Intellectual property ("IP," as it's commonly called) is a class of assets widely recognized by those in the ever-expanding universe of technology-driven professions. Yet the attributes of intellectual property are less widely understood, particularly with respect to determining and planning for the tax consequences associated with the creation, acquisition, or disposition of IP. This is a natural and expected state of affairs, because the Internal Revenue Code (the "Code") is complicated, and most successful entrepreneurs are more appropriately focused on building viable businesses. Nonetheless, because the Internal Revenue Service ("IRS") is not generally known for its sympathy, failing to understand the consequences of dealings in IP provides no relief from unexpected tax liabilities.
To help prevent heartburn and regret, this article highlights five questions that entrepreneurs, CFOs, and IP managers should ask, each a guidepost to aid the reader in preserving the desired tax consequences and maximizing the value of the reader's IP strategy. This article is not intended to cover every nuance imaginable. Rather, these guideposts are offered merely as guiding principles for interacting with a vastly more complicated subject area.
Guidepost #1: What type of property do you have?
The natural starting place for learning about the tax consequences of IP transactions is defining and understanding the assets referred to under the umbrella of "intellectual property." U.S. tax law differs from U.S. IP law, so the U.S. laws governing IP will be discussed only to the extent necessary to understand the laws governing its taxation.
U.S. law creates four broad categories of rights generally described as "intellectual property": (1) patents, (2) trademarks, (3) copyrights, and (4) trade secrets. A patent is a grant of the right to exclude all other parties from making, using, or selling the subject matter of the patent. A trademark is the word, logo, symbol, or name that distinguishes the source of a particular item from other goods. A trademark confers only the right to prevent another party from using "confusingly similar" marks to identify its goods. Copyrights are the rights afforded to authors of literary, dramatic, musical, artistic, and other works. The copyright owner has the exclusive right to reproduce, distribute, perform, and display the copyrighted material, as well as the exclusive right to create derivative works. A trade secret is a type of proprietary information that is not publicly disclosed and that derives some value from the owner's efforts to conceal the information (for example, the recipe for Coca-Cola).
U.S. tax law, in contrast, does not define IP at all, but instead refers to "intangible assets," a category encompassing the types of assets discussed above, in addition to other intangible assets, such as goodwill, market share, licenses, franchises, and so on. As a result, entrepreneurs must be somewhat bilingual, understanding that the classification of an asset for IP protection purposes may not coincide with its classification for tax purposes.
Guidepost #2: Who is the creator and who is the owner of the property?
Under U.S. tax law, certain types of IP are classified as "self-created" if the creator of the IP is also its owner. This affects the character of income upon disposition, as well as the treatment of acquisition costs.
Identifying an asset's creator for federal income tax purposes can be more complicated than simply naming the primary person whose efforts contributed to the IP, and partially depends on the type of asset being created and the tax attributes under examination. For example, for purposes of determining tax basis and appropriate amortization of acquisition costs, patents, copyrights, and trade secrets (but not trademarks) can be created by the person who pays for the creation of the asset, even if that person is not the one performing the work.
In contrast, for purposes of determining the tax rate applicable to disposition of IP, patents, copyrights, literary, musical, or artistic compositions, and similar property are created only by the taxpayer whose personal efforts created the asset (in the case of a patent, the original inventor). Such a person is the one who performs the work that actually creates the asset. So the person must have some personal connection to the work. Naturally, this definition of a "personal" creator contemplates individual persons as the creators of IP, but begs the question whether a business entity can also be a "personal" creator under this test. Under IRS rules, a corporation will be treated as the creator of IP if the person whose personal efforts created the IP was paid by the corporation for the person's efforts at market rates.
These examples are illustrative only, and are not intended to fully explain the various types of intangible property or the full scope of their creators’ relevant characteristics. Rather, each class of asset should be evaluated in consultation with the taxpayer's tax advise.
The owners of competing rights to IP should be clearly identified in the customary ways and with appropriate documentation, all in consultation with U.S. IP counsel. In this sense, identifying the owner of IP is straightforward by comparison to identifying the asset's creator: the taxpayer either owns an interest in IP under applicable U.S. IP laws or does not. If the taxpayer does own an interest in IP and is deemed the creator of the IP, then the asset is "self-created" and will be subject to particular tax rules upon creation and disposition.
Guidepost #3: How will the property be acquired?
The method chosen to acquire IP dictates how the acquisition costs are treated for tax purposes. Generally speaking, IP can be acquired by license, purchase, or internal development, or as a contribution to a company’s capital. Each method of acquisition bears its own attributes dictating whether the costs of acquisition may be immediately deducted, capitalized and recovered through amortization or other deductions, or capitalized and recovered on sale.
