AB 2415 (Ting) Property Tax Agent Registration – Oppose

June 10, 2014

The Honorable Bill Monning
California State Senate
State Capitol Room 4066
Sacramento, CA 95814

RE: AB 2415 (Ting): Property Tax Agent Registration: OPPOSE

Dear Senator Monning:

As a constituent and licensed attorney by the California State Bar, I am opposed to Assembly Bill 2415, which would create duplicative registration for lawyers, establish no minimum qualifications or standards for “Tax Agents,” and lead to costly, burdensome administration.

AB 2415 (Ting) calls for the Statewide registration of “Tax Agents,” referring to anyone representing a taxpayer and communicating directly with any county officer on a substantive property tax matter.

The bill is over-inclusive. Attorneys carrying out routine services, such as contacting the Assessor’s Office about the terms of a client’s Trust, would have to register as a “Tax Agent” under AB 2415. Yet this is unnecessary because attorneys are already closely regulated by the State Bar and held to strict ethical requirements, and along with following extensive state professional standards, attorneys must regularly satisfy continuing education requirements to maintain their licenses.

The bill adds no additional protections. Before they are licensed to practice law, attorneys must complete an extensive education, gain admission to the bar, meet ethics requirements, and submit to a criminal background check. AB 2415, however, recognizes anyone as a “Tax Agent” upon the submission of a registration form and accompanying fee. The bill does not ask for the satisfaction of any minimum standards in education, experience, ethics, or the passing of an exam, though these are already covered by the State Bar.

Finally, the bill is administratively burdensome. AB 2415 requires the Secretary of State to publicize and maintain lists of registered “Tax Agents”—not only those in good standing, but also those who have been fined or had their licenses revoked. Regularly updating such extensive records would be both expensive and time consuming, and all the more so because the bill contributes little to the betterment of the overall system.

Considering the above, I oppose AB 2415 and hope that you, Senator Monning, will consider my position and convey it to your fellow Senators.

Sincerely,
Roger Royse

Posted in General, Tax | Comments Off

Agriculture Technology: Where We Are and Where We Are Going

By Roger Royse
Royse Law Firm, P.C.
Palo Alto, San Francisco, & Los Angeles, U.S.

AGRICULTURE TECHNOLOGY
According to the United Nations’ Food and Agriculture Organization, food production must increase by 60% to feed the Earth’s growing population which is expected to hit 9 billion by 20501.   Ninety percent of the growth in crop production is expected to come from higher yields on existing farm land requiring farmers to gain additional efficiencies from their land.

The agriculture industry is already highly dependent on technology and is not slow to adopt new hardware and software if it can help improve yields.  Current forms of agriculture technology, often referred to as “precision agriculture,” help farmers determine where and what to plant on their land with a level of accuracy that was not possible ten years ago.  The next step is to move from precision agriculture to predictive agriculture and “Big Data” will be the main driver of this change.

Farmers want to be at the forefront of technology, however they face regulatory concerns on issues such as privacy and data ownership that must be overcome before the full potential of modern-day technology can be fully utilized.  This paper discusses: (1) the present day use of precision technology on farms; (2) the trend towards Big Data and drone technology; and (3) the availability of funding for agriculture technology companies.

I.    PRESENT DAY: PRECISION AGRICULTURE

Location is everything in agriculture.  A seed, fertilizer, or planting technique that works on one patch of land may not work on another with different soil or weather.  Historically, farmers have learned what works when and where the hard way and then passed this knowledge on to the next generation.  Precision agriculture technology reduces the need for this personal knowledge by providing satellite guidance, monitoring and mapping yields, and giving access to live soil information through built-in soil sensors in vehicles.

Satellite guidance, or GPS, is now installed on most new farming vehicles and provides a number of benefits to farmers.  Navigation aids help track what land has already been covered, reducing skipped land and overlaps.  Auto-guidance technology can steer the vehicle for the farmer enhancing accuracy and reducing operator fatigue.  Crops planted with this technology can later be harvested with optimal precision.

Yield mapping has existed in various forms since the 1990s and is capable of monitoring crop yield and soil moisture content.  The information gathered can be displayed on a map and, when combined with the GPS technology discussed above, allows for seed planting that can vary by the square foot to take advantage of the most appropriate soil conditions and minimize waste.  Farming is not immune to the mobile age and most of the data generated can now be viewed on mobile phone applications, allowing farmers to make quick decisions on the go.

II.    THE FUTURE: BIG DATA AND DRONE TECHNOLOGY

Precision agriculture involves collecting vast amounts of data and companies are now combining this data and using it to enhance knowledge and predict trends.  The increased use of drone technology will complement this drive towards Big Data, by allowing farmers to collect data on their farms without needing to drive a vehicle over the land.

A.    Big Data

Big Data complements and improves upon precision agriculture, but also has the potential to predict farming needs on a mass scale.  However, farmers must overcome a number of legal and regulatory challenges before Big Data is able to realize its full potential.  This section discusses the benefits of Big Data and then the issues of data ownership and data protection.

1.    Benefits of Big Data

Data can now be collected and uploaded to the cloud in real-time providing farmers with instant information on their land and crops.  When combined with the precision agriculture techniques described above, this sort of information could take the guesswork out of farming and substantially improve yields.

Big Data is even used to help farmers create custom made insurance to protect themselves against the weather.  Monsanto Company captured the headlines in 2013 with its $930 million acquisition of Climate Corp, a company founded by early Google employees who created a service whereby people can state what type of weather they want to insure against and receive a quote within seconds.  Climate Corp initially offered services to all business that depended on the weather, but soon realized that agriculture was by far the biggest and focused its activities on that sector.  Before the Monsanto Company acquisition Climate Corp raised over $100 million from Silicon Valley venture capital funds.

Climate Corp acts as an underwriter and pays out immediately should the insured against weather conditions occur.  To price the insurance, Climate Corp considers weather measurements from 2.5 million locations and 150 billion soil observations to generate 10 trillion weather simulation data points2.   The Climate Corp algorithm can divide the U.S. into nearly half a million plots and then develop ten thousand daily weather scenarios for each of them.

The system offered by Climate Corp is a big improvement over what was previously available to farmers.  The Federal Crop Insurance Program only covers about 60% of a farmer’s crop based on a farm’s average yield.  If a farmer tries and fails to increase production then the payout will be on the average yield and not the amount the farmer attempted to grow.  This system is seen as discouraging increased production and innovation3.

The significance of real-time data is not limited to farmers.  Currently, traders in agriculture futures rely on private surveys and yield data from the Department of Agriculture for information.  Access to real-time data would result in more informed pricing for these securities.  Also, as Big Data replaces local knowledge, there could be a correction in the price of farm land if buyers get access to the same information as the farmer.

Big Data may not benefit everyone.  While many farmers will benefit from access to shared information, those that currently have a competitive edge over the competition may want to keep that information in-house for as long as possible.

2.    Data Ownership and Privacy

With all the data being collected, a big concern is who owns the information and how to protect the privacy of those who generate it.  A farmer’s data is likely to be far more valuable than that of the average consumer.  Given the right information, advertisements could be sent to a farmer’s phone when a need for different fertilizer is detected.  Access to the information held by the companies in charge of collecting it could prove valuable.  If the company collecting the data does not want to, or cannot, sell the information then the farmers may consider doing so if the price is right.

Some companies aggregate the data they collect and make that available to those who provide it, however the American Farm Bureau Federation (AFBF) has warned that there is no policy in place to prevent those companies using the information to their advantage in other ways.  The AFBF has advised farmers to consider data ownership, use of data, and its value when signing up with services that collect real-time information.

Side-by-side with data ownership concerns are fears over privacy.  Where data is aggregated the risk to an individual farmer might be minimal, however farmers need to consider whether their own data might be used for other purposes.  For example, farmers may not want their pesticide use to be made public, even if within legal limits, because of the potential harm to their public image.

