispute in connection with this Agreement shall be subject to binding arbitration in Chicago, Illinois”), but they are also sometimes poorly understood features of contracts between small businesses who somehow heard from an uncle that arbitration was easier or cheaper than going to court.

In  November 2013, a long and expensive arbitration proceeding concerning a Gwinnett County software company came to a conclusion.  The process took three (3) years and cost $3.5 million in legal fees in addition to approximately $150,000 in arbitration costs.

The victors, Kenneth Shumard and Kenneth Shumard Jr. won the right to control the use of medical billing software that is anticipated to be highly valuable.  The Shumards also won $800,000 in attorneys’ fees.  Initially, the Shumards sought a restraining order from the Gwinnett County Superior Court preventing their other partners from making certain use of the software.  Judge Ronnie Batchelor referred the dispute to arbitration, because the partnership agreement between the Shumards and their partners required that disputes go to arbitration.

As such, the Shumards did not have the option to seek judicial process, but instead, were forced to go to arbitration.

Arbitration is conducted under its own standards and is a creature of state law.  In some ways arbitration resembles court proceedings.  For example, in the above-mentioned dispute, the arbitrator received briefs on the matter and received testimony from witnesses.  The arbitrator then required post-trial briefs and issued a written decision.

In other ways, however, arbitration is an animal unto itself.  Arbitrators are not bound the same rules as judges and their decisions are often final.  Their decisions are not subject to normal appellate court review, and only subject to attack in specific instances, such as when the arbitrator is not impartial, failed to make a final determination of the issues, or manifestly disregarded the law.  Basically, arbitration is like “private court.”

A court rarely finds that an arbitrator has committed such failings, and thus, it is best to plan on any arbitration award being the final word.  Case in point, in the above-referenced dispute, the Shumards’ partners, who were unsuccessful in arbitration, went back to Gwinnett County Superior Court Judge Batchelor seeking to have the arbitration award vacated.  Judge Batchelor denied those motions and confirmed the arbitration award.

In Georgia, Chapter 9 of Title 9 of Georgia Statutes sets out the standards for arbitration (the “Georgia Arbitration Code,” O.C.G.A. § 9-9-1 et seq.).  In Georgia, the contract controls.  If a contract that requires disputes be arbitrated is enforceable, the dispute cannot be heard by the courts and must be submitted to arbitration.  The courts do have power, however, to determine whether the contract with the arbitration clause is valid, to compel arbitration, and to validate and enforce an arbitration award.

From partnership agreements and operating agreements to construction deals and a variety of other contracts, a seemingly innocuous arbitration clause can be but a brief paragraph nestled neatly in the final pages of the contract, but nonetheless has great importance.  Before entering into a contract, seek the counsel of a contract attorney to ensure you understand the implications of every section of the agreement.

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Can You Copyright Your Label? Yes… well, no… well, partly.

A client of ours recently sought to copyright its label and wanted to know if that was possible. Understandably, the company didn’t want competitors copying its hard work in creating a unique and visually distinctive label for its product.

We first addressed the obvious, which is trademark protection for the name of the product. Ok, but the label is more than just the name, it is the artistic creation of a designer who was hired to give my client’s product a very purposeful and contemporary look.

So, can we copyright the label?

This seemingly simple question brings to bear a number of interesting issues. As a threshhold matter, Copyright protects original expression. The United States Supreme Court has held that with regard to copyright, originality means only that the work was independently created by the author and possesses at least some minimal degree of creativity. See Feist Publications, Inc. v. Rural Telephone Service Co., Inc., 499 U.S. 340, 346 (US 1991). The requisite level of creativity is typically extremely low; even a slight amount will suffice. See FMC Corp v. Control Solutions, Inc. 369 F.Supp.2d 539, 561 (E.D. Pa. 2005). Classic copyright material (like prose or photographs) typically meets the minimum threshold of creativity with ease. But that is not to say that the threshold is so low as not to exist at all.   Indeed short phrases, basic shapes, and lists of ingredients do not present the sufficient amount of creativity for copyright protection.

