Flow Through Taxation

Limited liability companies, partnerships, and subchapter S corporations have so-called “flow through taxation.”  That means that the entity files a tax return but the taxes are owed by the shareholders.  Typically the taxes are assessed based on a percentage of ownership.  Flow through losses may be beneficial if you have other income which you can shelter with the losses.  Flow through profits are good if you get a distribution.  There is no requirement for flow through entities to make distributions so you could end up with taxable income, tax liability, and no money to pay the taxes.  Some flow through entities provide limited liability (LLCs, LPs, Sub S Corps) and some do not (general partnerships).  They are great for businesses being run for cash flow with many non-employee shareholders, since dividends are not doubly taxed.  If all owners are employees erstwhile profits can be distributed as paychecks and bonuses which are chargeable at the corporate level.  But if many owners are not employees dividends are the only way to distribute profit.  Typically the entity keeps a capital account for each owner.  Investments and undistributed profits increase an owner’s capital account, while distributions and distributed losses decrease an owner’s capital account.  But be careful of a negative capital account because having that written off can result in discharge of indebtedness income.  Some flow through entities are allowed entity owners and some are not.  LLCs are sometimes used for strategic alliances because each alliance partner receives a cash flow stream to use as it pleases.  If a new business is set up for cash flow, a flow through entity makes sense; if it is set up for capital appreciation maybe a non-S corporation makes more sense.  Flow through entities can convert into non flow through entities, but it is harder to convert the other direction.  If you are considering a new entity, talk to your accountant about whether a flow through entity makes sense for you.

 -- Paul Marotta

Supremes:  Your DNA is Not Your Own

After being arrested on first and second degree assault charges, the cops took a cheek swab of Alonzo King to check his DNA.  They found a match with an unsolved rape case, charged him, and he was convicted.  King claimed the cheek swab was an unreasonable search and seizure which violated his Constitutional Fourth Amendment rights.  The Supremes, led by Kennedy, disagreed finding that a cheek swab was not unreasonable and comparing it to a blood test.  But when that cheek swab results in your DNA being permanently indexed for everyone to access, we think more caution is called for.  This is not a case of checking blood alcohol level; this is a case of being tagged with a DNA match a decade later.  We don’t have any sympathy for rapists.  Gas ‘em if you want.  But these concepts are only really tested at the margins and the more heinous the crime the more careful we need to be that the rules aren’t bent to get a conviction.  Otherwise there will be no rules left.  Ninth Circuit Judge Alex Kozinski has made clear to us all that we control what is deemed “reasonable” and “unreasonable” by what we allow and don’t allow.  We can all help each other by decrying all such searches as unreasonable.  If enough of us do that, they will be seen as unreasonable by our courts.  The more we allow the more we invite.  The majority spoke quite a bit about the database being used for other purposes but seemed to imply that this could be done even if the person is never convicted of anything.  In other words, suspected until proven innocent.  That is not our system.  Scalia wrote for the minority, joined by Ginsburg, Sotomayor (the racist), and Kagan, saying, “The Fourth Amendment forbids searching a person for evidence of a crime when there is no basis for believing the person is guilty of the crime or is in possession of incriminating evidence.”  In other words, the search was unreasonable unless there was a basis for believing King to be the rapist, even if he was arrested for something unrelated, as here.  Scalia continued, “That prohibition is categorical and without exception,” and later said, “The Court’s assertion that DNA is being taken, not to solve crimes, but to identify those in the State’s custody, taxes the credulity of the credulous.”  We agree.  They got this one wrong and our liberty suffers further.

  --  Paul Marotta

Social Media Securities Disclosure

 

The SEC’s Division of Enforcement launched an investigation of Netflix after its CEO Reed Hastings posted on his personal Facebook page that Netflix’s monthly online viewing had passed one billion hours for the first time.  Netflix didn’t report this information to investors through a press release or 8-K.  Neither Hastings nor Netflix had previously used Hastings’ Facebook page to announce Netflix metrics, and no one told investors they might do so.  Netflix’s stock price rose over 10% during the next day.  Regulation FD did away with private analysts calls, and requires companies to make publicly available as soon as possible any information disclosed privately.  Disclosure can be by press release or 8-K filing.  Public companies frequently make 8-K filings following annual meetings since execs sometimes spill beans not already public.  In the investigative report the SEC said that use of social media to disclose company information was OK as long as it has alerted the public that it might do so through a specific outlet.  Websites already serve as an effective means for disseminating information to investors if they’ve been made aware that’s where to look for it.  The SEC did not initiate an enforcement action or allege wrongdoing by Hastings or Netflix.  We were happy to see common sense prevail.

