Intellectual property (“IP”) is typically monetized either by sale or (royalty generating) license agreements. The Code[1] often allows sales to be taxed at preferential capital gains rates[2] while simple royalties are ordinary income.[3] At present the maximum capital gain versus ordinary income rate differential for non-corporate taxpayers – without more[4] – is seventeen percent[5] which is not immaterial. From a pure federal income tax perspective, monetizing parties thus have a tax incentive to structure sales or exchanges.[6]  Consistent with that theme, this post will explore select “sale versus license” issues from a federal income tax perspective with a focus on patents, trade secrets, and know-how.

Capital Gains and IP: The Basics

As noted above, taxpayers usually need to sell or exchange property to receive capital gain treatment. Additionally, a transaction needs to involve capital assets or otherwise be eligible for capital gains treatment to obtain preferential tax rates. Capital assets are defined expansively as all property held by a taxpayer (whether or not connected with a trade or business) subject to certain exceptions.[7] Some of the more important IP related exceptions include:

  1. Stock in Trade. Property held in a business primarily for sale to customers is excluded from the definition of capital asset.[8] While IP may not classically be thought of as inventory, professional (or even consistent) inventors may find their creations subject to the inventory exception. For example, where an inventor had 37 inventions over a 19 year period, the courts 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.”[9]
  2. Depreciable Property. Amortizable section 197 intangibles are treated as property subject to the allowance for depreciation and are therefore excluded from the definition of capital asset.[10]
  3. Self-Created Patents and Designs. Before the Tax Cuts and Jobs Act (“TCJA”) patents developed via “personal efforts” were not included in § 1221(a)(3)’s capital asset exclusion while copyrights were. But, the TCJA facially excluded personally developed[11] patents, inventions, models or designs, or secret formulas or processes from the capital asset definition. While the foregoing statutory change did eliminate one avenue for achieving capital gains on self-created patent sales, it at least clarified that IP capable of both patent and copyright protection cannot be capital assets.[12] Individual inventors therefore need to look to § 1235 to obtain capital gain treatment on the taxable disposition of self-created patents.[13] 

Finally, capital gain or loss treatment is not always assured even if the capital asset definition appears to apply. Taxpayers should consider the Code’s loss disallowance, netting, and recharacterization rules.[14]

But We Drafted a Purchase Agreement! Sale Versus License and Other Minutia

Distinguishing a patent sale from a license is not always easy. To be a sale, courts historically require that all substantial rights  to the asset must be transferred.[15] 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. A key question is whether the transferor retained any rights which in the aggregate have substantial value.[16] Trade secret sales are often analogized to patent sales.[17] This means that courts usually treat the transfer of a trade secret as a sale for federal income tax purposes only if all substantial rights are transferred, namely the rights to prevent (i) unauthorized disclosure and (ii) further use of the trade secret by all others.[18] A small selection of case law restrictions follows:

  1. Case Law Restrictions.
  • Limited Duration. Transfers for less than a patent’s full life are usually licenses, not sales.[19]
  • Limited Bundles of Rights. Transferring rights to sell, but not use, more likely results in a license.[20] Dividing the right to manufacture from the right to use patents can result in a license.[21]
  • Field of Use and Geographic Restrictions. Grants of all rights to sell, use, or make patents within a limited geographic area can sometimes be considered a sale.[22] Geographical restriction analysis is usually based on the laws of the country in which the patent or IP is issued, so the retention of the rights to sell, use, or make a patent issued under U.S. law outside of U.S. borders may still allow for sale treatment.[23]

It is also important to note that contract nomenclature is not dispositive as to tax treatment.[24] This means that calling what is substantively a license a “purchase agreement” will not change the analysis. Instead the whole package of transaction documents related to IP monetization must be reviewed.

Installment Sales – Did You Consider the Interest Charge?