Labels, however, are typically a combination of pictures, text, short phrases, and shapes. So are they copyrightable because of the pictures and process, or not, because of the short phrases and basic shapes?

There are a number of cases that indicate that labels are subject to copyright protection. See Kitchens of Sara Lee, Inc. v. Nifty Foods Corp., 266 F.2d 541 (2d Cir. 1959). Based on case law, it appears that consumer product labels containing more than a mechanical list of ingredients manifest the amount of creativity necessary to enjoy copyright protection. See FMC Corp. 369 F.Supp.2d at 572 (citing Sebastian Int’l, Inc. v. Consumer Contact (PTY) Ltd., 664 F.Supp. 909, 913 (D.N.J.1987), rev’d on other grounds,847 F.2d 1093 (3d Cir.1988); Drop Dead Co. v. S.C. Johnson & Son, 326 F.2d 87, 92–93 (9th Cir.1963), cert. denied,377 U.S. 907, 84 S.Ct. 1167, 12 L.Ed.2d 177 (1964) (copyright on aerosol wax product label held valid); Kitchens of Sara Lee, Inc. v. Nifty Foods Corp., 266 F.2d 541, 545 (2d Cir.1959) (defendant’s use of identical pictures on cake labels infringed plaintiff’s copyrights on the labels).

For example, in one case, a label on a bottle of shampoo was found copyrightable for a small bit of text describing the product:

“Hair stays wet-looking for as long as you like. Brushes out to full-bodied dry look … WET is not oily, won’t flake and keeps hair wet-looking for hours, allowing you to sculpture, contour, wave or curl. It stays looking wet until it’s brushed out. When brushed, hair looks and feels thicker, extra full. Try brushing partly, leaving some parts wet for a different look.” See Sebastian, 664 F.Supp. at 913.

The court held that “[n]o one can seriously dispute that if plaintiff were to discover that a competitor’s package utilized the exact language as above with the exception of the product’s name, plaintiff would be entitled to protection.” Id.

The court in Sebastian instructed that the language on a label is entitled to copyright protection when it is “more than simply a list of ingredients, directions, or a catchy phrase.” See Sebastian, 664 F.Supp. at 913.

Even shorter phrases can be sufficiently original to garner copyright protection, even for commercial works, such as labels. See Abli Inc. v. Standard Brands Paint Co., 323 F.Supp. 1400 (C.D. Cal. 1970) (label was copyrightable when it contained phrases such as “Cut to desired length … Will not run … Simply slide top bead into rod as illustrated”). Indeed, the length of a sentence is not dispositive of whether it is subject to copyright protection. See Rockford Map Publishers, Inc. v. Directory Service Co. of Colorado, Inc., 768 F.2d 145, 148 (7th Cir. 1985).

In addition to text, drawings or photographs typically are protectable.

Now when you register a copyright, you have to select whether it is a work of visual art, literary work, etc. As a whole, a label certainly seems like a visual work. Indeed, often it is registered as such. Federal courts have held that the form of registration of a work has no effect on the scope of copyright. See S.C. Johnson & Son, Inc. v. Turtle Wax, Inc. 1989 WL 134802 (N.D. Ill. 1989) (finding that a work registered as a nondramatic literary work rather than a work of visual arts does not negate copyright protection in visual elements of the work). Nonetheless, you will sometimes find pushback from the Copyright Office based on the nature of the work you claim.

Where the rubber really meets the road is in compilation, meaning, the compilation of multiple elements. As with my very first example, what is the result when you combine copyrightable elements like pictures and prose with non-copyrightable elements like lists of ingredients, brand names, titles, or short phrases?

