Whether you are transferring patent or acquiring rights in a patent, the tax consequences can vary greatly depending on how the transfer is structured. The IRS has recently issued a document (Legal Advice by Field Attorney 20131201F) (the "IRS Advice") in which the issue was whether an individual had sold or had licensed a patent to a corporation in which he was a shareholder. The IRS concluded that the individual sold the patent to the corporation, primarily because the transfer documents indicated the transaction was a "sale," rather than a "license." The individual had filed his tax return for the year of the transaction as if the transfer were a sale, while the corporation filed its tax return as if it were a licensee of the patent.
The federal tax considerations involved in transferring a patent noted below shed light on why the parties in the IRS Advice had incentive to report the patent transaction differently for tax purposes.
Sale or License?
If you transfer or acquire a patent or rights in a patent, the initial determination for tax purposes is whether the patent was sold or merely licensed. The determination requires a consideration of all of the facts and circumstances, and the transfer will generally be considered a licensing arrangement unless you transfer or acquire "all substantial rights" under the patent.
An exclusive license of all rights under a patent that remains in effect for the full remaining life of the patent will generally be treated as a sale for tax purposes, even if the licensor retains certain protections, such as the right to terminate the agreement if the licensee does not meet certain performance standards.
As demonstrated by the IRS Advice, you also need to document the transaction in accordance with your intent. In the IRS Advice, the parties recited that the rights in a patent were sold and the transfer document was titled "Assignment," so the corporation was not allowed to claim that it was only a licensee.
Tax Treatment of Licensor
If you decide to license a patent that you own, and the license is not considered a sale of the patent for tax purposes, then you will be taxed on the receipt of royalty payments as ordinary income. While you will not be able to offset the royalty payments against any tax basis you may have in the patent, you will continue to be able to amortize the patent to the extent that it is amortizable.
Tax Treatment of Licensee
If you are a licensee of a patent, then you will generally be able to deduct the royalty payments as a business expense.
Tax Treatment of Seller
If you sell a patent, you will have a gain or loss equal to the difference between your adjusted tax basis in the patent and the amount received from the buyer. You will normally desire that any gain be treated as a long-term (i.e., held for over one year) capital gain due to lower tax rates: for 2013, ordinary income can be taxed at a rate as high as 39.6%, while long-term capital gains are taxed at a maximum rate of 20%. However, note that the rate differential does not apply to C corporations, which are taxed at rates that do not differentiate between capital gain and ordinary income.
Unique Tax Benefit to Patent Sellers
As the seller of a patent, you may be able to benefit from a special provision in the Internal Revenue Code (Section 1235) which allows for long-term capital gain treatment for the sale of a patent if two key requirements are met, even if the patent has not been held for one year. The first key requirement is that you be a "holder" of the patent, which means you must have created the patent or have paid its creator for the patent prior to reduction to practice of the patentable invention. However, you will not qualify as a "holder" if you are the employer of the inventor or any party related to the inventor.
The second key requirement is that you must transfer "all substantial rights" in the patent. This requirement is not met if you limit use of the rights to the patent by geography, field of use, length of use (if that duration is less than the patent's life), or the inventions covered by the patent (if less than all existing inventions covered by the patent). A transfer that fails the "all substantial rights" test is deemed a license instead of a sale.
Even if you cannot meet the requirements of Code Section 1235, your sale may still qualify for long-term capital gain treatment if you have held the patent for at least one year prior to the sale. However, if the patent has been amortized, the gain will be taxed at ordinary income rates to the extent of the amortization. Additionally, if you hold the patent as "inventory" for tax purposes (which would be the case, for example, if you are a professional inventor deemed to be in the business of developing and selling inventions to customers), it will not be eligible for capital treatment outside the scope of Code Section 1235.
A note of caution is in order if you are an employee seeking to obtain capital gain treatment for a sale of a patent to your employer. The issue that often arises is whether an employee who is paid to create patentable inventions can transfer the rights to such patents since the employee never owned those rights as they were the property of the employer. The IRS usually asserts that any payments received in such situation are just additional compensation. Nevertheless, it may still be possible for you as an employee-inventor to show that payments received from an employer are in exchange for the transfer of all substantial rights to a patent instead of compensation. To be successful, you will need to show that any payments you receive for any patentable inventions you created are in addition to your regular wages for performing invention work.
Tax Treatment of Purchaser
If you buy a patent as part of the acquisition of a trade or business, then you will be required to amortize the cost under the straight-line method over 15 years. If you acquire a patent separately, then you will have a choice of depreciation methods: (1) straight-line over the patent's remaining useful life; or (2) the "income forecast" method, which provides for annual depreciation deductions based on the ratio of current year income to forecasted total income from the "property" (that is, the patent).
The federal tax consequences of transferring of a patent or rights in a patent can be fairly complicated. The information in this newsletter focuses only on certain key considerations and is a limited summary which does not address all of tax consequences.
When dealing in the tax arena, advance planning and weighing various considerations is essential, and appropriate documentation often is a critical pre-condition to achieving the desired tax result. Always consult with experienced tax counsel when your project involves the sale or license of patents or patent rights.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.