Intellectual Property Monetization And Tax Efficiency

1. Overview: The Treasury's Take

Developing intellectual property requires both skilled labor and large amounts of capital. Recouping the developer's initial investment and earning profits typically requires monetizing the assets by either sale of license. In addition to general business concerns like asset and market share protection, developers should plan for the tax¹ consequences of their monetization transactions because, at its core, tax planning is cash planning. Legitimate federal income tax planning under the Code usually² involves two levers. The first lever is structuring a transaction to achieve a specific character of gain or loss. Second, thoughtful planners might utilize techniques to accelerate or defer a taxpayer's recognition of gain or loss.³ Courts have long recognized the application of careful rulesbased tax planning:

Intellectual property taxation is a complex and constantly evolving area of the law. Understanding the current rules is key to staying within the judicial boundaries of reasonable (and not aggressive or frivolous) tax planning. Like most areas of tax, the sale of intellectual property is usually required to (x) be taxed at capital gains rates and (y) use an asset's tax basis to reduce gain on the sale. In contrast, royalties are taxed at ordinary rates with no basis offset. To provide a materiality context for the capital gains versus ordinary income distinction as to non-corporate taxpayers, capital gains are taxed at a maximum 20% rate while ordinary income is taxed at a maximum 37% rate. That 17% rate differential is sufficient to drive many intellectual property holders to monetize through sales.⁵

Unfortunately, there are several hurdles to structuring intellectual property sales to be taxed at capital gains rates. First, no matter the type of intellectual property at issue (i.e. patents, copyrights, know-how, etc.), a taxpayer has to transfer enough rights in the asset to no longer be considered the tax owner. This alone may make a sale a non-starter if business exigencies require the owner to prioritize preservation and retention of trade or patent secrets. Second, in some cases, the Code expressly limits the types of intellectual property that can be sold at capital gains rates. For example, certain "self-created" inventions were excluded from the Code's primary capital asset (or recharacterization) definitions following the Tax Cuts and Jobs Act (TCJA) and therefore need a different statutory basis to receive preferential capital gains rates.⁶ Third, even the special statutory bases for receiving capital gains rates can be quite limited.⁷ Finally, defense and enforcement costs should be considered. Incorrect characterizations can be costly so front-end planning is strongly advised.

Because of the breadth of intellectual property taxation, this article covers only two primary topics. Section 2 discusses monetization and taxes, specifically the general principles distinguishing a sale and a license, as well as select methods by which capital gains are either precluded or potentially achievable. Section 3 discusses a special type of enforcement risk and the taxation of intellectual property recoveries.

2. Sale Structuring and Capital Gains Issues

A. Sale vs. License

A highly simplified example can be used to illustrate the basis offset benefit. Assume that Owner owns a self-created patent not eligible for capital gains taxation with a $1 million tax basis and a $1.25 million value. Owner sells the patent to Buyer. Upon sale, Owner has a $250,000 gain, taxed at a 37% rate,8 resulting in a $92,500 tax bill. In contrast, assume Owner licensed the same patent for annual $250,000 payments for five years. Royalty payments under the license agreement are taxed at ordinary rates with no basis offset, so the gross tax bill, without considering any time value benefits of receiving payments over five years, accounting convention issues, or deductions is $462,500.⁹

A sale, in contrast to a license, requires the owner of intellectual property to transfer "all substantial rights"10 or all "significant powers, rights, or continuing interest"¹¹ to the property. For example, in the patent context, substantial rights are those that provide the transferee the exclusive right to make or use the patent or sell for the life of the patent. The gating question is whether the transferor retained any rights, which in the aggregate, have substantial value.¹² The transfer of intellectual property is unfortunately an area of tax law with a large body of cases that dictate the contours of the "sale versus license" question, and some of those cases make very fine (perhaps nebulous) distinctions. Despite the heavy jurisprudential overlay, it is worth mentioning that in simple cases no real analysis is required. For instance, assume Owner signs an agreement transferring a patent to Buyer for a single lump sum payment, with Owner retaining no rights, and Buyer can use, license, sell, or operate the patent in any way it wishes post-transaction. In such a case, it is difficult to see how the transaction could be something besides a sale. However, when the transferor limits the transferee's scope of use, or perhaps retains minor rights, the picture is muddied and simply following the Code's sale provision will not suffice. It is in that context that a deeper dive into case law and supplemental guidance is required.