The more information a farmer has stored in the cloud, the more there is available to those with the appropriate legal authority to access it.  In 2012, the Environmental Protection Agency (EPA) released personal information on 80,000 livestock facilities in twenty-nine states in response to a Freedom of Information Act request from environmental groups4.   The information released included names, addresses, GPA coordinates, and contact information.  In July 2013, the AFBF took legal action to stop the EPA releasing information about farmers and their ranches for other states, however for many farms the damage had already been done.

With environmental activist groups targeting farms, concerns over data protection and privacy are not trivial for farmers and it is understandable that some are still reluctant to fully commit to the cloud.

B.    Drones

Unmanned Aerial Vehicles, or drones, have captured a lot of media headlines in the last few years for reasons as varied as their use in war zones to their potential to deliver online shopping to consumers.  Drone technology has huge potential in the agriculture technology space, allowing for mass data collection, planting seeds, and even delivering spare parts to a tractor broken down in the field.  Drones could be used to survey land and cut down on time spent travelling to the far corners of a farm only to find that the conditions are not suitable for work.

Drones are already used in agriculture in countries such as Brazil and Japan, however in the U.S. the Federal Aviation Administration (FAA) does not allow them for commercial use, for the time being at least.  Congress has directed the FAA to allow drones access to U.S. skies from 2015.  Some farmers are already using drones legally by building their own and essentially treating them as model airplanes which are legal when below 400 feet.

Despite Amazon grabbing most of the headlines for its plans to deliver packages via drones, farms could be the industry where drone technology takes off fastest.  Some of the concerns about drones in other industries, such as privacy and safety, are less likely to apply on large farms.  In theory, a drone flying over a farmer’s own land should not be an invasion of privacy and the safety issues are a smaller concern over farm land when compared to urban areas.

Drones could revolutionize farming by allowing surgical use of pesticides, fertilizer, and water, while improving environmental efficiency in the process.  Against that, some farmers are concerned that drones will be used by environmental groups to spy on their land, with People for the Ethical Treatment of Animals (PETA) already announcing plans to use drones to monitor factory farms5.

III.    FUNDING

In 2012, agriculture technology companies raised just over $100 million of venture capital funding from around 40 deals.   Although this may seem a lot, it is a small fraction of the estimated $27 billion of venture capital investment in the U.S. in 20126.   This demonstrates that the agriculture technology market is still immature and most deals are at the seed stage.  While Silicon Valley is home to the vast majority of venture capital investment within the U.S., only around 20% of the agriculture technology deals originated in Silicon Valley, with the majority taking place nearer agriculture markets.

There are signs that investors are waking up to the potential of agriculture technology as an industry to invest in.  2013 saw the advent of agfunder.com which seeks to be a type of Kickstarter for agriculture.  The site seeks to raise funds for interesting new ideas in the agriculture technology field and then negotiate a convertible note with participating companies.  In addition, the group Silicon Valley Ag Tech hosts meetings, webinars, and conferences to bring together the farming and tech communities to work on solutions that will solve actual problems7.

Fig. 1: Agriculture Technology Funding in 2012 (from CB Insights)8

Figure 1 Agriculture Funding in 2012 (From CB Insights)

CONCLUSION

Many people still hold images of farmers as old fashioned, clinging on to the old way of doing things, however this is not representative of the industry.  Farmers that fail to keep up with the latest technical advances fall behind.

There still needs to be more communication between technology start-ups and farmers, and venture capital firms could do more to support agriculture technology start-ups, however the growth in this area is promising.

There are real challenges ahead to feed Earth’s ever increasing population, however the advances in Big Data and drone technology could provide farmers with the resources they need to increase supply to the required levels.


Footnotes

1 “How to Feed the World: High-Level Expert Forum,” United Nations Food and Agriculture Organization, October 12-13, 2009, available at http://www.fao.org/fileadmin/templates/wsfs/docs/Issues_papers/HLEF2050_Global_Agriculture.pdf
2“Climate by Numbers: Can a Tech Firm Help Farmers Survive Global Warming?” by Michael Specter, The New Yorker, Nov. 11, 2013, available at http://www.newyorker.com/reporting/2013/11/11/131111fa_fact_specter
3 “Climate by Numbers,” by Michael Specter
4 Letter from U.S. Senators to the EPA, available at http://www.blunt.senate.gov/public/_cache/files/010ba920-d3c8-41b2-8ea7-721786d0fdd8/6-6-13%20Letter%20to%20EPA%20re%20Info%20Release.pdf
5 “PETA Eyes Drones to Watch Hunters, Farmers,” CNN, April 12, 2013, available at http://www.cnn.com/2013/04/11/us/animal-rights-drones/
6 “Annual Venture Investment Dollars Decline for First Time in Three Years, According to the MoneyTree Report,” PWC, January 18, 2013, available at http://www.pwc.com/us/en/press-releases/2013/annual-venture-investment-dollars.jhtml.
7For more information on the Silicon Valley Ag Tech group, of which the author is a member, please see the website at http://www.meetup.com/Silicon-Valley-AgTech/, the LinkedIn group at http://www.linkedin.com/groups/Silicon-Valley-AgTech-4726672?trk=my_groups-b-grp-v, or the Facebook page at https://www.facebook.com/TheSiliconValleyAgtech.
8 “The Farmer in the Dell – Ag Tech Investment Tops $100m in the Last Year,” CB Insights Blog, May 9, 2013, data from CB Insights Industry Analytics, available at http://www.cbinsights.com/blog/trends/agriculture-tech-venture-capital-financing.


Roger Royse Biography

Roger Royse, founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries, including technology, entertainment and new media, sports, real estate and agri-business. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms as well as Milbank, Tweed, Hadley and McCloy in New York City.

Roger’s work in the Agriculture Technology field includes membership with Silicon Valley Ag Tech and he is the founder of AgTech, S.V., a company that seeks to bring Silicon Valley innovation to agriculture technology.

Roger is a participating instructor of corporate law for the Center for International Studies (Salzburg Austria) and has been an adjunct Professor of Taxation (Property Transactions and International Taxation) for Golden Gate University. Roger is the founder of the philanthropic organization “Team Motion to Dismiss Cancer” which conducted high profile auctions of meetings with venture capitalists to raise money for charity and has been recognized for his efforts on behalf of The Leukemia & Lymphoma Society by being named the 2012 San Francisco Bay Area Chapter Man of the Year.

Roger is the author of the recently published Dead on Arrival: How to Avoid the Legal Mistakes That Could Kill Your Startup, sits on the boards of advisors and mentors to several funds, accelerators and tech companies and takes an active role in the strategic planning decisions of his clients. Roger also acts as trusted advisor to a national and international clientele of high net worth individuals.

Roger is a Northern California Super Lawyer, is AV Peer-Rated by Martindale Hubbell, has a “Superb” rating from Avvo and is a recipient of the Intercontinental Finance 2013 500 Leading Lawyers Award.

Education:
• J.D., B.S. (Accounting), University of North Dakota
• LL.M. (Taxation) New York University School of Law

Admitted To Practice:
• Nevada, California, New York, Minnesota, South Dakota and North Dakota
• U.S. Tax Court
• United States District Court, Northern District of California

Affiliations:
• American Bar Association
• Santa Clara County Bar Association
• State Bar of California
• Palo Alto Area Bar Association
• ND Society of Certified Public Accountants
For more information on Roger Royse, please email to: rroyse@rroyselaw.com

Posted in Agri-Tech | Tagged | Comments Off

The Next Shoe to Drop on the Affordable Care Act

The problems surrounding the roll out of Obamacare (aka the “Affordable Care Act”) have continued to mount,  including a non-functioning web portal, inaccurate or uninformed descriptions of the Act by the White House, low enrollment, slowness of adoption by state Exchanges, selective delays and other problems. Now that we are well into the implementation phase of the Act, a new and politically volatile issue is coming to light – the Advance Premium Tax Credit (“APTC”).