Many have and many will continue to argue that the work is registrable as a whole work in the arrangement and selection of the components. Indeed, the Copyright Act itself provides that a work as a whole can be copyrightable due to the originality expressed in the overall selection, organization, and arrangement of the work, and the United States Supreme Court has agreed. See Feist at 360; see also 17 U.S.C. § 103. Yes, originality can be displayed in taking commonplace materials and making them into a new combination and arrangement. See Drop Dead Co. v. S.C. Johnson & Son, Inc., 326 F.2d 87 (9th Cir. 1963) (finding arrangement of color, layout, design and wording on bottle of PLEDGE furniture polish is copyrightable as a whole, including laudatory and instructional text); see also X-IT Products, LLC v. Walter Kiddie Portable Equipment, Inc., 155 F.Supp.2d 577, 609-611 (E.D. Va. 2001) (finding that although short phrases and bullet points on packaging were not protectable, label as a whole was protected under copyright, which necessarily includes the arrangement of the individual elements). Even very simple arrangements can be sufficiently original to be entitled to copyright protection. See S.C. Johnson & Son, Inc. v. Turtle Wax, Inc. (finding that a label with red stripes on a yellow background with a ribbon and the company name is sufficiently original for copyright protection).

Now hold on to your hat…

Despite this line of case law, it is the well-articulated policy of the Copyright Office to deny registration of the arrangement of elements on the basis of physical or directional layout in a given space. See Darden v. Peters, 402 F. Supp. 2d 638 (E.D.N.C. 2005). Not only does this apply to labels, it applies to websites, too!! To perhaps put it another (and more awesome) way, on a phone call with an examiner from the Copyright Office wherein I recited the above mentioned case law, the examiner told me, “Well the court can say that, but that’s not how we see it.

So where to go from here?

Are labels copyrightable?

Yes.

Can you successfully register a label for copyright?

Um, maybe not.

Can you successful register just those creative elements of a label, like a picture, drawing, or prose?

YES. The way you do this is to submit the entire work, but claim only the creative elements, essentially disclaiming the rest.

There you have it – the more creative the elements of your label, the better your shot of gaining copyright protection from the Copyright Office.

Intellectual property issues like copyright and trademark can be tricky. If you or your business have a question about an intellectual property issue, contact a trademark attorney, copyright attorney, or intellectual property attorney at Briskin, Cross & Sanford.

A Primer on Business Opportunities (“Biz Ops”), Part II: disclosure and filing requirements

In the first part of this blog series on business opportunities, I explored the definition of “business opportunity” (or “Biz Op”) to determine what type of enterprises may fall under federal and state law and thereby trigger compliance issues.

After conducting this initial inquiry to determine whether or not a seller’s offering qualifies as a business opportunity, the seller can then determine what is required, both federally and in each state the Biz Op is sold. Of course if a seller is not marketing a Biz Op, there are no special business opportunity requirements with which it must comply (keep in mind, however, that even if a seller is not selling a “business opportunity,” it must still comply with other state and federal laws concerning fraud and unfair or deceptive business practices or the sale of securities) .

If a seller is in fact marketing a Biz Op, it must comply with the following regulations.

Federal law requires the business opportunity seller to provide prospective purchasers with a one page form disclosure document disclosing the seller’s name, address, and phone number; whether the seller had been the subject of a civil or criminal action; whether the seller offers a cancellation or refund policy; whether the seller makes any earnings claims (earnings claims can be express {“you’ll make a million dollars”} or implied {purchasers of this business opportunity drive Ferraris]); and the name and phone number of ten (10) other purchasers closest in distance to the prospective purchaser. If the seller has litigation history or makes earning claims it will have to attach these to the disclosure documents as additional pages.