It is not uncommon for purchase agreements to provide payments that cross tax years. In those cases the Code’s installment sale rules may apply.[25] When IP is sold on a deferred time frame, buyer and seller typically must provide for adequate interest or the Code will impute interest for the parties. The interest imputation rules recharacterize a portion of the selling price as interest, causing (x) the seller to have less capital gain and more ordinary income and (y) the buyer to have more interest expense and less amortizable tax basis. Which interest rule applies usually depends on the value of the installment contract. Sales involving total payments of less than $250,000 generally follow § 483[26] and those with greater payments typically use § 1274. The foregoing are not absolute rules. For example, § 1274 does not apply if no payment is due under a debt instrument more than six months after the sale date.[27] Special IP rules also apply. For example, in the event § 1235 applies to a patent transfer, contingent payments are excluded from §§ 483 and 1274.[28] Interestingly, some courts have discussed whether patent transfers to related parties would be ineligible for § 1235 tax treatment but might arguably still be excluded from interest imputation as transfers “described in” (although not necessarily “qualifying for”) § 1235(a).[29] This post does not attempt to cover all issues related to the interest imputation rules. We simply note that those rules have IP specific components that should be consulted whenever IP is sold.

[1] All “§” references are to specific sections of the Internal Revenue Code (the “Code”) unless otherwise noted.

[2] See, e.g., §§ 1, 1001, 1221, 1222.

[3] § 61(a)(6); Treas. Reg. § 1.61-8(a).

[4] For example, the net investment income tax of § 1411 may apply to many transactions.

[5] See § 1(j) and § 1(h).

[6] We note that many persons that monetize IP care more about asset protection and retention than tax rates and therefore intentionally monetize their property through license agreements. 

[7] See § 1221(a).

[8] § 1221(a)(1).

[9] Lockhart v. Commissioner, 258 F.2d 343 (3d Cir. 1958). But see Rollman v. Commissioner, 244 F.2d 634 (4th Cir. 1957) and First National Bank of Princeton v. United States, 136 F. Supp. 818 (D.C. N.J. 1955).

[10] See § 197(f)(7) and § 1221(a)(2). Note that § 1231 should still be evaluated.

[11] This includes taxpayers who took a substituted or transferred basis in property from a taxpayer that personally developed the IP. § 1221(a)(3)(C).

[12] Before the TCJA changes to § 1221(a)(3) this result was uncertain.

[13] This post does not explore § 1235 in detail. However, we note that the statute typically requires the transfer of a patent held by a holder (specially defined) to an unrelated person. If the statutory requirements are met, the transfer can be taxed at capital gain rates.

[14] See, e.g., §§ 165, 1231, 1222, 1239, 1245, and 1253. A complete discussion regarding the application of these rules is beyond the scope of this post.

[15] 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.”)

[16] E. I. du Pont de Nemours & Co. v. United States, 432 F.2d 1052, 1055 (3d Cir. 1970)

[17] The Stalker Corp. v. United States, 209 F.Supp. 30 (E.D. Mich. 1962) (“Whether or not the transfer of a trade secret constitutes a sale for tax purposes, the tests used in determining whether or not there has been a sale of a patent have been applied.”)

[18] Id.

[19] See, e.g. Pickren v. United States, 378 F.2d 595 (5th Cir. 1967).

[20] See, e.g., National Bread Wrapping Mach. Co. v. Commissioner, 30 T.C. 550 (1958).

[21] See, e.g., Broderick v. Neale, 201 F.2d 621 (10th Cir. 1953).

[22] See, e.g., Marco v. Commissioner, 25 T.C. 544 (1955).

[23] See, e.g., Water Res. Control v. Commissioner, 61 T.C.M. (CCH) 2102, 2113 (1991).

[24] 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.”)

[25] See generally § 453.

[26] § 1274(c)(3)(C).

[27] § 1274(c)(1)(B).

[28] § 483(d)(4) and § 1274(c)(3)(E).

[29] See Ransburg Corp. v. Commissioner, 621 F.2d 264, 268 (7th Cir. 1980) and Busse v. Commissioner, 479 F.2d 1147, 1152 (7th Cir. 1973).