In order to assist low income taxpayers purchase health insurance from an exchange, the law provides for a tax credit for the cost of premiums. The credit is “refundable,” meaning that if the credit exceeds the taxpayer’s income, the Internal Revenue Service (“IRS”) will pay or “refund” the excess. In the case of the APTC, the credit will be paid monthly on behalf of the taxpayer directly to health insurance provider to help offset the cost of premiums.

The Tax Code contains several refundable credits but the thing that makes the APTC interesting is that it is payable in advance directly to the insurer, in advance, based on estimates provided by the taxpayer. Because of this provision of the APTC, Senator Orrin Hatch (R-UT) has referred to the credit as “a fraudster’s dream come true.”

The Senator may be right. Because it has been structured as a tax credit, and not a direct grant, the IRS must administer the APTC. However, the IRS’ inability to combat fraud in the Earned Income Tax Credit (EITC) realm suggests there may be substantial problems when the IRS begins distributing ACA tax credits.

The IRS has three key roles to play in implementing and maintaining the health care exchanges: (1) determining eligibility; (2) calculating the maximum APTC (the amount paid directly to health insurance providers); and (3) reconciling Premium Tax Credits (PTCs; the refundable credit paid after the taxpayer has filed the tax return) with the taxpayer’s reported taxable income.

To calculate the tax credits, the IRS created an ACA Program Management Office which oversaw the development of the software to handle requests from exchanges, calculate the credits, and return responses to the exchanges.  A recent audit conducted by the Treasury Inspector General for Tax Administration concluded that the software was generally working as intended, although there were some security problems and issues dealing with inter-agency transfers. Although the software appeared to be functional, the audit discovered a significant lack of fraud detection mechanisms within the software and held that the IRS did not yet have a fraud mitigation strategy in place.

This is likely to be a big talking point in the next few years, because experience with the EITC shows that refundable tax credits are subject to a huge risk of fraud.  A 2013 annual audit by the Treasury Inspector General for Tax Administration found that the IRS is failing to comply with this EO and current fraud levels with EITC payments are between 20% and 25%.  A 1999 Treasury Report disclosed that 27% to 31% of EITC should not have been paid. Thus, in the past 15 years, the IRS has not been able to reduce the fraud and error rate by much. The reasons for the IRS’ dismal performance include the complexity of the law, the fact that the credit is self reported, and the lack of verifiable taxpayer information.  The 1999 Report also concluded that the IRS is unlikely to achieve any significant reduction in EITC improper payments.

The IRS will face similar issues with the tax credits under the ACA and in fact the problem may be even more difficult to control.  The ACA tax credits measure “household income,” so it will be difficult to cross-check the income reported for tax credits with what is reported on the taxpayer’s tax return.  Politicians and commentators are promising to “closely monitor the IRS.”  The IRS may not be front and center of the ACA discussion yet, but it soon will be.

I joined a recent American Bar Association (“ABA”) panel on the Role of the IRS in the Administration of Social Policy at the ABA Tax Section’s midyear meeting in Phoenix to discuss these issues. The panel was joined by Nina Olson, the National Taxpayer Advocate, who recently reported to Congress on the various issues facing the IRS, including inadequate funding, reduced services and the problem of unregulated tax preparers. Clearly, now is not the time for the IRS to be talking on additional duties in the role of administering social welfare programs such as the APTC.

Posted in General, Tax | Tagged | Comments Off

Crowdfunding is Dead, Long Live Crowdfunding

Washington is a funny town. Good ideas get turned into bills which then get analyzed, compromised and bastardized into laws that the rest of us have to live with. Example: what’s a camel? Answer: a horse created by committee. Nowhere is this more evident than in the JOBS Act.
The equity crowdfunding idea that spawned Title III of the JOBS Act was a noble idea: let the wisdom of the crowd decide who to invest in. What the legislators and regulators have done to that noble idea, however, shouldn’t happen to a dog. Equity crowdfunding is a lassaiz faire notion in an age of regulation that gained enough steam to pass the Republican controlled House. The Democratic controlled Senate, predictably, then added a series of investor protections. As if that wasn’t bad enough, the SEC has been tasked with sitting on the point of the spear, as it were, and adding implementing regulations that will allow retail investment while restricting retail investment. I don’t blame them for dragging their feet.
By way of background, Title II allows a US company to raise up to $1 million in a 12 month period by selling stock on a portal, through an intermediary, to any number of accredited and non accredited (i.e. rich and not so rich) investors provided that certain requirements are met. The investors are limited in how much they can invest, depending on their net worth and annual income, and the scheme is designed for small bets – $1,000 to $10,000 per investor. Ideally, the law would give the little guys out in the internet ether an opportunity to invest in Startup America just like the Super Angels of Silicon Valley. As enacted, the law relies on disclosure to protect investors instead of crowdsourced wisdom, and that is its fundamental and fatal flaw.
On October 23, the SEC proposed regulations implementing Title III of the JOBS Act. The SEC action includes extensive requests for comments (295 questions), so there may be substantial movement before we have final rules.
At is conclusion, I am not sure there is much that the SEC can or will do to salvage this noble experiment. It may be that Congress has to go back to the drawing board and come up with a workable structure, like some less conflicted states have done. Or it may be that the technology and business models have to catch up with the law as it is currently written. Here are the challenges.
First, the costs of an equity crowdfund offering may be prohibitively high given the requirement of CPA – reviewed or audited financial statements, the requirement of extensive information filings with the SEC, the requirement to use an intermediary, the requirement to verify an investor’s qualification to invest (if the regs require it), and the high standard and risk of liability for material misstatements. In addition, contrary to popular wishes, advertising is not permitted. An investor can scan a portal, but that is about it.
I am hopeful that the final regs will assist. I am also hopeful that creative business models and new technologies will solve many of the problems that the Senate created when it added the investor protections. For example, I have talked to accountants who believe they can reduce the costs of reviews and audits for early stage startups to a point where a crowdfund company is not dead in the water from the start. Some entrepreneurs will drive down the costs of legal compliance, disclosure and due diligence through artificial intelligence technologies, interactive query programs and easy to use interfaces.
Other problems are simply going to require legislative fixes. For example, promoter liability for material misstatements means that more companies will get sued more often, thus driving up the costs of D&O insurance and legal compliance (if you can find a lawyer at all who wants to touch it). The law has to change to deal with the cost of that risk. Similarly, only a law change can completely address reducing the costs of using intermediaries and obtaining audited statements. Only a law change can allow advertising so that a company can get some exposure for all its trouble.
In sum, the law has to go back to deferring to the wisdom of the crowd, or not bother at all. The King is Dead.
That’s enough about Title III. The real news in equity crowdfunding is in Title II, which allows a company to advertise the sale of its securities IF it takes investment only from accredited investors. The idea makes sense – accredited investors can be assumed to be able to protect themselves from the dangers of advertisers. Again, what started as a good idea has, for all practical purposes, been gutted by the SEC. The rules that allow accredited-only advertised investments (known as 506(c)) require a company to “verify” that its investors are in fact accredited. This means asking for tax returns, or financials, or bank statements or third party certifications or stuff that no one wants to ask for. As a point in case, since the 506(c) rules became effective, there have been very few 506(c) websites. In fact, many of the websites that were developed and have been lying in wait for the 506(c) rules have instead opted to do old fashioned non-advertised accredited only investments. In a way, nothing has changed except the delivery mechanism.
Interestingly, this major development in crowdfunding has had nothing to do with the JOBS Act and has had everything to do with technology and a couple of SEC No Action letters. First, the no action letters established, quite simply, that you don’t have to be a registered broker dealer to take a carry (i.e. a percentage of the gain from the sale of an investment) in a pooled investment vehicle. Simply put, this means that the people who used to take finders’ fees on the front end for finding investments will now take a percentage of the gain on the back end when the investment is sold and the SEC says that this is just fine. Well, not exactly “just fine” but that fact alone will not cause the finder or intermediary or whatever to have to register as a BD (they still have to comply with the laws relating to investment advisors). Just between you and me, these letters only clarify what everyone was doing anyway; however, in an amazing incident of Jungian synchronicity (google it) a million light bulbs seemed to have illuminated over the heads of a million former “finders” who are now rushing to form their one-off special purpose syndicated pooled investment website vehicles for 506(b) investments. How will we know who is good at it? The Crowd Will Decide.
The market, or the crowd, promises to punish the finders who are finding dogs and richly reward the ones who know what they are doing by tying their comp to carry (just like a VC) and ensuring an early demise for lack of a “track record.” Already, the bigger players are quietly anticipating yet another “death of the VC model” given their reach into heretofore unreachable companies – and they can do it with large online communities. It is the triumph of the crowd at last, and the JOBS Act did not have one little thing to do with it.
Time will tell whether this new model lives up to expectations and whether Washington ever catches up with the market and the technology. In the meantime, I will hang out at the hearings and listen, comment and blog as the legislators and regulators continue to solve a problem that no longer exists.