All things considered, this disclosure document is much simpler and more streamlined than it once was. Prior to March 2012, the business opportunity rules were contained along with the franchise rules under one code section, 16 CFR § 436. This rule required extensive disclosures, as is still the case with regard to franchises.  The Federal Trade Commission (“FTC”), which promulgates business opportunity and franchise regulations, ultimately determined that while franchises involved complex contractual licensing relationships and substantial investment costs, business opportunities often involved simple contracts and significantly lower investments. As such, the extensive disclosure requirements of the franchise rule imposed unnecessary compliance costs on both business opportunity sellers and buyers.

Therefore, the FTC decided to split the franchise rule into two separate code sections, one governing franchises and the other governing Biz Ops. The first business opportunity rule was set out in new code section 16 CFR § 437 as an “interim rule.” The interim rule was identical to the previous franchise rule, requiring the same detailed disclosures. Finally, however, in March 2012, the new and much-simplified business opportunity rule went into effect. As stated, the new rule requires the seller to disclose a one-page form disclosure document to prospective purchasers. This disclosure must be given to each prospective purchaser 7 days before the purchaser gives the seller any consideration or enters into a contract. This must be given to every prospective purchaser in every state, whether or not the state has its own law on point, and cannot be combined with other information that may confuse or obscure the disclosures required by federal law.

In addition to the federal disclosure requirement, many state laws not only require disclosure to the prospective purchaser, but also require registration with the state. Typically this means that the seller sends a copy of the state-specific disclosure and any required attachments (typically a copy of the contract the seller uses with purchasers; financial statements of the seller) along with a required payment (typically a couple hundred dollars) to the state’s regulating department (often the secretary of state, the attorney general, or the securities commission). If a state requires the seller to register the disclosure document with the state, it is critical the seller does so before soliciting sales in that state.

Each year the seller is required to file a renewal and pay the renewal fee. Throughout the course of a year, a seller is required to file an amendment if any material changes in the required information occur.

A number of state laws, however, were created to mirror the former federal business opportunity law, which required much more extensive disclosures. Despite the fact that the federal rule has since changed and become more simplistic, many such states have retained the more extensive disclosure requirements and have not amended their disclosure requirements. As such, these state disclosures may require the seller to disclose additional information such as the name and address of each of the seller’s salespersons, the business and education background of the seller’s principals and officers, as well as their personal litigation and bankruptcy histories; the terms and conditions of the offer and any training provided; statistical figures regarding the amount of business opportunities sold, failed, terminated, refunded, and still operating; audited financial statements; proof that the seller has obtained a bond; certain disclaimers or mandatory refund periods required by state law, or even copies of advertisements used by the seller. The disclosure document often also requires the seller to attach a copy of the proposed contract, which also must include certain content required by state law.

States have varying requirements for the timing of disclosure documents to prospective purchasers. A number of states require that the seller give disclosure documents to prospective purchasers no less than 48 hours prior to the time the purchaser signs a contract or gives any consideration (typically, the whole or a part of the purchase price). Some states, however, require disclosures be made 10 business days prior. It is critical that the seller have a clear guide to follow when marketing to prospective purchasers to ensure it does not run afoul of state-specific disclosure requirements.

Some states also require the seller to secure a bond, against which aggrieved purchasers can recover. Not all sellers must secure a bond, but only those that make certain representations, such as a guaranty that the purchaser will derive income from the business opportunity that exceeds the price paid, or a representation by the seller that it buy back from purchaser any unsold products.

Based on the foregoing it is not difficult to see why a Biz Op seller may seek to negotiate a balance between the representations it makes in courting prospective purchasers and the corresponding compliance required under state law. This nuanced dance is explored in greater detail in Part III of this blog series, which explores business opportunities as a growth strategy.

 

 

 

The importance of timing in the sale of your franchise: when to say “No” to a prospective franchisee

Your franchise is up and running and generating a buzz.  You are getting inquiries from across the US, some of which are clearly qualified buyers itching to get into this new franchise opportunity.

It’s difficult to turn away a prospective buyer, but sometimes that’s exactly what you need to do, at least temporarily.

