United States: Tax 101: Taxation Of Intellectual Property—Selected Tax Issues Involving Corporations And Partnerships

Last Updated: December 7 2017
Article by Stanley C. Ruchelman and Elizabeth V. Zanet

This article reviews the basic US Federal tax con- siderations of intellectual property (IP) taxation in the context of corporations and partnerships and exam- ines some typical tax considerations when IP is held through a corporation or a partnership.

Corporations

Acquisitions

A corporation may acquire IP in several ways, including

  • receiving a contribution of IP from a shareholder,
  • purchasing or licensing the use of IP from another person, or
  • creating IP in-house.

Under Internal Revenue Code (Code) § 351, a shareholder's contribution of property, such as IP, to a corporation will be tax-free if

  • the transfer is solely in exchange for stock of the transferee corporation, and
  • the transferor is in control of the transferee cor- poration immediately after the exchange, which for this purpose means ownership of 80 percent or more of the total value and 80 percent or more of the total voting rights with respect to the corporation's stock.

In a Code § 351 exchange, the transferee corpora- tion's basis in the contributed IP will be the same as that of the transferor shareholder.

If the Code § 351 requirements are not met, the shareholder will recognize gain, but not loss, to the extent that the value of the stock exceeds his or her adjusted basis in the IP. Here, value of shares is closely associated with the value of the IP at the time of transfer. Any gain recognized by the trans- feror shareholder will be added to the transferee corporation's adjusted basis in the contributed IP. Examples of circumstances in which a shareholder will recognize gain in an otherwise tax-free Code § 351 exchange include a transfer where the trans- feror receives cash or other property in addition to the stock of the transferee corporation.

In the past, there was some doubt as to whether intangible assets, such as IP, constituted "property" for purposes of Code § 351. Though the issue has been settled in favor of the taxpayer, an issue that is not clear is whether a transfer of less than all sub- stantial rights in the property, such as a transfer of a license to use the IP, is a tax-free transfer under Code § 351. In Revenue Ruling 69-156,1 the Internal Revenue Service (IRS) determined that the transfer by a domestic corporation of an exclusive right to import, make, use, sell, and sublicense a patent involving a chemical compound to its foreign subsidiary was not a transfer of "property" within the meaning of Code § 351. It stated that tax-free treatment under Code § 351 is only available when the rights trans- ferred by the shareholder would constitute a sale, not a license, if the transfer were a taxable transfer. In contrast, in E.I. Dupont de Nemours v. U.S.,2 the Court of Claims held that a carved-out right to a non- exclusive license would qualify for tax-free treatment under Code § 351 and that there was no basis for limiting tax-free treatment under Code § 351 to transfers that would constitute sales or exchanges if they were not subject to a nonrecognition provision. The IRS has recognized that this case has precedential value and must be strongly considered, although it has not withdrawn the ruling.3

A shareholder's receipt of stock in exchange for ser- vices does not meet the requirements of Code § 351. However, if IP is transferred and the IP constitutes property for the purposes of Code § 351, the transfer will be tax free under Code § 351, even though the shareholder performed services to produce the property. Further, where the transferor shareholder agrees to perform services in connection with a transfer of property, the IRS determined that tax-free treatment under Code § 351 will be accorded if the services are "merely ancillary or subsidiary" to the transfer. These ancillary and subsidiary services could include pro- moting the transaction by demonstrating and explain- ing the use of the property, assisting in the "starting up" of the property transferred, or performing under a guarantee relating to the effective starting up.4

Under circumstances in which the shareholder must recognize gain on the IP transfer, the gain will be subject to the recapture rules of Code § 1245 if the IP was amortizable. The rules of Code § 1221 and § 1231 must be applied to determine whether the gain is ordinary income or capital gain.

A corporation may acquire IP as a separate asset or as part of a trade or business. In the case of separately acquired IP, the corporation's basis in the IP generally will be the purchase price. In the case of IP acquired as part of a trade or business, the corporation's basis in the IP will depend on whether the acquisition is an asset or stock acquisition. In the case of an asset acquisition, the purchase price must be allocated among the assets of the trade or business, including the IP, under the rules of Code § 1060.

In the case of a stock acquisition, the corporation will not receive a step-up in the basis of the underlying assets of the acquired corporation, unless it makes an election under Code § 338 to treat the stock purchase as an asset purchase. The purchase price will be allo- cated under rules similar to the rules of Code § 1060. In the case of self-created IP where the corporation capitalizes the costs of developing the IP, the corpora- tion will have a basis in the IP generally equal to the capitalized costs. As discussed below, this basis may be amortized. Alternatively, if the corporation is per- mitted to deduct all or some of the costs incurred in developing the IP, the corporation may have no basis or a very low basis in the IP.

Amortization

Corporations are subject to amortization rules for self-created and acquired IP. Thus, for example, under the rules of Code § 197, a corporation generally may amortize its basis in a broad list of acquired IP (including, patents, trademarks, trade names, trade secrets and know-how, copyrights, and computer software) if the acquired IP is used in a trade or busi- ness or an activity carried on for the production of income and was not separately acquired. Though corporate taxpayers have several choices in amor- tization methods, Code § 197 requires straight-line depreciation over a 15-year period. The rules of Code § 167 must be applied to determine the amortization permitted for a corporation's self-created and sepa- rately acquired IP.