Long Live the King.

Posted in Entrepreneurs, Small Business, Startup Law | Tagged , | Comments Off

The New Face of Law

“Should he hang on to the Old, Should he grab on to the New?” (The Bellamy Brothers)
I have often said that Arnold Schwarzenegger is my favorite celebrity. Not (only) because he was Conan the Barbarian, but because he, more than most people, understood the concept of obsolescence. When he was the best body builder in the world as Mr. Universe, he decided that he would try acting. Maybe, he thought, he would be good at it. And when he was the highest paid actor in the world, at the top of his career, he decided he was tired of acting and would try politics. He resisted the temptation to hang on to the old instead of grabbing for the new. I like that example because no industry resists change more than the legal industry. At least that is how it once was.
Last month I keynoted the Mellem Business and Law Symposium at the University of North Dakota and spoke on the topic of the new face of law practice. My thesis is that the practice of law, or the business of law, is changing drastically, almost every day. The impetus for that change can be traced to a perfect storm of the following three phenomena: (1) advances in technology, (2) new and evolving business models, and (3) a changing regulatory and business environment.
Technology. Each morning on my way to work I drive past Stanford University. Lurking within those walls is CodeX – the Stanford Center for Legal Informatics, a multidisciplinary laboratory operated by Stanford University in association with affiliated organizations from industry, government, and academia. CodeX is doing some big things in the technology of law firms, but they are not alone. Throughout the country, law schools are promoting law tech courses of study to better prepare their students for the new demands of the legal profession. More importantly, lawtech companies are sprouting up every day (and I see at least one new law-tech company per day) that claim to have a technology solution to some legal problem. LawTech has been around forever in the sense of technologies that help lawyers more easily do their jobs. The thing that is new, however, is the emphasis on consumer facing law technologies that change the way consumers engage with lawyers, sometimes taking the lawyer completely out of the equation. If you think I’m kidding, see the website Robot, Robot and Hwang for an example.
There are, of course, the high flying companies that harness big data and provide legal research, and we have all heard about online incorporators or trademark filers. That is nothing compared to what is coming next. Consumer facing Law-Tech now includes robots, artificial intelligence, game theory and crowdsourced legal solutions. You can negotiate online with a game theory optimized algorithm that guarantees that you will make the most rational decision. Or you can let the crowd adjudicate your dispute online, Judge Judy style, from the safety of a computer screen.
The one thing that all of these technologies have in common is that they are cheaper than a real lawyer, and maybe sometimes better. The other thing that they have in common is an extremely high failure rate. You will lose money faster betting on law tech these days than any other technology. Yes, there have been some venture back successes, and there will undoubtedly be more. But I still do not think that the humans who practice law should worry too much about the cyborgs, because their advantage is their flaw– the fact that they are not lawyers.
I suppose there may come a time when a computer can acquire human judgment and learn to cross examine a witness, or properly balance costs and benefits of a choice of entity question based on the sensibilities of the client, or understand the significance while drafting a buy sell agreement to knowing that one shareholder is an alcoholic, another doesn’t get along with his wife, a third is about to suffer a midlife crisis and the fourth has a deep vengeful pocket. I suppose that someday computers will “think” in a way that currently requires three years of law school and 20 years of witnessing human foibles, but it ain’t happened yet. And it won’t happen in our lifetimes. Period.
And that brings us neatly into the next major development – the use of these technologies to actually solve problems and make money.
New Business Models. In a nutshell, the internet has changed everything. No longer must we all work a shift for a law firm, partnership or other well established entity. Lawyers can easily collaborate with unaffiliated lawyers as easily as law firm lawyers can talk to their partners down the hall (more easily in fact, because they have a choice as to who we want to seek assistance from). Lawyers can outsource routine functions and bundle non-legal related services. They can hire non lawyer professional managers to handle the aspects of law business that lawyers are notoriously bad at (i.e. everything other than practicing law). The day is coming when law firms become managed much like medical offices – by an outside manager. A consumer today can even walk into a bookstore in Palo Alto and buy legal advice along with his books.
A little over ten years ago, at an American Bar Association Annual Meeting, a partner from the accounting firm of Arthur Anderson announced to a large group of lawyers that the “battle” between accountants and lawyers was over, the accountants won the battle, and the lawyers did not even know there was a battle. He was referring to MDP (multi-disciplinary practice) and the fact that the major accounting firms had entered the legal market and were well on their way to dominating it forever. They very well may have, if not for the Enron and World.com scandals that led to Sarbanes Oxley, the demise of Arthur Anderson and the death of MDP. Enough time has now passed that a few organizations have been quietly (and not so quietly) bundling legal services and engaging what could only be called MDP. It’s here again and this time it is here to stay.
With all that has happened in technology and new and more efficient business models, you may wonder not why law has changed so much, but why it has not changed more. And that leads me to the third, and most significant, development.
A Changing Regulatory Environment. I work in a regulated industry. Oh, they may not regulate how much I can charge (actually they do) but they certainly regulate how I can practice. Each state has Rules of Professional Conduct or a Code of Professional Responsibility that are for the most part very similar, and reflect some common themes. Among the more troublesome of those themes are the following: No non-lawyer ownership of law firms, no fee splitting with non-lawyers, limits on referral fees, fees based on legal work (not non legal value adds), and limits on testimonials that might actually make someone think that a lawyer is good at achieving a certain result. These rules have served for many years, by design or accident, to limit the accessibility of legal services to the public and to keep the cost of legal services artificially high. US lawyers might have been able to continue to get away with it if not for the impact of globalization. What Web 2.0 has done to the internet, globalization has done to the law.
Very few of us lawyers now compete only in our own back yard any more. I am as likely to be skyping a lawyer in Hong Kong as one in Sunnyvale, and if that lawyer plays by an entirely different set of rules than I do, two things will happen: either (i) the rules will change and harmonize or (ii) they will simply lose their legitimacy. In fact, both of those things are happening.
Law firms in other countries (notably the UK and Australia) can have non-lawyer ownership in forms they call Alternative Business Structures (ABS). That means they can attract capital and even go public. They can then adopt efficient capital intensive business practices. In the US, a well-known personal-injury firm has filed federal lawsuits in several states challenging ethics rules that prohibit outside investment in law firms. Proposals to loosen up on this issue are often before the ABA and state bars.
The flip side to increased competition caused by ABS is the increased cost pressure caused by the rise of outsourced legal services. There are millions of lawyers in India, and thousands in The Philippines, that are capable of doing US law. Currently, there are more than 100 LPO (legal process outsource) organizations that trade in cheap legal talent. US law firms face competitive pressures both from better financed and more loosely regulated foreign firms, as well as cheaper sources of supply.
The rules regarding fee splitting do not reflect the reality of the new economy in which law firms and lawyers collaborate and split fees based not only on how many hours they billed, but other business benefits they bring to the table, like origination of new business. The rules against testimonials are not consistent with Yelp and LinkedIn endorsements and reviews. The rules limiting referral services do not fit well with websites and companies that match attorneys with clients, and we haven’t even talked about the issues of formation of an attorney client relationship, confidentiality and conflicts that arise when lawyers interact and give advice remotely to unknown parties through web portals. State bar organizations have been bending over backwards to make these antiquated rules fit modern practice and, when they cannot, the rules are simply, widely and publicly ignored. They have lost much of their legitimacy.
Clearly, the legal industry is going through a revolution. There will be displacement, there will be winners and losers and as we move into the new and next era of law practice, the pressures are bound to get more pronounced. Many models will fail, many more technologies already have. The only thing we know for sure is that everything will change.