Say, you get an inquiry from a prospective franchisee in New York. You are aware that New York is one of the states that requires franchise registration–in fact, you have already begun the process of registration with the state. Is now a good time to enter preliminary conversations with the prospective buyer? What if you fully disclose to the buyer the fact that you are still waiting on approval from the State of New York and cannot consummate any deal until such time as you are approved, are you in the clear now?

The answer, as you may have suspected, is no.

The previous summary is based on Reed v. Oakley, 661 N.Y.S. 2d 757 (1996). In Reed, a franchisor began negotiating with a prospective buyer after the franchisor had registered with the state of New York, but before receiving approval. The franchisor informed the buyer it was not able to close the deal until it was approved by New York, and the initial agreement of the parties even specified that the buyer was to receive disclosure documents and have the required time to review them before any deal would close.

When the relationship between buyer and franchisor later soured, the buyer cried foul, claiming that the franchisor violated New York’s Franchise Sales Act by soliciting and negotiating the sale of a franchise prior to receiving approval to sell franchises in the state of New York. The court agreed with the buyer, finding that New York’s Franchise Sales clearly prohibits solicitation or negotiation of a franchise sale prior to registration approval. The fact that franchisor appears to have acted in good faith and did in fact give the buyer all the relevant disclosures plus time to review them prior to closing the deal appeared to have no influence on the court’s decision.

The real rub in this case for the franchisor is the loss it sustained. Typically, the remedy for violation of the New York Franchise Sales Act is the amount of damages the buyer can prove were sustained by the franchisor’s violation of the law. If, however, the franchisor has “willfully” violated New York’s Franchise Sales Act, then the franchisee may rescind the contract, get all his money back, plus 6% interest, plus attorneys fees, and court costs.

Ouch!

Sometimes the word “willfull” is associated with conduct you would think of as knowingly wrong, but in Reed v. Oakley, the court determined that the word “willful” means simply “voluntary and intentional, as opposed to inadvertent.” The franchisor had, in fact, voluntarily and intentionally negotiated with Reed, and in so doing it “willfully” violated New York law, subjecting it to all of the penalties.

In the world of franchise and business opportunity sales, it is almost unavoidable that a few buyers will feel that the business they have bought does not quite meet their expectations. If this happens to you, you want to be sure that you have fully complied with all state disclosure laws.

Compliance can be challenging, given the fact that there are both federal and state requirements, state franchise laws vary from state to state, and franchise requirements can be rather complex. Sometimes franchisors are tempted to do it all themselves, but like an attempted home haircut that winds up back in the barber’s chair, a do-it-yourself approach all too often results in franchisee complaints, state action, wasted money, and worst of all, wasted time. A franchise attorney can help you avoid the disclosure pitfalls, protect your intellectual property, and bolster your contracts and agreements, freeing you up to focus on the job you should be doing, growing your business.

Before you begin soliciting franchisees or advertising in a state, make sure you are informed of the law. Develop a registration roll-out game plan, follow it, and avoid the pitfalls.  A franchise attorney at Briskin, Cross and Sanford can help you do this.

UPDATE – Raysoni v. Payless Auto Deals, LLC et al.

In a previous blog, I discussed the case of Raysoni v. Payless Auto Deals, LLC et al. (see “To Carfax or not to Carfax“), a rather frustrating case in which the Georgia Court of Appeals held that the plaintiff did not have a good claim for fraud against a used car dealership even though the salesman for the dealership told Raysoni that the car he purchased was not in a wreck – which was a blatant lie and the salesman knew it.

In that case, the Court of Appeals held that despite the salesman’s lie, a claim for fraud could not be supported because Raysoni’s reliance on the lie was not justified.

In a claim for fraud, the plaintiff must show that his/her reliance on a false and injurious representation was reasonable or justifiable. The Court of Appeals found that after verbal negotiations between Raysoni and the salesman, Raysoni signed a written contract which clearly stated that the car had been in a wreck, that a buyer was not to rely on the representations of a salesperson, and that a buyer should get the car independently inspected. The contract trumped the salesman’s representations as well as the Carfax report which showed the car as being clean.