Internally Developed IP
The cost of self-creating an intangible asset is immediately deductible as an ordinary business expense, amortized as a start-up expense, or capitalized into the tax basis of the asset and recovered only on the asset's sale. There are several exceptions to classification as self-created IP- notably, the “self-created” designation does not apply to trademarks, trade names, licenses, franchises, or assets created in connection with the purchase of a trade or business (for example, goodwill or going- concern value purchased as part of a business acquisition). The Tax Cuts and Jobs Act, passed in late 2017 as the most sweeping tax reform act since 1986, created another exception, effective beginning in 2022, requiring taxpayers to amortize the costs of developing software over five years.
Acquisition by Company From Equity Holder
IP is frequently contributed to a company in exchange for equity, often in the case of start-up companies centered on a single product or technology. Generally, the contributed IP will retain its character as self-created, and the same amortization and capitalization rules will apply to the IP in the hands of an entity as would apply if the assets had been held directly by the creator.
Acquisition by License
If developing IP internally is impossible or too expensive, another common option is to acquire rights in IP by licensing those rights from a third party. In such a case, the royalty payments are immediately deductible as the ordinary and necessary expenses of doing business.
Acquisition by Purchase
In some instances U.S. tax law distinguishes between IP purchased on a stand-alone basis and IP purchased as part of a line of business. This is particularly relevant in the case of computer software; films, sound recordings, videotapes, or books; and patents and copyrights. If these types of assets are purchased on a stand-alone basis, the cost of acquisition is recovered through amortization and depreciation deductions calculated in roughly the same manner as for any other tangible asset employed in the taxpayer's business. Alternatively, if these assets are acquired as part of the acquisition of a trade or business, then cost of the assets is amortized ratably over 15 years.
Guidepost #4: How will the property be monetized?
The method chosen to monetize IP dictates how the income from the IP is taxed. Generally speaking, there are two ways of monetizing intellectual property: by license and by sale. Licensing the IP results in royalty payments, which are taxed as ordinary income, while the sale of the IP generally results in ordinary or capital taxable gain.
Sale or License
Distinguishing between a license and an outright sale is not always straightforward. In many cases, the parties may call a transaction a “license,” a “sale,” or something altogether different, yet the tax consequence may not follow the transaction's naming convention. Rather, the substance of the transaction determines the correct tax consequence. A sale usually occurs when the owner relinquishes legal title and all substantial rights to the IP, and a license usually occurs when the owner retains substantial rights over the IP.
Character of Income
The character of income, as either ordinary or capital income, is based on the character of the IP being sold and the identities of the asset's creator and owner. Generally speaking, royalty income is taxed as ordinary income, as is any gain from the sale of self-created IP. Before 2018, the sale of a patent was treated as the sale of a capital asset and taxed at the long-term capital gains rate. The Tax Cuts and Jobs Act revised the definition of “capital asset” to specifically exclude patents, inventions, models, designs, secret formulas, and secret processes if the asset is self-created.
Yet because the Tax Cuts and Jobs Act did not repeal the existing law mandating capital gains treatment for sales of self-created patents, the Code now contains conflicting treatment of sales for self-created patents, and it is unclear whether Congress intends such sales to be taxed as sales of ordinary or capital assets. One thing is certain, however: beginning in 2018, very few sales will remain eligible for long-term capital gains treatment under existing law. In most instances, the conservative approach is to assume that a patent will be treated as an ordinary asset in the hands of the patent's creator.
Guidepost #5: Who are your partners?
Finally, many businesses carefully evaluate potential licensees, franchisees, and vendors for fit within a larger business plan, but infrequently consider whether these relationships may inadvertently create partnerships for tax purposes. Under the commercial law of most states, a general partnership arises when two or more parties have a common undertaking with a profit motive. Similarly, for federal tax purposes, a partnership includes any group carrying on any business or venture with the intent of sharing profits.
A number of common IP-related agreements, if not carefully drafted, can cause the parties to be treated as a partnership for tax purposes. For example, licensing agreements, development agreements, marketing agreements, and collaboration agreements run the risk of creating a partnership between the contracting parties. While this result might not be fatal in itself, classification as a partnership carries a number of attendant burdens, such as filing partnership tax returns.
Significantly, if contracting parties become classified as a partnership for federal tax purposes, those parties are subject to the streamlined partnership audit rules (the "Audit Rules") enacted by the Bipartisan Budget Act of 2015. Among other things, the Audit Rules create the position of "partnership representative," a person with authority to act on behalf of the partnership and all present and future members of the partnership with respect to tax matters. If no partnership representative is appointed by the partners—as generally happens when the partners don't realize they're in a partnership—the IRS has the authority to appoint any person in the United States to act in that capacity.
Any party unwilling to abdicate its tax affairs to an unknown person appointed by the IRS should take great care not only in identifying potential licensees, franchisees, and the like but also in structuring its interactions in such a way as to avoid creating an unintended partnership.