Some examples of when transferor retained rights or transferee restrictions resulted in licenses are useful, though the authors note that planners must always consider the type of intellectual property being monetized, because case law support may vary depending on whether the asset is a patent, knowhow, copyright, etc.:

• A transfer that allows the transferor the unconditional right to terminate the transfer looks more like a license.¹³
• Transfers that provide the transferor the right to prevent the transferee from assigning the asset or controlling the prosecution of infringement suits are more likely licenses for tax purposes.¹⁴ For example, if only the transferor has the right to sue for infringement in the transferor's capacity and name, the retained rights are not consistent with sale treatment.¹⁵
• The imposition of durational limits, or limits which do not allow the transferee access to the underlying asset or formula following a transfer usually result in a license for tax purposes. In fact, duration is a very key issue, particularly in knowhow (usually trade secret) cases. United States courts consistently conclude that transfers for less than the entire life of an asset will not constitute a sale.¹⁶
• If the rights granted by a transfer are limited in geographic scope or to a specific field of use (e.g. perhaps the transferee can only sell to a specific industry), the transfer is usually not a sale of a capital asset unless there is no commercial value to the rights in other geographic areas or other fields of use.¹⁷ For example, a transfer was deemed a license where a transferor retained the right to sell its intellectual property platform to other industries or persons that did not compete with the transferee.¹⁸
• Contracts that give a licensee only the right to manufacture, sell, and distribute patented articles, but which do not provide the right to use the patented articles, results in the transfer of something less than all substantial rights, and is more likely a license.

Despite the many ways in which contracts can be considered licenses and not sales for tax purposes, some restrictions do not prevent sale treatment. A transferor can sometimes reserve the right to terminate for nonpayment or in the event of a transferee's insolvency or bankruptcy. In most cases if the goal is to sell the asset, any post-transfer rights held by the transferor should be for conditions outside of the transferor's control.²⁰ Finally, merely styling a contract as a "sale agreement" or "purchase agreement" is not dipositive. Courts will look to the underlying substance of the contract and factual evidence supporting the transaction when determining whether an agreement created a sale or a license.²¹ Therefore, the drafter of any agreement should consider how the specific language and terms will be interpreted by a court.

The takeaway is that when drafting transaction documents when a sale is desired, both the transferor and transferee should do a granular review of what rights are retained by the transferor, whether posttransfer the transferee is subject to field, geographic, or use restrictions, and whether the agreement covers all, or just a portion, of the intellectual property's life cycle.

B. Select Capital Gains Issues

If capital gains treatment is desired, and not just the basis offset a sale provides, then special considerations may be required. A full discussion of capital gains planning for intellectual property dispositions is beyond the scope of this article, but a few points are worthy of discussion. Taxpayers should first know that some types of assets are incapable of capital gains treatment.

Property held in a business primarily for sale to customers (i.e. inventory) is facially excluded from the statutory definition of capital asset.²² Intellectual property might not obviously be thought of as inventory; however, courts have found otherwise and professional inventors may find their property subject to the inventory exception. For example, where an inventor created and monetized nearly forty inventions over an almost two-decade period, a court found such regularity indicated the inventor "was in the business of selling and licensing his inventions" and it follows "the patents...were not to be regarded as capital assets, or the profits from their sale by him as capital gains."²³

Additionally, any property that is an "amortizable section 197 intangible" is treated as property subject to the Code's allowance for depreciation, and thus is statutorily excluded from the definition of "capital asset".²⁴ "Amortizable section 197 intangibles" are typically things like goodwill, know-how, customer intangibles, workforce-in-place, and information base items acquired as part of a trade or business acquisition,²⁵ although some separately acquired intellectual property, like franchise renewals and governmental granted rights or licenses (e.g. trademarks or liquor licenses),26 can be as well. However, in these cases, taxpayers should consider whether Code Section 12³¹ might provide capital gains treatment upon a disposition.27

Finally, as noted in Section 1, the TCJA detrimentally changed the tax treatment of the disposition of intellectual property created by "personal efforts". Perhaps most prominently, the TCJA facially excluded personally developed patents (and certain other assets) from the Code's capital asset definition. Individual inventors therefore need to look to Code 1235 to obtain capital gain treatment on the taxable disposition of self-created patents. Code Section 1235 applies to individual inventors and can provide capital gain treatments on patent dispositions regardless of holding period, method of payment, or status as a professional or amateur inventor.²⁸

3. Select Enforcement Risks and Litigation Recovery

A. Select Enforcement Risks

A brief discussion of two related enforcement risks in the intellectual property transfer arena may also be useful. First, taxpayers often fail to consider the assignment of income doctrine. The assignment of income doctrine can be distilled into the concept that income is taxable to the person who earns it.²⁹ It is somewhat common for personal inventors, and sometimes even sophisticated entities with valuable intellectual property, to gift or assign such property to other persons in more favorable tax situations to reduce tax bills. By way of illustration, a parent might gift a trademark to a child who is in a lower tax bracket. If the gift is bona fide and occurs before a monetization event occurs, there may be no issue. But, if the parent pre-negotiated a sale of the trademark before the gift, or if the parent kept specific rights to the trademark, then the IRS may view the gift as an attempt to assign income from a sale or license to a lower-bracket taxpayer and reallocate back to the parent.³⁰ The assignment of income doctrine is particularly important for intellectual property transfers, because intellectual property rights can often be divided easily. It is typically wise to ensure that either a gift is bona fide, or an assignment for full and adequate consideration occurs.