Apparently, Raysoni did not take this decision lying down, as he is now appealing to the Supreme Court of Georgia.   Oral Arguments are set for June 16, 2014.

In his appellate brief, Raysoni argued that the Court of Appeals incorrectly applied the law, based on the Georgia Supreme Court case City Dodge, Inc. v. Gardner (1974), arguing that fraud prior to the entering of the contract voids the contract, and thus the disclaimer in the contract is of no significance. Under City Dodge, the disclaimer in a contract is only one of the factors a jury will look at in deciding whether reliance was justifiable, but does not by itself preclude a finding of fraud.  Raysoni also reiterated the fact that the disclaimer was in a font size the equivalent of 5.6 Arial type (!!) buried in other text.  See if you can find the disclaimer of damage:

disclaimer text

It will be interesting to see how the Supreme Court deals with the issue of justifiable reliance.  Stay tuned for the conclusion of this case… and feel free to call a contract attorney at Briskin, Cross & Sanford if you ever have ANY doubt about what you are being asked to sign.

A Primer on Business Opportunities. Part I: “Business Opportunity” defined.

The term “business opportunity” is sometimes used in a generic sense to mean a variety of things related to purchasing and/or starting a business. Much like a “franchise,” however, a “business opportunity” (or “Biz Op”) has specific meaning under state and federal law. This blog is the first in a series of short articles discussing business opportunities. This part is dedicated to defining a business opportunity, an important threshold issue in determining whether the particular business is subject to regulation.

Since the term “franchise” is familiar to most people, it may be helpful to understand what a business opportunity is in terms of how it is different from a franchise. Purchasers of a franchise (franchisees) sell goods or services that are associated with the franchisor’s trademark, and the franchisee is subject to significant control by, or receives significant assistance from, the franchisor. By contrast, purchasers of business opportunities do not operate under the seller’s trademark, and the biz op purchaser has substantially more flexibility to run the business as he or she sees fit. Where the franchise typically becomes part of a “system,” the biz op purchaser is typically given the tools to operate his own business and then does so with a greater degree of freedom.  For further discussion on how a biz op platform can be used to grow your business, see the next blog in this series.

While this is a general definition of a business opportunity, the definition as prescribed by law is more particular and varies somewhat from state to state.  Nonetheless, it is essential to understand whether an enterprise qualifies as a business opportunity as defined by relevant law, because, if it does, the seller of the business opportunity must then comply with certain disclosure and registration requirements. Like securities laws, this is the ultimate purpose of business opportunity and franchise law – to promote transparency and accountability on the part of the seller and to give prospective purchasers enough information to make educated investment decisions. With that in mind, let’s take a loot at the specific definition of business opportunity under federal and state law.

Under the Federal Trade Commission (FTC) Trade Regulation Rules, 16 CFR § 437 et seq., a business opportunity is defined as a commercial arrangement in which a seller solicits a prospective purchaser to enter into a new business in exchange for a required payment, where the seller represents one of the following: (i) that the seller will provide locations at which the purchaser may operate vending machines or similar devices, (ii) that the seller will provide outlets, accounts, or customers for the purchaser’s goods or services (which includes providing sales leads for purchasers or recommending a source for sales leads), OR (iii) that the seller will buy back goods or services made by the purchaser. Vending machine or display routes, envelope stuffing or craft-building enterprises, and other opportunities that promise refund or buy-back are the traditional concerns of business opportunity law because these are some of the original business opportunities and those which have been the subject of the most abuse and deception.