   

-- Paul Marotta 

Megaupload

Megaupload was established in 2005 in Hong Kong to allow cloud based file sharing.  But the domain was seized in January by the US Government allegedly for copyright infringement.  When that happened, users lost access to their files and $330 million in assets were frozen.  The owners, including New Zealand resident Kim Dotcom, were indicted.  Megaupload had enjoyed 50,000,000 visitors per day, 180,000,000 registered users, was the 13th most visited Internet site, and hosted 12 billion unique files taking up 25 petabytes (25 million gigabytes).  Dotcom’s house was intentionally raided on his birthday by New Zealand authorities at the instigation of the US.  It turned out that the company was never properly served with the property seizure notice nor the underlying federal case.  The Department of Justice has apparently been writing to lawyers taking on the defense, and warning them off the case, threatening to call their clients as witnesses.  Santa Clara University Law School Professor Eric Goldman described the Megaupload case as, “a depressing display of abuse of government authority.”   He claimed that seizing Megaupload’s site had created the “deeply unconstitutional effect” of denying users their data.  The Electronic Frontier Foundation has taken on cases on behalf of users denied their data.  We say, “Go for it!” 

-- Paul Marotta

BATs Failed IPO

A funny thing happened on the way to the initial public offering of BATS Global Markets, Inc.; a computerized stock exchange; it failed.  A bug in their own trading system disrupted trading within seconds of its debut and raised concern the exchange didn’t work.  By mid-day on IPO day BATS has fixed the bug, but by then had lost the confidence of its IPO buyers, mostly hedge funds and buy-side analysts.  The fiasco raised doubts about BATS technology, business model, and valuation, and no one wanted to pay $16 a share anymore.  So it withdrew its IPO and trades for more than a million BATS shares were voided.  BATS CEO said, “The fact that our own stock was out there to be traded for the first time, and we showed systems problems, eroded customer confidence.  Of course investors are going to say, ‘Hey, wait a second.’”  And the IPO already wasn’t going great guns.  The first trade was at 10:45 and was down $0.75 to $15.25.  When that hit, some people wanted to liquidate their entire position in BATS.  BATS wanted to reopen trading but some brokers said it would have been a bloodbath.  And pre-IPO shareholders, including the underwriters, had awarded themselves a $100 million dividend contingent on the IPO.  Had they kept trading, a lawsuit was almost certain.

-- Paul Marotta

Government Infringer

The Federal Circuit Court (the circuit responsible for most intellectual property disputes) recently held that the federal government can be held to patent infringement when one of its contractors infringes offshore.  In Zoltek Corporation v. US and Lockheed Martin, the owner of a patent concerning carbon fiber sheeting sued the U.S. because Lockheed Martin infringed in building F-22s.  The court found that the U.S. government can face patent infringement claims for products made outside the U.S. using infringing patented processes and then imported into the U.S. for use by a government contractor.  Also at issue was a statute providing immunity to the government contractor and whether or not Zoltek could sue Lockheed (they can’t).  Zoltek’s original complaint was filed in 1996.  The wheels of justice are apparently almost frozen.  

-- Paul Marotta

IPO's and Opt-Outs

We saw an interesting article recently concerning the place in our world for IPO’s.  The article argued that whereas IPO’s used to raise money for small companies, now they don’t really serve that function very well.  The flip side is that growing companies that don’t want to be public are stuck once they reach 500 shareholders and decent sized assets, in filing periodic reports whether they want to encourage a market for their stock, or need capital, or not.  Google didn’t need the money and Facebook doesn’t either.  And, of course, our increasing web of regulations (a lá Sarbanes Oxley) all based in an effort to regulate away dishonesty (good luck with that; how’d it work out in Bernie Madoff’s case) makes doing business harder and harder for the honest folk.  We think that our markets are not well served in any way:  Expense, burden; capital formation; reporting, ease of use, transparency, etc.  They simply don’t work. 

We’ve advocated before for a securities opt-out.  You don’t want SEC protection, opt out of their protection, good luck, and caveat emptor.  Maybe we need some wholly unregulated markets for trading securities.  The family Buzz has wanted for a long time a TSA-free airline.  Everyone get on the flight with your Louisville sluggers and during flight we’ll see whether the good guys or the bad guys are better batters [credit where credit is due:  That was the idea of a director of a public company we represent].  If the nanny state was created for our own good, can’t we decide we don’t want the protections offered?  In any case, we’ll likely see incremental changes in the SEC’s watchful eye but we doubt we’ll see any real reform.  Maybe we’ll just keep exporting public offerings to Britain, Canada, and Hong Kong.

-- Paul Marotta