Posted in Legal representation | Tagged , , | Comments Off

The Growing Field of Agri-Tech

The conference rooms of the Silicon Valley might seem like an unlikely place to hear talk of crops, soil, animal tracking and farm management, but a widening group of techies and investors see the potential of applying the Silicon Valley formula to California’s largest industry – agriculture – and are aggressively seeking out the new opportunities. Agriculture has never been far from technology, since the first Fordson tractor replaced an ox-drawn plow. In fact, based one financial data, the thing that is most striking about tech companies based on agriculture (“AgTech”) is how much catching up the need to do. Last year, depending how broadly you define the sector, venture capitalists invested $30 to $40 million in 100 to 155 deals. That may seem like a lot until you consider that roughly the same amount was invested in transportation-tech (companies that help you find cabs more easily, for example). If $150 million still seems high, consider that venture capitalists (VCs) invest roughly $30 billion per year in the US, and of that, $10 million emanates within walking distance of Palo Alto and San Francisco.

A recent webinar conducted by the Royse Law Firm in Palo Alto illustrated the numerous areas that are ripe for innovation. For example, water remains one of California’s most valuable and sometimes most controversial resources, and technologies are being developed that control flow, purify and desalinate and process waste water. As the largest consumer of water in the state, the agriculture sector has the most to gain from efficiencies in water use, storage and distribution.
Because of the importance of soil, environmental technologies are inherently suitable for ag applications. Soil technologies address contaminants such as e-coli as well as nutrients, fertilizers, herbicides and composts. Other production related technologies provide pinpoint and up to the minute weather information.
One of the more interesting areas in Ag is in hardware and machinery. The term, “precision farming” has recently become popular, referring to the ability of machines (such as drones and remote controlled or “smart” tractors) to farm a filed with pinpoint accuracy. That may seem like science fiction, but commercial applications of sensors and monitors are now available and getting better.

Similarly, technology now allows farmers and ranchers to track animals from field to table with RFID and tracing technologies. Similar technologies capture and analyze that information, placing agriculture in the cross hairs of the most popular new idea in technology – Big Data. What use can farmers use of the vast amounts of information they are gathering? Who owns that information? How can the process of monitoring, analytics and information gathering be more easily automated, especially in connection with regulatory requirements. Perhaps the biggest gains will come in this emerging sector.

Finally, the end result of all agriculture eventually ends up on a table (or in a glass), and while the VCs catch up to Ag, the related areas of WineTech and FoodTech has also taken off as areas of innovation and interest. Urban restaurants no longer have to ship all of their produce from far away – urban farms can supply them with at least some fresh produce. In fact, herbs and spices now grow in warehouses next door to software companies. A “chip” company in the Silicon Valley can mean a computer chip or a corn chip, both fabbed through high technology.

With all of these potential changes and opportunities in progress, what should the producers be doing? How can rural America get its share of the new wealth about to be created? For starters, the great disconnect in the field, and the reason why Ag-Tech is not yet as big as other “Techs”, is the failure of communication between consumer and producer, farmer and techie. Venture capital might help close that gap, but in the meantime the group “Silicon Valley AgTech” is hosting meetups, webinars and conferences designed to put the groups together so that the tech community can work on solutions that solve actual problems and create products that farmers actually needs. Some farmers have “cut out the middleman” and created their own Ag technologies, based on solving their own current need. They only need to pitch to the right investors in the right way. Eventually they will start to “hit,” get funded and launch.

An agricultural revolution is underway that is no less significant than the mechanization of farming during the industrial revolution. This revolution will trade in information and software more than machines, will lower the cost of production and expand markets. All signs indicate that, given the technological basis of the coming change, the center of agriculture will soon be where the technology is located. For information on how to join this movement, interested persons can check out the Meetup and LinkedIn groups, such as Silicon Valley AgTech, or the website http://www.agtechsv.com/ or attend one of the upcoming meetings, webinars or conferences.

Roger Royse
Royse Law Firm, PC
Palo Alto, San Francisco, Los Angeles
650-813-9700 ext. 201
rroyse@rroyselaw.com
Skype: roger.royse
www.rroyselaw.com

Posted in Agri-Tech, General | Comments Off

May 6 Letter to Senate Finance Committee

May 6, 2013

The Honorable Max Baucus, Chairman

The Honorable Orrin G. Hatch, Ranking Member

Committee on Finance
United States Senate
219 Dirksen Senate Office Building
Washington, D.C. 20510

Re: Tax Reform Options and Proposals to Raise Tax Revenues under the March 23, 2013 Budget Resolution

Dear Chairman Baucus, Ranking Member Hatch, and Members of the Finance Committee (the “Committee”):

This paper contains suggestions as the Committee reviews proposals to reform the Internal Revenue Code of 1986, as amended (the “Tax Code”).

The Concurrent Resolution of the Senate Budget Committee proposes a deficit reduction plan and instructs the Senate Finance Committee to report legislation that will reduce the deficit by $975 billion through changes to the Tax Code. In particular, the budget guidelines acknowledge the goals of fairness as well as boosting economic growth.

The United States remains the world’s most desirable location for new companies to develop innovative technologies, resulting in job creation and increased productivity, especially in technology hubs such as the Silicon Valley, Boston and New York.  However,  companies also find themselves paying the highest tax rates in the world. In addition, domestic companies are subjected to a worldwide, rather than territorial, tax basis, placing them at an additional competitive disadvantage.

As an attorney who has represented international startup and tech companies in Silicon Valley since 1991, I observe that even startup companies now find it worthwhile to structure their operations offshore and limit their involvement in the United States. This development is significant since much new technology is developed and exploited in a startup environment. When the startup community leaves the U.S., the future of technology development and innovation also leaves the U.S. Much of the industrialized world awaits this migration with incentives, accommodating immigration laws and, importantly, low tax rates.

No one disagrees that fundamental tax reform is needed or that companies operating in the U.S. must confront negative incentives artificially created by our tax system. This paper suggests approaching tax reform and rebuilding our economy on three basic principles:

  1. Lower corporate tax rates;
  2. Territorial taxation while limiting deferral of tax on excess foreign intangible income; and
  3. Restricting the states from undercutting federal tax incentives through inconsistent, excessive and unfair tax policies.

Increasing revenues solely through removing or restricting tax expenditures, especially small business incentives such as additional depreciation under section 179 of the Tax Code, would unfairly shift a large portion of the tax burden to small business. This paper proposes increasing the tax base, rather than increasing the tax on the existing base, as a means of resolving the tax/budget gap.

Corporate Tax Rates.  Schedule A compares the federal and state tax burdens on companies doing business in California and in the United States as compared to  companies located in other countries.