Twenty-eight states have laws regarding business opportunities. The definition of a business opportunity varies on a state-by-state basis. Many states define business opportunities as the sale of products or services to a purchaser for a payment of $500 or more that enable the purchaser to start a business in which the seller represents one of the following: that the seller will provide locations for vending machines (mirroring federal law), that the seller will buy back products made by the purchaser (also mirroring federal law), that the seller guarantees that the purchaser will derive income from the opportunity that exceeds the price paid for the opportunity, or that the seller provides a marketing plan.

As you can see, while some state definitions of a business opportunity mirror those of federal law, some are more encompassing. For example, simply by offering a “marketing plan” along with the business, a seller may be providing a biz op. A marketing plan often is broadly defined, and includes a situation in which the seller provides know-how to help the purchaser get the business up and running. Suddenly, the representations made by the seller are of critical importance. While it is surely a compelling sales pitch to guarantee that purchasers of a business opportunity will make a certain amount of money, or at least make enough to cover the purchase price, doing so may cause the seller to be a biz op as defined by relevant state law, triggering duties of registration and disclosure.  What’s more, certain marketing representations can trigger a seller’s duty to obtain a bond to protect purchasers, which is costly and time-consuming.  If the seller does not comply with disclosure and registration requirements (explored further in a future blog), there can be serious consequences, including misdemeanor charges, right to full refund, and perhaps most damaging, a ban from selling in that state in the future (penalties will be explored further in a future blog).

To avoid the consequences of non-compliance, it is critical to identify the states in which compliance is required before selling in those  states.  For my clients, I suggest creating a roll-out plan.  I highly recommend this practice.  The offering will most likely be on the Internet, and it is tempting for the seller to begin expanding as quickly as interest develops and the market will bear, but doing so is certain to run afoul of state law.  Picture a map of the United States where all the states are red.  When a state turns green, you can begin selling there.  The roll-out plan determines the order in which states will turn from red to green, and ensures that compliance always precedes sales.  If you are considering growing your business by leveraging your knowledge, concept, or name, contact the business opportunity and franchise attorneys at Briskin, Cross & Sanford to learn more.

The Business of Bitcoin: Taxable Property

As you may have now heard, on March 25, 2014, the IRS declared that, at least for now, Bitcoin will be taxed as property, rather than as a currency.  For those who view bitcoin as an investment vehicle similar to stocks, this ruling sets a clearer path with well known “rules of the game” for dealing with the tax implications of bitcoin.

But for those who are interested in bitcoin as a new currency, the path is now cluttered with administrative, legal, and financial complexities.

In order to better understand the implications of the IRS’ new stance, let’s take a quick look at the taxation of property. Generally speaking, if you purchase property and it appreciates in value, you must pay tax on the gain you realize above the original purchase price when you sell the property. This rule has traditionally applied to stocks and bonds in the same way that is applied to real estate and other physical property. Now this tax treatment has been extended to apply to bitcoin as well. Where this starts getting interesting is that bitcoin, like stock, fluctuates in value. An upside to the determination that bitcoin will be taxed as property is that gains on property held for more than one year are subject to long term capital gains tax rates, which max out at 23.8%, as opposed to the higher tax rates which apply to short term capital gains or ordinary income. Conversely, if the value of bitcoin depreciates, the loss realized on the sale of such a depreciated bitcoin when it is sold can be written off against ordinary income, up to $3,000 in loss per year. These rules on the sale and disposition of assets are tried and true and readily accessible (see IRS Publication 544). In that sense, the IRS’s decision may be seen as a desire to keep things simple. But what are the implications on the use of bitcoin to pay for everyday purchases?

A popular example circulating the Internet right now discusses the implications of purchasing a cup of coffee with bitcoin. If the purchaser buys a $2 cup of coffee with a bitcoin that he purchased for $1, the purchaser actually realizes $1 in capital gains. In case this concept seems a bit confusing, let’s briefly look at the basic elements of gain. The Internal Revenue Code (“IRC”), section 61 defines “gross income” as “all income from whatever source derived.” The Supreme Court has held that “income” exists whenever you experience an “accession to wealth”. See Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431-33 (1955). In other words, whenever you are richer, even in some small way, you’ve realized gain. So in the coffee example above, in exchange for the dollar you invested in Bitcoin, you received one dollar worth of coffee, but you also received one additional dollar worth of coffee without paying anything additional. You are essentially one dollar richer than you were before, and so, you have taxable gain. Hmmm… a bit complex for buying coffee isn’t it? Actually, it’s even a little more complex still.