Similarly, many taxpayers fail to appreciate the nuances of the Code's transfer pricing rules, which like the assignment of income doctrine, attempt to ensure that income is recognized by the appropriate party. The transfer pricing rules involve groups of related entities that do business together. As an example, a United States corporate parent may have a controlled foreign subsidiary in a low-tax jurisdiction. The corporate parent may try to assign intellectual property to the subsidiary to reduce the total tax burden from monetizing the property. The obvious goal is to shift profits from the United States to low-tax or no-tax jurisdictions.³¹ The Code's transfer pricing regime treats these related party transactions as if they were between unrelated parties. This means that the transactions will be respected, and not readjusted, only if executed in a manner that clearly reflects arms' length considerations and properly reflects income.³² Transfer pricing challenges are likely to be increasingly common as (i) compliance is complex and (ii) intellectual property companies often operate across the world.³³ Taxpayers with related party affiliates should consider the appropriateness of related party transaction terms in addition to their general structures.

B. Controversy Recovery

Taxpayers occasionally find themselves in disputes or lawsuits over intellectual property. In most cases, one party or the other to a business dispute wins or obtains financial compensation via settlement. A question arises then over how to characterize the monetization of intellectual property through controversy (i.e. settlement or court) procedures. In business cases there is usually not much dispute that an award is in response to a taxable transaction, so the question is whether a recovery is ordinary income, capital gains, or at least in part a basis recovery. The test for characterizing litigation proceeds is thus often captured by the quote "[i]n lieu of what were the damages awarded?'"³⁴

If a lawsuit makes demands for lost profits, then of course any recovery is ordinary income as a substitute for those lost profits.³⁵ By contrast, a settlement may involve recovery of a "harm to capital" or "lost capital". There, the recovery represents a nontaxable return of capital, at least to the extent the recovery does not exceed tax basis of the asset.³⁶

Alternatively, a litigant may claim that a different party improperly used its asset, in which case recovery may be bifurcated between capital damages and profits. In the intellectual property world, it is not unusual for software, know-how, patents, trademarks, or copyrights to be misappropriated. In such cases, the real owner of an asset may make two claims: (i) to be compensated for the lost asset and (ii) loss of earnings.³⁷ Here the return of the asset value may represent a non-taxable return of capital while the excess recovery is ordinary income for lost profits. This makes the language in the settlement agreement much more important so that it is absolutely clear what damages are being awarded for which cause of action. The IRS, in particular, will look to the settlement agreement first as the recitation of the agreement among the parties. An amount and a general release may end up with an interpretation nobody intended.

The factual key to most intellectual property damage cases is to be able to prove the value of the asset and lost profits so that the recovery allocation properly reflects the intended deal. Taxpayers that fail to substantiate the value of their assets may be subject to a court's reasonable discretion as to an allocation. Given increased IRS budgets and staffing levels and the material value of intellectual property on the world economy, greater enforcement efforts are to be expected. Taxpayers should take stock of their existing contractual arrangements and how they plead and support damage claims in order to avoid adverse tax consequences.

Footnotes

1. For purposes of this article, "tax" is limited to United States federal income taxes under the Internal Revenue Code of 1986, as amended (the "Code") and the regulations promulgated under the Code (the "Regulations").

2. There are other tax planning considerations beyond character and timing of income or loss recognition, but the foregoing issues are, more often than not, a taxpayer's most important concerns.

3. For instance, in an asset sale, if the buyer provides purchase price consideration over more than one tax year, gain recognition can be partially deferred under the Code's installment sale rules. See Code Section 453 and Code Section 453A. Some assets are not eligible for installment sale treatment. See, e.g., Code Sections 453(b)(2), (i), and (k).

4. Gregory v. Helvering, 293 U.S. 465, 469 (1935).

5. Sales are governed by Code Section 1001. Gain on sale is calculated as amount realized less the tax basis of the asset sold. Tax rates are imposed by Code Sections 1 and 11 (corporate tax) with Code Section 1(h) dictating the capital gains rates. Corporations presently pay a flat 21% tax rate against their taxable income, but a corporation's capital gains or losses are still subject to a netting process. See, e.g., Code Sections 1222 and 1223. This means that when considering only tax rates (i.e. without looking at attributes like time based deferral or capital loss carryovers) capital gains treatment for C-corporations have less utility vis-à-vis capital gains generated by tax partnerships or S-corporations. Additionally, when a corporation distributes property to its shareholders, a second level of tax applies under either Code Section 301 or Code Section 302. Note that a 3.8% "net investment income tax" ("NIIT") imposed by Code Section 1411 may also apply to sale transactions. This article omits further discussion of the NIIT.