Faced with this dramatic tax rate difference, a company seeking a jurisdiction in which to establish a business presence must clear a high tax rate hurdle before it can consider the United States. Multinational companies must pay a blended federal and state U.S. rate that is much greater (up to 25%) than in other industrialized nations.  A glance at the numbers illustrates that reducing corporate rates may be the single most significant tax factor confronting inbound and international investors.

Territorial Taxation/Excess Foreign Intangible Income.  The Budget resolution notes the migration of intangibles from the U.S. to low- or no-tax jurisdictions and, in fact, almost every large multi-national company has a foreign IP holding company structure in place.  It is likely only because mobile or intangible income can be easily moved offshore (and reduce the effective worldwide tax rate) that U.S. companies have tolerated high corporate tax rates. As noted, a system that encourages foreign migration of intangibles is costly in the long run, as jobs, business and economic activity shift to foreign jurisdictions. Thus, any proposal to reduce corporate tax rates should also encourage the repatriation of foreign earnings back to the U.S., both through territorial taxation and cessation of tax deferrals on foreign mobile (or intangible) income.

Limits on State Taxation. One of the factors contributing to the decline of American competitiveness has been the increasing tax bite of states seeking new forms of revenue.  For example, as illustrated in Schedule A, the state of California takes almost 9% in additional taxes.  In states such as California, even a lowered 25% federal corporate tax rate will result in an excessive combined federal and state rate. Thus, a tax reform proposal that seeks to increase the taxable base through lower corporate rates and territoriality must also address the effect of state taxes on those goals. In particular, the following general tax initiatives would be most consistent with the federal tax reforms:

  1. Extend Public Law 86-272 to apply to all income;
  2. Mandatory Tax Code conformity with respect to certain federal tax incentives; and
  3. State compliance with international treaty obligations.

Each of these ideas is further developed below.

It is important to note that there is precedent for federal oversight when states have over-reached on tax issues. For example, Public Law 104-95 prohibits state taxation of certain pension income of nonresidents.  Public Law 86-272 (PL 86-272) prohibits the states from imposing net income based taxes on non–domiciliary sellers of tangible personal property. Both of these laws reflect the power of Congress to limit state taxation of interstate commerce.

Extend Public Law 86-272

No discussion of raising the tax base by lowering rates can ignore state income taxes. While it may seem that states should be free to compete with other states with respect to tax rates and other incentives, at the global level the competition is more properly framed as a comparison of combined U.S. federal and state tax rates vs. foreign country tax rates. Voters in California, for example, recently increased the top marginal individual income tax rate to 13.3%. The result of this increase will not merely force companies out of  California; because of California’s unique position as the nation’s technology and venture capital hub, the likely result will be to force companies out of the country. In that regard, confiscatory state income taxes frustrate federal tax policy and should be restrained so as to not burden interstate and international commerce.

PL86–272 prohibits a state from taxing a company’s income if it’s only activities are solicitation of orders for sales of tangible personal property which are sent outside the state for approval or rejection and are filled from outside the state. Since the enactment of PL 86-272, however, the global economy has evolved, and remote services and information technology are now significant businesses worldwide. The law, however, has not kept pace with these changes and the concepts that limit a state’s right to tax sales of tangible personal property have not been extended to other types of income.

In the new economy, companies from all over the world may do business in the U.S. with very little physical contact. Based on an ambiguity left open in Quill v. North Dakota, many states are now imposing income taxes based on “economic nexus” as opposed to physical presence. Economic nexus refers to nexus based on the amount of business done in a state. California nexus exists, for example, if a taxpayer’s sales in California exceed the lesser of $500,000 or 25% of the taxpayer’s total sales, a taxpayer’s real and tangible personal property in California exceeds the lesser of $50,000 or 25% of the taxpayer’s total of such property or if compensation paid by a taxpayer in state exceeds the lesser of $50,000 or 25% of the total compensation paid. R&T Sec. 23101.

Unfortunately, the result is a confusing and contradictory set of tax rules that complicate business decisions. A comparison of state nexus laws is compiled at http://www.cob.sjsu.edu/nellen_a/taxreform/economic_nexus.htm. Unfortunately, the trend is to tax companies that have no physical contact with a state, thus undermining Congressional initiatives designed to make the US more competitive in the global economy.

The Quill case has left the door open for Congress to define the extent of the states’ right to tax out of state businesses. Congress should act to impose a uniform nexus standard by extending PL 86–272 to income from services and intangibles.

Mandatory Tax Code conformity with respect to certain federal tax incentives

The Tax Code contains many provisions designed to encourage innovation of investment in various areas. For example, the research and development (R&D) credit encourages new R&D.  Recently, the tax exemption for gains from the sale of qualified small business stock (QSBS) was extended. Again, however, the economic activity encouraged by the Tax Code is frustrated by some states’ nonconformity with federal tax law.

The Franchise Tax Board in California, for example, has recently determined that the state QSBS tax exemption is unconstitutional because it required that economic activity occur in the state.  That reasoning could be extended to deny state R&D and Enterprise Zone credits as well.

The federal policy behind the enactment of the QSBS provisions (in this case, to encourage investment in startups) is frustrated by a contrary state tax treatment. At a 13.3% top marginal rate (when the federal savings was only 15% [20% in 2013]), it is easy to see that state tax treatment is almost as significant as federal tax treatment of this particular item.

The state codes are filled with provisions that contravene the policy behind the federal laws. Congress should designate certain incentives as mandatory for state tax purposes. QSBS is one example.

State compliance with international treaty obligations

One of the more significant impediments to the conduct of commerce between U.S. companies and companies in ther nations is the lack of treaty protection at the state level for foreign trading partners. U.S. income tax treaties exclude coverage of state income taxes, and no U.S. income tax treaty extends to state taxes. As a result, foreign companies regularly find themselves exempt from federal taxes but burdened by state taxes if they attempt to do business in this country.

For example, a foreign corporation might find that it is exempt from federal tax on its US business income because it lacks a US permanent establishment, yet find that it is subject to tax under a state’s economic nexus standard. Similarly, that corporation might claim an
exemption from withholding on dividends, interest or royalties under a tax treaty, yet find itself subject to state tax withholding on the same income.

When the federal government enters into an income tax treaty to avoid double taxation of income, state tax rules completely undercut that policy. The states should be required to conform to federal law in this important area.

The foregoing is a non-exclusive list of areas in which tax reform could serve to increase the table base and promote a consistent federal/state policy goal. As a tax and business law practitioner, my perspective is entirely anecdotal and economic analysis is appropriate to gauge the economic drain that results from state tax overreaching. I am available for meetings, testimony or further comments if requested.

Very truly yours,

Roger Royse, Founder

Royse Law Firm, PC

Schedule A

Posted in Uncategorized | Comments Off

Comments on Tax Reform Submitted to Small Business/Pass Throughs Working Group

April 14, 2013

Dear Representatives Buchanan and Schwartz:

The Small Business Draft provides for two options for reform of the rules relating to the taxation of pass-through entities. My comments address both options.

Option 1 contains changes to the S corporation rules that are long overdue in eliminating tax traps and “gotcha’s” that have deprived many taxpayers of the benefit of S corporations due solely to inadvertence. Other S corporation provisions remove some restrictions on qualifying for S corporation status. In particular, the restriction on the ability of a non-resident alien (“NRA”) to be a shareholder of an S corporation has been very problematic for many companies. Under current law, if an S corporation desires to acquire NRA equity and maintain pass-through tax treatment, the company must engage in complex restructuring through blockers and non-corporate entities. The proposal to allow non-resident aliens to hold stock through an electing small business trust (“ESBT”) is helpful but does not go far enough. The benefit of the proposal would only be available to taxpayers who can plan into NRA ownership and establish an ESBT. The proposal would not help companies that lose S status because of a change in status of a shareholder from a US person to an NRA or the transfer of an interest by a shareholder to an NRA. This is one of the few places in the tax law where one taxpayer’s (the S corporation shareholder) tax consequences may be determined by another person (the transferring shareholder). Not only should S corporations be allowed to have NRA stakeholders, the corporation should not be at risk of losing the S election due to the changing status or transfer by one of its shareholders.