One of the great strengths of bitcoin is the highly developed means of tracking bitcoins. This built-in tracking system helps prevent counterfeit and similar fraud, prevents redundant use of the same bitcoin, and helps make bitcoin more reliable as a source of payment. However, because bitcoins can be tracked, and because their value fluctuates, a bitcoin you bought last year and a bitcoin you buy today can be tracked to determine when each is sold or exchanged for goods or services, and the tax implications for each bitcoin. The price you pay when you obtain any given bitcoin is referred to as your “basis” in that bitcoin, and the tax to which you are subject is based upon the gain you realize in excess of that basis in the bitcoin when the bitcoin is either sold or exchanged for a good or service.  This means that which bitcoin you use to make a purchase matters.

Let’s go back to our coffee example. As stated, if you get $2 worth of coffee for $1 in bitcoin, you have realized $1 worth of gain. Your basis in the bitcoin was $1 and you exchanged it for value of $2, thereby realizing $1 in gain. If, however, you buy $2 worth of coffee with bitcoin you bought for $2, your basis in the bitcoin is $2 and you have no gain. If you buy $2 worth of coffee with $3 worth of bitcoin, then you have realized a loss! So, as stated, which bitcoin you use to make a purchase matters. Imagine, for example, that you have to track all of the bills in your wallet by serial number and have to keep records to determine differing amounts of gain or loss on a transaction based on when those bills came into your possession, when they were spent, and the value of the thing you received in exchange for the bills when you spent them. This is essentially what will be required of bitcoin when they are used to purchase goods or services. Of course bitcoins are digital, so tracking them is not quite like tracking the serial numbers of your dollar bills, but nonetheless, you can see how this certainly complicates bitcoin as a payment source, at least for now.

From a business perspective, the IRS determination has a number of interesting implications. Take for example bitcoin “mining.” If you aren’t familiar, “mining” is the way in which bitcoins are generated. Bitcoin miners are essentially service providers who process transactions and secure the bitcoin network by solving complex mathematical problems, in exchange for which they collect new bitcoins. The process is competitive, however, and does not always result in the award of a new bitcoin. If the work does result in the award of a new bitcoin, the value of that bitcoin on the day it was mined is taxable income. Consider wages.  If bitcoins are rendered as wages in a business, they are subject to federal income tax withholding and payroll tax and must be reported on W-2s or 1099s. If a business accepts bitcoin as payment, it will be taxed on the fair market value of the bitcoin payment in US dollars on the date it was received as part of the business’s gross income.

For my two cents (or bitcoins?), the IRS’ determination appears to be a subtle, yet rather clever way of de-legitimizing bitcoin as a payment source by making it more complex to use in this way. I could be wrong, and maybe the IRS simply decided not to reinvent the wheel. In fairness, bitcoin does resemble a stock or publicly traded commodity in many ways, and there are tried and true guidelines for tax implications regarding the handling and taxation of those types of property. So maybe it’s a fair determination after all. “But currencies can fluctuate in value, too!” you say. Well, that’s true. So with approximately 9 million more bitcoins left to be mined until the Bitcoin supply reaches its predetermined maximum, there remains considerable room for controversy and potential changes of position by the IRS and other governmental entities. The one thing we know for certain at this point is that, for better or worse, at least for now bitcoin is taxable as property… and if you buy a $2 cup of coffee for a bitcoin you bought for $1, you may well find that you owe Uncle Sam capital gains tax on that extra dollar at the end of the year.