In the case of contributed IP, one of two situations may arise:

  • A shareholder may contribute IP that was amor- tizable in the hands of the shareholder.
  • A shareholder may contribute IP that was not amortizable in the hands of the shareholder, such as certain self-created IP.

In the former case, the transferee corporation generally steps into the place of the transferor share- holder and, thus, receives a carryover basis, which must be amortized over the remainder of the original amortization period. If gain is recognized on the transfer, the transferee corporation's basis in the IP will equal the transferor shareholder's basis plus the recognized gain. The amortization of the IP will be bifurcated: The portion of the basis corresponding to the carryover basis will continue to be amortized over the remaining original amortization period, and the portion of the basis that corresponds to the rec- ognized gain will be amortized under a new 15-year amortization period.

In the latter case, the corporation generally will not be permitted to amortize the contributed IP, unless the transferor recognizes gain. In that case, the recognized gain will be treated as a purchase price, and become the transferee corporation's basis in the IP, which may be amortized. Dispositions

A corporation's disposition of IP may take several forms, including

  • a sale of IP to an unrelated third party,
  • a sale of IP to a shareholder, or
  • a distribution of IP to a shareholder.

If a corporation sells amortizable IP to an unre- lated third-party, any recognized gain attributable to the pre-sale amortization deductions will be charac- terized as ordinary income under the recapture rules of Code § 1245. Any remaining gain or loss may be characterized as either ordinary or capital under the rules of Code § 1221 or § 1231.

In the case of a sale to a shareholder owning a sig- nificant portion of the corporation, any gain in excess of the Code § 1245 recapture amount recognized on the sale will be treated as ordinary income under Code § 1239, which generally applies to the transfer of property from a corporation to a shareholder if the transferred property is depreciable or amortizable in the hands of the transferee shareholder and the shareholder is considered a related person. For the purposes of Code § 1239, the shareholder is a related person if it holds more than a 50 percent interest in the corporation.

If the shareholder does not meet the Code § 1239 ownership threshold, the recapture and characteriza- tion rules applicable to an unrelated third-party buyer will apply, as discussed above.

IP that is amortizable under Code § 197 is subject to a loss disallowance rule under Code § 197(f) that prevents the recognition of loss in the case of an asset that was acquired in a transaction or a series of trans- actions if, at the time of the disposition, the taxpayer retains the other intangible assets amortizable under Code § 197 that were acquired in the same transac- tion or series of related transactions. The purpose of this rule is to prevent taxpayers from recovering their basis faster than over the 15-year amortiza- tion period. The unrecognized loss is not completely forfeited, but rather, it is added to the bases of the remaining intangible assets and amortized over the remaining 15-year amortization period.

The following example illustrates the loss disallow- ance rule:

In tax year 1, a corporation, C, acquires a trade or business, which includes IP assets. C receives a step-up in the basis of the IP assets and takes amortization deductions. C utilizes the IP assets in business line 1 and business line 2. Subsequently, in tax year 5, C decides to sell business line 1. The sale is structured as an asset sale and includes one of the IP assets acquired in the acquisition of the trade or business that occurred in tax year 1. The remaining IP assets acquired in the tax year 1 acquisition will not be sold. Under the loss disallowance rule, any loss realized on the IP asset sold as part of the sale of business line 1 will not be recognized by C. The loss will be added to the bases of the remaining IP assets, essentially meaning that the basis in excess of the fair market value of the disposed asset is transferred to the remaining assets.

The loss disallowance rule applies in the case of nonrecognition transactions. Thus, in the above illus- tration, the loss disallowance rule would apply if C transferred the assets of business line 1 to a corpora- tion in a tax-free exchange for stock under Code § 351 and then sold the stock in that corporation.5

For the purposes of the loss disallowance rule, members of a controlled group of corporations are treated as a single taxpayer so that no loss is allowed on the disposition of IP by one member of a con- trolled group of corporations if another member of the controlled group retains other Code § 197 intan- gible assets that were acquired in the same transac- tion or series of related transactions as the asset that was disposed of.

If a corporation transfers IP to a shareholder as part of a nonrecognition transaction, such as a dis- tribution that is part of a liquidation of a subsidiary into its parent corporation or a like-kind exchange, the shareholder will step into the shoes of the corpo- ration with respect to the IP. Thus, the shareholder will receive a carryover basis in the IP, and if the IP was amortizable in the hands of the corporation, the shareholder will continue to amortize the IP over the remaining amortization period.

If a corporation distributes IP to a shareholder in a transaction that does not qualify for nonrecogni- tion treatment, such as a dividend in-kind under Code § 301, a stock redemption under Code § 302, or a distribution in complete liquidation under Code § 336, the shareholder's basis in the IP will be its fair market value and the corporation will recognize gain. To the extent of depreciation recapture under Code § 1245, the gain will be taxed as ordinary income. Any additional gain will be treated as capital gain. Note that for the corporation, capital gains and ordinary income are taxed at the same rate. In the event that the corporation has a capital loss carryover from other transactions, the carryover capital losses can reduce capital gains generated from the distribution. Any loss likely will be disallowed to the corporation under the loss disallowance rule discussed above.

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