The ESBT accomplishes the goal of retaining tax jurisdiction over the share of S corporation income of the NRA, but is itself subject to technical requirements that may not be widely understood or easy to meet. Given the policy concern of taxing NRAs on their share of the S corporation’s income, a narrower and more effective approach would borrow from the partnership withholding rules, and require the S corporation to withhold on the NRA’s share of effectively connected income and fixed or determinable or periodic income at a statutory or treaty rate. Thus, I suggest that the S corporation itself be subject to the same withholding rules that currently apply to partnerships with foreign partners.

Option 1 also repeals the rules relating to guaranteed payments, in effect allowing partners to be employees. Anecdotally, it is the commentator’s experience that the rules prohibiting partners from being employees is so counter intuitive and contrary to the way business is conducted that it is widely disregarded in practice. Large employee leasing companies have taken the position that partners can be employees under published IRS guidance. In addition, some states do not follow the federal rules on classification of partners and, in fact, require partners to be treated as employees even though they may not be treated as such for federal withholding purposes, creating complexity and confusion in withholding. The proposed change would eliminate a regime that has served little purpose and has burdened rather than benefitted withholding on compensation as an enforcement mechanism.

Option 2 proposes a unified system of taxation of pass-throughs that addresses the concern that different tax treatment may result from the same transaction due solely to choice of entity. The proposal prohibits special allocations, allows allocations only of net (and not gross) income and loss, requires entity level withholding, and requires gain on distributions of appreciated property. Option 2 would repeal well established partnership tax concepts and I oppose Option 2 for the following reasons and in the follow specific respects.

Fundamentally, I disagree with the proposition that a “one size fits all” structure is necessary or appropriate. For very good corporate and tax reasons, each of the S corporation, C corporation and partnership tax structures have qualities that fit certain businesses. At its core, some businesses are more properly conducted through an “entity” (the entity is a separate tax or reporting vehicle whose interests are separate from its owners) whereas others are more properly conducted as an “aggregate” (the entity is a relationship among its owners which pools or reflects the separate interests of its owners). See my article on this distinction at http://www.rogerroyse.com/PDF/MetaphoricalConstructsinLegalAnalysis042502.pdf. The partnership structure preserves the ability to operate as an aggregate of members while limiting those members’ personal liability. Removing this aggregate feature (which the proposal would do) will result in a loss of a basic method of structuring business ventures and will require the creation of complex multi entity structures to accomplish the same result.

The defining needs of the entity model are (i) differing risk levels, goals and levels of participation of the stakeholders, (ii) the ability to preserve continuity of interest or ownership in an acquisition, (iii) centralized management, and (iv) the ability to use equity as compensation. Prior to the “check the box” regulations (Treasury Regulations sections 301.7701-1 through 301.7701-3), the tax law recognized the characteristics of a corporation as (i) limited liability, (ii) centralized management, (iii) free transferability of interest, and (iv) continuity of life. While those distinctions may have been forgotten in a “check the box” age, they are useful in determining whether a business venture is more like an entity or more like an aggregate and how it should be taxed. The S corporation as an entity fits many operating businesses since it may have (i) numerous stakeholders, such as founders, investors, employees and creditors, (ii) a board of directors and selected officers, and (iii) the expectation of exiting via a stock for stock exchange or merger.

The partnership (or limited liability company [LLC] taxed as a partnership) structure, however, is better suited to combinations that are more properly viewed as aggregates of its members. Pooled real estate investment, in particular, is often considered an aggregate of the owners, which is why most real estate is held in LLC or limited partnership form. In fact, if not for the limited liability that LLCs provide, jointly owned real estate would almost always be held as tenants in common (“TIC”) interests.

Pooled securities investment vehicles, such as private equity and investment funds, are similarly well suited to aggregate models. In both those cases, the venturers seek to pool their resources for economies of scale or market reasons to acquire and hold for investment, as an aggregate of its owners, the acquired assets. In that regard, partnership structures look more like aggregates than entities, and the tax law has accommodated this market reality in Subchapter K of the Internal Revenue Code of 1986, as amended (the “Code”).

The analogy is not perfect, of course, and there are places where partnerships are treated as entities and not aggregates, and S corporations are treated as aggregates and not entities, but the basic distinction has evolved to reasonably fit business practice. Option 2 ignores the fundamental difference between entity and aggregate business combinations.

Specifically, Option 2 is problematic in two main areas. First, the concept of recognizing gain on distributions of appreciated property may fit the entity model, but runs contrary to the type of business that could just as easily be conducted as a TIC pursuant to a co-tenancy agreement. The ability to freely transfer property in and out of a partnership is the single most important distinction in making a choice of entity decision when the business is an appreciating asset such as land or securities. The entity model simply does not work for that kind of business, and those types of businesses will opt for inefficient TIC arrangements before accepting that model.

Secondly, Option 2 proposes to limit the ability to specially allocate gains and losses. Currently, the Code contains numerous restrictions on special allocations to ensure that such allocations must have “substantial economic effect.” In the aggregate model, differing stakeholders will regularly accept degrees of risk that may or may not match their percentage ownership in other partnership items. It is fair to allocate gross income and loss to the partners who actually benefit or lose economically. In fact, it would inappropriately shift loss or gain in some cases if such special allocations were not allowed.

In conclusion, I support the modernization of the S corporation rules to remove artificial impediments to doing business through the S corporation form. However, I oppose the unification of pass-through taxation as unworkable and inefficient.

