Jason Klimek, BridgeTower Media Newswires
What is considered "intellectual property" for tax purposes? The Internal Revenue Code (the "Code") has a rather expansive definition of intellectual property, which includes patents, trademarks, copyrights, trade secrets, software, contractual rights, goodwill and covenants not to compete, many of which fall under the definition of "capital asset." How the Code treats various IP depends on numerous factors including what section of the Code governs the IP and who is using or purchasing the IP.
This article is intended to review the provisions governing various IP taxation based on the following categories: (1) creation of IP; (2) sale of IP by the creator; (3) purchase of IP by non-creator; (4) use of purchased IP by non-creator; and (5) sale of purchased IP by non-creator.
-----
Patents
The Code allows for the deduction of the costs of obtaining a patent, including attorney's fees spent on making the patent application and prosecuting the patent. Further, a creator may qualify for tax credits under § 41 credit for increasing research activities. Section 174 may apply which allows for the deduction of research and experimental expenditures. These deductions and credits are similar to the standard "trade or business expense" deduction under § 162. However, the major difference is that under § 174, you do not have to be "engaged in the trade or business" to make use of the deduction.
When the creator of a patent sells the patent, the recognition of tax will be treated as a capital gain. If the patent is held over a year, there will be long-term capital gains. However, in certain circumstances, if a patent is held for under a year, the creator/seller may still be able to get long-term capital gains treatment.
When acquiring a patent, the code looks to whether the patent was separately acquired or whether it was acquired in the acquisition of assets constituting a trade or business. If the patent was separately acquired, the Code allows the purchaser to depreciate the patent over the useful life of the patent, typically using the income forecast method. If, however, the patent was acquired as part of a trade or business, the patent is amortized over 15 years. If the transfer of a patent is pursuant to Code § 1235 and the seller has depreciated the patent, the seller can avoid § 1245 recapture.
It is also important to keep in mind how the patent is transferred, i.e., whether there is a license or a sale. Where there is a sale of a patent, that income is treated as capital gains. However, where there is a licensing of the patent, the transfer will generate ordinary income. There are certain circumstances where a license may get sales treatment, resulting in capital gains treatment for the seller.
-----
Trademarks and Trade Names
Unlike patents, where expenses in the creation may be deducted up front or even qualify for a tax credit, expenses related to the creation of a trademark must be amortized over a 15-year period.
The sale of a trademark or trade name that otherwise qualifies as a sale or exchange of a capital asset may be barred from long-term capital gains treatment if the transferor retains a "significant interest" in the transferred mark or trade name.
A significant interest may best be described as a transfer that resembles more of a license than a sale.
The retention of a significant interest, or a straight licensing agreement, will result in what the IRS will consider royalties, which generate ordinary income. Payments may also be bifurcated into capital gains and ordinary income depending on the terms of the transfer.
-----
Copyrights
Production of tangible personal property as part of a trade or business requires costs to be capitalized. However, qualified creative expenses incurred by individuals engaged in the trade or business of being a writer, photographer or artist are exempt from the capitalization requirement if the expenses would be deductible but for the capitalization requirement.
If the creator of a copyright sells the copyright, the gain is taxed as ordinary income. However, musical compositions or copyrights in musical works sold by the creator, at the creator's election, may be taxed as a capital asset. If held for more than one year, the sale of the copyright will generate long-term capital gains.
When a buyer purchases a copyright, tax treatment depends on whether the mark is "separately acquired" or acquired in connection with an acquisition of assets constituting a trade or business. If the mark is considered separately acquired, the cost can be amortized using the income forecast method for depreciation. However, if the property is acquired as part of a trade or business, the expense must be capitalized and amortized on a straight-line method over 15 years.
Sales of copyrights by anyone other than the creator can generate long-term capital gains if the asset was held for over one year. However, unlike patents, the seller will be subject to depreciation recapture. Like patents and trademarks, the sale of a copyright will generate capital gains, but the licensing of a copyright will generate ordinary income.
-----
Trade Secrets
Trade secret protection is available for intellectual property that may not qualify for, or may not be adequately protected by, a patent, copyright or trademark. In order to qualify as a trade secret the information must be (1) not known outside of the particular business entity; (2) known only by employees and others involved in the business; (3) subject to reasonable measures to guard the secrecy of the information; (4) valuable; and (5) difficult for others to properly acquire or independently duplicate.
Trade secret research expenses, like those of patents, may qualify for the research and development tax credit. For those expenses that do not qualify for the R&D credit, the standard business deduction is available for ordinary and necessary business expenditures.
If used in a trade or business and held for more than one year, the sale of a trade secret will generate long-term capital gains for the creator. The buyer must amortize the cost of the acquisition over 15 years. The sale of a trade secret, by a buyer, is treated as capital gains.
-----
Conclusion
Understanding these tax issues or the right accountant or tax attorney can make a tremendous difference in terms of the taxes sellers and buyers pay. Equally important, IP creators and business owners must utilize a professional who is capable of structuring sales and acquisitions to minimize the tax effects through items such as intangible asset allocation and licensing agreements.
The taxation of intellectual property is an incredibly complex topic, but if a creator or business engages the right professional, he or she can save the buyer or seller payment of unnecessary taxes.
-----
Jason Klimek is an associate and a member of Boylan Code's Corporate Practice and Real Estate Groups. He concentrates his practice in business planning and development, tax planning, advising and financing.
Published: Fri, May 05, 2017
