Taxation of Intellectual Property:
Capital Gain or Ordinary Gain?
Taxation of assets can have a substantial impact on how an individual or a business operates. Generally, all entities seek to minimize tax liability. Entities tend to acquire or offload assets at the end of the year to strategically manage the effect of taxes on their balance sheets. To this end, there are several aspects of the taxation of intellectual property (IP) that are worth taking into consideration.
First and foremost, the amount of tax liability may depend on the type of asset being taxed. The United States allows for capital gains taxes on the growth of investments sold by individuals and corporations. Currently, capital gains tax rates for individuals are 0%, 15%, or 20% for most assets held for more than a year by an individual, or a flat 21% for corporations. These are highly favorable rates compared to the tax rates for ordinary income, which can be as high as 37%. Accordingly, successful tax planning typically involves managing capital gains and losses to minimize overall tax liability.
In the recent past, intellectual property transactions, e.g., patent sales, were treated as long-term capital gains. However, in December 2017, Congress passed the Tax Cuts and Jobs Act (TCJA) which muddied the waters through the amendment of two key Internal Revenue Code (IRC, 26 U.S.C.) provisions: Section 1221 and Section 1235.
Prior to the TCJA, IRC § 1221(a)(3) denied capital asset status for a copyright, or a literary, musical, or artistic composition, in the hands of a creator or a person who acquired the property from the creator in a tax-free transaction. Because patents were not included in this list of intellectual property, a patent held for more than one year and sold by an individual would be taxed as a long-term capital gain. With the TCJA, IRC § 1221(a)(3) was amended to include “a patent, invention, model or design (whether or not patented), [and] a secret formula or process” as IP that is denied capital gain status.
While IRC § 1221(a)(3) by itself sets clear lines for property not eligible for capital gain treatment, confusion sets in when this provision is read in combination with IRC § 1235, which was not modified or repealed by the TCJA. Notably, IRC § 1235 states:
“A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year[.]”
In other words, patents are not capital assets when held by their creators per IRC § 1221, but patents are considered capital assets when transferred per IRC § 1235. This conflict within the Code has created mass confusion as to whether patents are capital assets or not. Careful planning is required for inventors to take advantage of the favorable capital gains tax rates through IRC § 1235.
In addition to the type of asset, tax liability further depends on the value of an asset. Because patents are intangible assets, it is important to obtain a thorough valuation that places a logical, defensible monetary value to them. Not only does a valuation allow for a business to account for a patent’s value in their balance sheet, but obtaining a valuation is particularly important in negotiations, technology transfers, mergers and acquisitions, and dissolution and bankruptcy.
As with any other type of asset, the value of intellectual property needs to be properly assessed using generally accepted valuation methodologies. Entities that have to deal with the IRS, the SEC, or any financial or investment institution for their IP transactions/transfers should seek a Fair Market Valuation report that is defensible under scrutiny by third parties and government authorities.
GHB Intellect is a top-ranking IP strategy and consulting company that provides IP valuation services. Our valuation reports are consistent with standards and methodologies set forth by the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 157 Fair Value Measurements, and American Institute of Certified Public Accountants (“AICPA”) Statement on Standards for Valuation Services – Valuation of Business, Business Ownership Interest, Security, or Intangible Asset, and other publications pertaining to valuation and intellectual property.
Please reach out to us for further questions regarding the taxation of intellectual property or for any other IP-related needs you may have.
GHB Intellect is a full-service intellectual property consulting and engineering services firm. With a growing cadre of hundreds of industry-seasoned experts & professionals, as well as access to full suites of design and testing equipment, we specialize in high-tech, science, and innovation.