Posted in Uncategorized | Tagged | Comments Off

Comments on International Tax Reform Submitted to House Ways and Means Committee

Comments: International Tax Reform Working Group
Dear Representatives Nunes and Blumenaur,
The Silicon Valley of Northern California has become one of the most desirable locations in the world for new companies to develop innovative technologies, create jobs and contribute to the nation’s productivity. As business has become increasingly global and income has become more mobile, US businesses face increasing competition from companies based in other countries. However, companies in the US now find themselves paying the highest tax rates in the world. The US is not only unattractive in terms of tax rates, it is also unattractive in its method of taxing on a worldwide rather than territorial basis.
The last major tax reform in the United States was the Tax Reform Act of 1986 (“TRA ‘86”). Since that time, whole industries have emerged that did not exist before. Some of the largest companies in America could not have even been conceived of in 1986. Taxable income has become “mobile” and workers transient in ways that our tax laws are ill-equipped to deal with. More significantly, foreign businesses have become much more competitive and mobile.
While global tax rates have decreased and competition has increased, the US tax system has changed very little in some important ways. Practitioners struggle to apply decades old statutes and antiquated regulations to new transactions and business relationships. Having represented international startup and tech companies in Silicon Valley since 1991, I observe that even startup companies have now find it worthwhile to structure their operations offshore and limit the involvement in the United States. This development is significant, since much new technology is developed and exploited in a startup environment. When the startup community leaves the US, the future of technology development and innovation also leaves the US. Much of the industrialized world awaits this migration with incentives, funding and, importantly, low tax rates.
It is clear that fundamental reform is needed to remove the negative incentives artificially created by our tax system. The time has come to revamp both the tax rates and the tax system.
Given the existing tax environment, I applaud the efforts of the Committee and agree with the proposed approach that would:
1. Lower corporate tax rates to no more than 25%;
2. Tax US companies on a territorial basis by granting a participation exemption for dividends received from foreign subsidiaries; and
3. Limit deferral of tax on excess foreign intangible income.
I believe that the proposed changes, if enacted into law, would increase the US tax base by incentivizing global startups to locate in the US and encouraging multi-nationals to remain in the US.
While the proposals go a long way towards increasing America’s global competiveness, they do not address the problem of creeping state tax jurisdiction. In recent years, many states have steadily increased the tax burden on out of state and foreign companies operating within their borders. In some states, such as California, even a lowered 25% federal tax corporate rate will result in an excessive combined federal and state rate.
High state tax rates, when combined with the federal rates, discourage companies from locating in those states, even though the location of their markets, talent and financing may make those states logical places to establish themselves. Sometimes companies that are taxed out of a state will locate in another state; often, in my experience, they will simply leave the country, taking their talent, jobs and technology with them. Some
states have not only discouraged inbound investment through tax rates; many states have become notoriously more aggressive about finding sales and income tax nexus for imposing tax on international technology companies. While the states’ ability to impede interstate commerce is limited by the Commerce Clause of the US Constitution, no law exists that prevents excessive state tax rates or compels states to comply with tax treaties negotiated with foreign countries.
I will, within the next several days, submit comments proposing that Congress act to limit the ability of states to frustrate the efforts of Congress to encourage companies to do business in the US. In particular, I will propose the consideration of the following initiatives:
1. A federal limitation on the maximum rate of tax on income that states may levy;
2. The establishment of a uniform income tax nexus standard for information technology companies;
3. A Code-conformity requirement with respect to certain federal taxes designed to encourage innovation and investment; and
4. A requirement that the states comply with treaty obligations negotiated by the United States with foreign countries.
The idea of Congress regulating state taxes may at first seem unusual, but it is worth noting that there is precedent for federal oversight when states have over-reached on tax issues. For example, P.L. 104-95 prohibits state taxation of certain pension income of nonresidents. I am mindful of the significant constitutional issues involved in the regulation of state taxes, and am confident that, in view of the significant adverse effect state tax policies may have on international commerce, Congress can find constitutional authority in the Necessary and Proper Clause.
These ideas will be further developed in additional comments.
Roger Royse
Founder
Royse Law Firm, PC

Posted in Uncategorized | Tagged | Comments Off

That Big Sucking Sound (or The Tax Rush of 2013)

Ross Perot coined the phrase “giant sucking sound” in 1992 to refer to the job loss that he thought would result under NAFTA. Twenty years later there is a different sucking sound – the sound of California’s eroding tax base under the Proposition 30, which was approved last fall. Proposition 30 increases the California sales tax rate and imposes higher taxes on taxable income over $250,000. Best of all, it applies retroactively to January 1, 2012, so you could end up paying more tax on income earned a year ago. Based on the new tax rates, California is actually expected to have a budget surplus this year.

Or will it?

With the increased federal taxes, California taxpayers would now pay a marginal rate of tax of up to 56.7%.  According to the Tax Foundation, a non partisan tax research group based in Washington D.C., California now has the highest statewide sales tax in the nation (7.25%), the second highest personal income tax in the nation ((10.3%) and the highest corporate tax rate in the West (8.84%).

Can you guess where I am going with this?

Several years ago, while I was on some (don’t laugh) business related junket to Las Vegas, I had the opportunity to hear state governmental and business leaders pitch their benefits to out of state companies. The basic theme was simple, not at all subtle, and very direct: “We Are Not California”. Yes we have drugs and gangs and OJ Simpson, but at least We Are Not California. The corollary was “So Move here Now.”  I was so impressed by the pitch that I ran right out and took the Nevada Bar exam (PS – I passed [yay!]). And then…. I waited…. And….Not much happened. I would have to admit that I did not get much benefit out of taking the bar exam, other than four days of testing in balmy Las Vegas in late July.  They held the exam in Vegas in July, by the way, because apparently the surface of the sun was all booked up.  Now it looks like I may be able to dust off my Nevada bar license and help some soon-to- be-former Cali’s move.

And I am not trying to pick on Nevada. Many other states have followed suit. Arizona and Oregon have regularly harvested companies from California with their more business friendly climates back when we had lower taxes. What do you suppose is going to happen now?

We call it erosion of the tax base, i.e., when you tax the rich with the expectation of getting more revenues, you end up losing a certain percentage of taxpayers. Because 14% of 0 is less than 10% of anything, you end up with less tax revenues from the taxpayers that leave, so the big question is “will enough people stay to make up for those who leave?” And will the extra 4% on the Richie Riches that stay be more than the 0% on those who leave.

Obviously, no data is yet available but we do have anecdotal evidence.  By anecdotal evidence, I mean that I have stories about what taxpayers look like after I advise them of what to expect if they stay in this state. The early anecdotal evidence suggests (are you ready for this?) that it is going to be ugly. Ten percent tax rates people could live with – 13 and 14 percent many will not. Prepare for a great outbound tax rush to rival the inbound gold rush of 49. In fact, I am going to call it the “Tax Rush of 2013” ™. If you are smart, you already own property in Incline Village. If you are like the rest of us, you are studying your options.

It’s not all bad, of course. There will be the poor saps who stay. In addition, did I mention that the tax is retroactive to January 1 2012? That means even the Cali expats will not be able to escape one year of 2102 tax increase (so it looks like that budget will be balanced after all, but look out for 2013).

I think that we must resign ourselves to losing a few rich folks. The bigger question is what will this do to business. After all, I am also a business attorney, so I should be concerned about what happens to business. Fortunately, not all business decisions are based solely on tax, believe it or not, and businesses sometimes locate in California for business reasons. Personally, I moved here to watch drug free professional cycling, and you know how well that turned out. However, sometimes companies set up shop in California for the talent and brains that reside here. Sometimes they come for access to customers and technology or maybe even for the $30 billion of venture capital that is looking for a home. We call those companies “startups” and they do Not Pay Tax. Hardly ever. If they do, we revoke their office ping pong tables and make all their employees wear adult clothes, and call them “middle market.” Middle market sounds like middle age and it is just about as sexy (not) to the technoistas that hang out in my neighborhood.  Therefore, to avoid becoming middle anything, the founders exit before getting profitable and start all over with a new non taxpaying company. We call them “serial entrepreneurs” (or Peter Pan Syndrome Sufferers).

Besides, for someone who survived the dot bomb crash of the last decade, I can tell you that tax is not a bad problem for a company to have. It means they have income, just long enough to exit and start the next non-taxpayer. And that brings me to the subtle point that needs to be made. (whew! Finally).

The fiscal cliff deal gave startups and VCs a huge bennie when it brought back the 100% exclusion from gain for qualified small business stock. You can read all about it here, but in a nutshell, a founder or investor could escape ALL federal income tax on up to $10 million of gains from the sale of certain small business stock. IF that founder is smart enough to move to a tax haven state, like Nevada or South Dakota (the little known weaker sister of its much more prominent neighbor, North Dakota), they could avoid paying US income tax at all on sales gains. Think about that for a minute. Zero rate of tax. Nevada would be like the Cayman Islands, without the scuba diving.

Would California business owners actually do that? Would they dare to leave and “stiff” California out of its share of taxes? Would they actually buy a house in one of those states (in most states you can get a mansion for the cost of a windowsill in California) and maybe end up living next to a neighbor with a monster truck and a girlfriend named Porsche?

You bet your ass they would. It happens all the time. Even now.

Ross Perot was talking about something different when he came up with “giant sucking sound” but I think the name is still good, almost as good as “The Tax Rush of 2013” ™ which I invented. It sort of sounds like an IRS frat party thing, but I still like it.

Of course this is all speculation on my part. The California magic of innovation, film, finance and technology may offset the increased costs. As I said, no hard data is yet available. Unfortunately, by the time it is ready, it will likely be too late.

Posted in Entrepreneurs, Nevada, Startup Law, Tax | Comments Off