6. See Code Section 1221(a)(3)(A) and Code Section 1231(b)(1)(C).

7. See, e.g., Code Sections 1235 and 1253. The foregoing sections are limited to specific types of persons and structures.

8. Tax rates under the Code are graduated, but for simplicity this hypothetical assumes that Owner's income at the time of sale is already within the highest bracket.

9. Of course Owner would still retain all rights to the licensed property at the end of the license agreement. This example is highly simplified and used only to illustrate the potential benefit of a basis offset upon a sale. It does not consider any deductions, expenses of production, etc.

10. See Waterman v. Mackenzie, 138 U.S. 252 (1891). Waterman is not a tax case but is often used to assist in determining whether a patent transfer is a sale or license. See also Fawick v. Commissioner, 436 F.2d 655 (6th Cir. 1971) ("The monopoly right granted by the patent is the right to exclude others from making, using, or selling the invention.")

11. See, e.g., Code Section 1253(a) ("A transfer of a franchise, trademark, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.")

12. E. I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052, 1055 (3d Cir. 1970) ("To determine whether the taxpayer did transfer all of the substantial rights in the patents in question, the key question is whether the transferor retained any rights which, in the aggregate, have substantial value.") (subsequent citations omitted).

13. See generally Bell Intercontinental Corp. v. United States, 381 F.2d 1004 (Ct. Cl. 1967).

14. See Oak Mfg. Co. v. United States, 301 F.2d 259 (7th Cir. 1962).

15. For an interesting discussion of this topic see Eterpen Financiera Sociedad de Responsabilidad Limitada v. United States, 108 F. Supp. 100 (Ct. Cl. 1952).

16. See Pickren v. United States, 378 F.2d 595 (5th Cir. 1967).

17. See United States v. Carruthers, 219 F.2d 21 (9th Cir. 1955) (The court upheld the lower court's sale treatment in part based on the fact that the patents at issue "had no established value for any purpose other than processing tuna fish, and that no attempt had ever been made to use the patents outside of the tuna industry.")

18. See, e.g., Vision Info. Servs., LLC v. Commissioner, 419 F.3d 554 (6th Cir. 2005).

19. See Broderick v. Neale, 201 F.2d 621 (10th Cir. 1953).

20. See Watson v. United States, 222 F.2d 689 (10th Cir. 1955) (A right to terminate upon transferee's failure to produce sufficient numbers of patented product is outside of transferor's control and sale treatment can still result).

21. Juda v. Commissioner, 877 F.2d 1075, 1078 (1st Cir. 1989) ("In deciding whether a transferee acquired all substantial rights to a patent, the nomenclature in the agreement is not controlling, rather the entire agreement must be examined to see if in fact all substantial rights were transferred.") (subsequent citations omitted).

22. Code Section 1221(a)(1).

23. Lockhart v. Commissioner, 258 F.2d 343 (3d Cir. 1958). But see Rollman v. Commissioner, 244 F.2d 634 (4th Cir. 1957) (patents not held for sale in the ordinary course of business).

24. Code Section 1221(a)(2); Code Section 197(f)(7).

25. See Code Section 197(c).

26. See, e.g., Code Section 197(f)(4)(B).

27. See Code Section 197(f)(7) and Code Section 1221(a)(2).

28. Code Section 1235 and its regulations are complex, and this article does not discuss the full scope of those rules.

29. See Lucas v. Earl, 281 U.S. 111 (1930).

30. See, e.g., Helvering v. Horst, 311 U.S. 112 (1940); Commissioner v. Court Holding Co., 324 U.S. 331 (1945); and Townsend v. Commissioner, 37 T.C. 830 (1962).

31. The Code includes a host of taxes and rules to combat abusive transactions in addition to transfer pricing adjustments. This article does not attempt to cover all such rules. See, e.g, Code Section 59A and Code Section 951A.

32. Code Section 482; Treasury Regulations Section 1.482-1 et seq.

33. For examples of cases involving heavy consideration of transfer pricing rules, see Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009) and Coca-Cola Co. & Subsidiaries v. Commissioner, No. 31183-15., 2023 BL 402512 (T.C. Nov. 8, 2023).

34. Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944).

35. See Estate of Longino v. Commissioner, 32 T.C. 904 (1959).

36. See, e.g., Tribune Publishing Co. v. United States, 836 F.2d 1176, 1177 (9th Cir. 1988) and Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944).

37. See, e.g., Arcadia Ref. Co. v. Commissioner, 118 F.2d 1010 (5th Cir. 1941).

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.