United States: Tax Basics Of Intellectual Property

Last Updated: September 2 2018
Article by Elizabeth V. Zanet and Stanley C. Ruchelman

Like most assets developed, used, and sold in business, intellectual property (IP) is subject to important tax considerations. For purposes of U.S. federal tax law, intellectual property is part of a broader cate­gory of assets called "intangible assets." Intellectual property specifically addressed in the Internal Rev­enue Code (I.R.C.) includes patents, copyrights, formulas, processes, designs, patterns, know-how, format, trade secrets, trademarks, trade names, franchises, and computer software.1 This article pre­sents a brief overview of the basic U.S. federal tax considerations of events that may occur over the life cycle of intellectual property, from its creation to its acquisition, exploitation, licensing, and transfer. It begins by discussing important general tax concepts such as tax basis, capitalization, amortization, and asset characterization, in the context of intellectual property. Certain new rules introduced by the Tax Cuts and Jobs Act of 2017 (TCJA)2 are also addressed, including a new tax regime applicable to off­shore intellectual property.

Tax Basis as the Starting Point

A taxpayer's tax basis in an asset generally reflects the economic cost of the asset to the taxpayer. For example, if a company acquires a patent from an unrelated patent inventor for cash, the company's tax basis in the patent will be the amount paid to the inventor. The tax basis will be the company's starting point for computing any amortization deductions, which involves computing the annual amortization deduction as a percentage of the company's tax basis in the intellectual property over its useful life. If the company sells the intellectual property, its gain or loss on the sale generally is computed by refer­ence to its tax basis or its adjusted tax basis if the basis was adjusted, for example, downward to reflect amortization deductions. To compute any gain or loss, the company would subtract its adjusted tax basis from the consideration received on the sale. As for the inventor in the example, its tax basis in the intellectual property depends on whether it was allowed to deduct or required to capitalize the costs attributable to creating the intellectual property. These issues are considered in more detail below.

Tax Basis in Self-Created IP: Deduction or Capitalization?

A taxpayer that creates and utilizes intellectual property as part of a profitable ongoing business likely will prefer deducting the costs attributable to creating the intellectual property because that allows the taxpayer to receive a current tax benefit for the tax year during which the research and development (R&D) costs were paid or incurred. I.R.C. § 162 permits a current deduction for all the ordinary and nec­essary expenses paid or incurred during the tax year in carrying on any trade or business. To be deductible under § 162, a business expense must not be subject to any provision of the I.R.C. that requires capitalization, as discussed below.

I.R.C. § 174 provides a current deduction for certain types of research and experimental (R&E) expenses. R&E expenses are R&D costs in the experimental or laboratory sense; that is, activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.3 Thus, for example, the cost of creating a patentable pharmaceutical prod­uct, including the costs of obtaining a patent such as attorney fees, may be currently deducted under § 174.4 Under § 174, a taxpayer may elect to (1) currently deduct all R&E expenses made in connection with the taxpayer's trade or business, or (2) amortize the expenditures over a period of not less than 60 months beginning with the month in which the taxpayer first realizes benefits from the expenditures. For taxpayers operating at a loss, such as a new venture starting up operations, the deferral of the 60-month amortization period may provide a more valuable tax benefit than a current deduction. Fur­ther, § 174 applies more broadly than § 162 because it is available to taxpayers that are not yet engaged in a trade or business.5 As a result, it may be a valuable deduction for startups that may not yet be con­sidered "engaged in a trade or business" within the meaning of I.R.C. § 162. Note, however, a § 174 deduction likely is not available to a taxpayer that invests in IP development by funding the R&E expenses of a third party because such expenses likely would not be considered connected with the trade or business of the investor.

Under the TCJA for any tax year starting in 2022, I.R.C. § 174 expenses will not be deductible, but will continue to be amortizable as described above, and foreign R&E expenses (i.e., research conducted out­side the United States, Puerto Rico, or any U.S. possession) will have to be amortized over a 15-year period.6

Another useful provision for startups is I.R.C. § 195, which allows taxpayers to elect to defer deducting certain expenses incurred before the business becomes active and to deduct such expenses over a 15-year period beginning with the month in which the active business begins. Startup expenses are lim­ited to costs that would be deductible if the business was already an active trade or business.

If the costs paid or incurred by a taxpayer in the creation of intellectual property are currently deductible under the I.R.C., the accelerated tax benefit prevents the expenditure from being part of the taxpayer's basis in the intellectual property. Consequently, a taxpayer may have zero basis in self-cre­ated intellectual property if all the costs were deducted. If the I.R.C. requires the costs paid or incurred by a taxpayer in the creation of intellectual property to be capitalized, the capitalized costs will form the taxpayer's tax basis in the self-created intellectual property.

Case law and I.R.C. § 263 require the capitalization of a business expense if that expense will create or enhance a separate and distinct intangible asset or create or enhance a future benefit beyond the tax year in which the expense is incurred. The Treasury Regulations (Regulations) under § 263 generally require that amounts paid to create or acquire an intangible asset must be capitalized.7 Amounts paid to facilitate the creation or acquisition of an intangible asset also must be capitalized.8 The Regulations list some of the costs related to self-created intangible assets that must be capitalized. Some of the most significant in the context of intellectual property are (1) costs incurred to obtain rights from a govern-mental agency, such as costs to obtain, renew, renegotiate, or upgrade rights under a trademark, trade name, or copyright; and (2) costs to defend or perfect title to an intangible asset, such as the cost to set-tle a patent infringement lawsuit.9

I.R.C. § 263A requires the capitalization of a variety of costs attributable to property produced by a tax-payer or acquired for resale in a trade or business or an activity conducted for profit. For the purposes of § 263A, "property" is defined to include tangible property, which would seem to exclude intellectual property. However, tangible property under § 263A includes films, sound recordings, videotapes, books, and similar property that is intended to be produced on a tangible medium and mass distributed in a form that is not substantially altered. Thus, for example, the cost of writing a book, including the cost of producing a manuscript and obtaining a copyright or license for the project, must be capitalized pur-suant to § 263A.

Under the TCJA, certain property, referred to as "qualified property," is eligible for a temporary 100 percent bonus deduction under I.R.C. § 168(k). The term "qualified property" was expanded to include "qualified film or television productions," which generally means a film or television production in which 75 percent of the total compensation is paid to actors, directors, and producers for services per-formed in the United States and which meets the placed-in-service requirement, i.e., its initial release or broadcast is before December 31, 2026.

Tax Basis in Acquired IP: How to Allocate Purchase Price among Assets

A taxpayer's tax basis in an acquired asset generally is the amount paid for the asset. In an arm's length transaction, the amount paid should be the acquired asset's fair market value (FMV). In such case, if the taxpayer acquires a single asset, the basis of that asset will be the purchase price. In the case of an acquisition of multiple assets, the acquirer must determine the FMV of each asset, typically by having the assets appraised. If the assets comprise a trade or business, the I.R.C. provides rules for allocating the purchase price among the assets of the trade or business, as described below.

Direct Asset Acquisition

The assets of a business may be acquired directly through an asset acquisition or indirectly through a stock acquisition, as discussed below. Although more complicated to execute than a stock acquisition, an asset acquisition offers the benefit of receiving FMV basis in the assets, often referred to as a "stepped-up" basis because the acquirer's tax basis is stepped up to FMV. A stepped-up basis maximizes the new owner's amortization deductions and reduces the potential gain on a subsequent sale of the assets.

When a taxpayer acquires an intangible asset as part of the direct acquisition of assets comprising a trade or business, the bases of the acquired assets are determined under the rules of I.R.C. § 1060, which applies to any direct or indirect transfer of a group of assets that constitutes a trade or business in the hands of either the acquirer or the seller, and the acquirer's basis in the assets is determined wholly by reference to the consideration paid.

 The acquired assets are divided into seven classes, referred to under the Regulations as Class I through Class VII. Intangible assets, such as intellectual property, typically would fall into Class VI. The basis is allocated among the assets under a method by which the consideration is first reduced by the amount of Class I assets, and any remaining consideration is then allocated among the assets by ascending class number in an amount generally not in excess of FMV of the assets within each class. Thus, after the allo-cation of the purchase price to Class I assets is completed, the purchase price is allocated to Class II assets to the extent of their respective FMVs, and so forth until the balance of the purchase price is allo-cated to Class VII assets.

Stock Acquisition

In an acquisition of stock, the acquirer generally will have a tax basis in the acquired corporation's stock equal to the consideration paid for the stock and a carryover basis in the acquired corporation's under-lying assets. Thus, for example, if the consideration paid by a taxpayer to acquire all of the stock of a corporation exceeds the aggregate bases of the corporation's assets (often referred to as the stock-holder's "inside basis" in the corporation), neither the acquirer nor the acquired corporation will be entitled to increase the bases in the corporation's assets.

The inability to obtain basis step-up in the usual stock acquisition makes stock acquisitions less advan-tageous than asset acquisitions, especially if the corporation's assets have desirable tax attributes such as amortization deductions. On the other hand, asset acquisitions can be complicated because some assets, such as permits and licenses, may be difficult to transfer. Under a special election regime in I.R.C. § 338, taxpayers may elect to treat certain stock acquisitions as asset acquisitions for the purpose of obtaining basis step-up in the underlying assets of the acquired corporation. The basis is allocated among the assets of the acquired corporation under rules similar to the rules described above, in which basis is first allocated to one class of assets and will continue to be allocated among the assets by ascending class number.

The basis step-up is achieved through a hypothetical sale of the target corporation's assets. There are two types of elections: a § 338(g) election, which may be made by a corporation acquiring another cor-poration and is made at the election of the acquirer; or a § 338(h)(10) election, which may be made by a corporation acquiring a corporate subsidiary and is made at the election of both the acquirer and the seller. Under the § 338(g) election, the tax cost of the deemed sale is borne by the acquirer; under the § 338(h)(10) election, the tax cost is borne by the seller and will be reflected in the purchase price.

Acquisition Costs

The costs to acquire an intangible asset, including many IP assets such as patents, copyrights, fran-chises, trademarks, trade names, or computer software, must be capitalized.10

Footnotes

1 See I.R.C. § 197.

2 Pub. L. No. 115-97, 131 Stat. 2111 (2017).

3 Treas. Reg. § 1.174-2(a)(1).

4 Id.

5 Snow v. Comm'r, 416 U.S. 500 (1974).

6 I.R.C. § 174(a) (as amended by TCJA § 13206(a)).

7 Treas. Reg. § 1.263(a)-4(b)(1).

8 Id. § 1.263(a)-4(b)(1)(v).

9 Id. § 1.263(a)-4(d)(5), (9).

10 See id. § 1.263(a)-4(c)(vii), (viii), (xiv).

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