Patents and Taxes, Part I

     Individuals and corporations alike need to know the tax consequences of patents and patent licensing, but these are matters generally left to tax attorneys. Unfortunately, by the time a patent matter comes to the tax attorney's attention, it is often too late to take advantage of certain deductions because the documentation required to prove eligibility for available tax deductions and to survive audit was not properly acquired beforehand. A patent attorney cannot be expected to play tax expert, but it must also be remembered that tax counsel cannot be expected to pass the patent bar. The patent attorney should have the minimal knowledge set forth in these articles so as to effectively aid the company's or client's tax counsel when tax time rolls around.

     The tax consequences of a patented invention begin in the research and development stage, long before the specification is drafted, the patent issued, and the invention practiced or licensed. The tax treatment of research and development expenditures (R&D) of concern to the patent attorney are the Section 174 deduction and the Section 41 credit of the Internal Revenue Code. Not all R&D costs are deductable, and the IRS refers instead to Research and Experimental costs (R&E) in order to reflect these limitations.

Section 174 Deduction

     Section 174 of the Internal Revenue Code (hereinafter, IRC) permits a taxpayer to treat research or experimental expenditures as expenses and deduct them. These may be amortized over 5 years or expensed in the taxable year they are incurred. The IRS allows the deduction for all "reasonable" expenses incurred for such R&E items as experimental or pilot models, a plant process, a product, formula, invention or other such property. When dealing with individual clients, make sure they're keeping receipts.

     Attorney's fees paid by the client to obtain patents, foreign or domestic, are also deductable as Section 174 expenses.

     Note that Section 174 specifically excludes expenditures for land or any other property that would qualify for an allowance under Section 167 or Section 611 of the IRC. That includes depreciable property and resources, such as oil and timber, that qualify for a depletion allowance. There is an exception, however: Even though computer software qualifies for a depreciation deduction under Section 167, the taxpayer may still deduct expenditures for computer software development under Section 174. See 58 Fed. Reg. 42, 198 (1993).

     It must be noted that these exclusions for Section 167 and 611 property only apply to direct purchases by the taxpayer. If the taxpayer hires, for example, an independent contractor to conduct R&E and that contractor purchases Section 167 or 611 property to conduct the research and then bills the cost to the taxpayer, then the taxpayer may take a Section 174 deduction, assuming the taxpayer himself does not take the property in the taxpayer's name. See Treasury Regulations, 1.174-2(a)(3).

     Finally, after Section 167 and Section 611 allowances for property used for R&E have been computed in accordance with those sections, then the allowances themselves may then be taken as Section 174 deductions. IRC Sec. 174(c).

     Confused? Leave it to tax counsel. Your job as a patent attorney is to advise your client to collect and maintain a records of R&E expenditures and to remind him to keep the records so as to classify and distinguish Section 174, Section 167, and Section 611 expenditures. It is also essential that separate records be kept for costs allocated to research and those allocated to materials, construction, and installation of depreciable property because these expenses will not qualify for Section 174 treatment even if for research and development. Treas. Reg. 1.174-2(b)(4). This is true even if the construction of the property is the end result and objective of the research.

     Now take warning: the disallowance for construction and installation holds true even if the R&E was performed by another. If your corporate client, for example, funded R&E to be performed by a university or independent contractor, the construction and installation costs of depreciable property are disallowed. Note how this differs from simple purchases of depreciable or depletable property as described above. The exception is if the property is obtained by the taxpayer purely at his own economic risk, that is without any performance guarantees "express, implied, or imposed by law." Treas. Reg. 174-2(b)(3).

     As I've stated, the details of the tax law are best left to the tax attorneys. It is the patent attorney, however, who is assigned the task of drawing up the research agreement with the university or contractor. For reasons that should now be clear, each and every such agreement should contain a boilerplate provision that requires the entity performing the research to keep detailed records of all research costs and that the records clearly distinguish between pure research costs and the costs of labor, construction, materials, and installation of any depreciable property, including the purchase of any patent rights needed to conduct the research (because purchased patent rights are depreciable property).

     Note that Section 174 R&E deductions are allowable only for research reasonably connected with the taxpayer's trade or business. This used to mean that the business had to be a "going concern" at the time the R&E was conducted. That was bad news for startup businesses and independent inventors. Happily, that rule was overturned by the Supreme Court in Snow v. Commissioner, 416 U.S. 500, 94 S.Ct. 1876, 40 L.Ed. 336 (1974). The modern rule is that the taxpayer need only a "realistic prospect" of going into a business related to the R&E to qualify for the deduction. Scoggins v. Commissioner, 46 F.3d 950 (9th Cir. 1995).

     Finally, if the taxpayer is a partnership, Subchapter S shareholder, or individual, then the Section 174 R&E deduction will be subject to the Alternative Minimum Tax. IRC 56(b)(2)(A)(ii). If the AMT applies, consider electing to rateably deduct the expenditures over 10 years in accordance with IRC 59(e)(2)(b).

Section 41 Credit

     Section 41 of the IRC provides a tax credit for a taxpayers who increase their R&E expenditures over the previous tax year or make payments to qualified research organizations. Unfortunately, the taxpayer's Section 174 deduction, if any, must be reduced in the amount of the credit. The credit is equal to 20% of the increase or expenditure. The statute specifically allows the credit for startup ventures so long as the expenditures are for "in-house" research, as described below. IRC 41(b)(4).

     Unlike Section 174, Section 41 specifically distinguishes between "in-house" and "contract" research expenses in the very wording of the statute itself.

In-house research

     "In-house" research expenses means wages, supplies, and computer rentals. IRC 41(b)(2)(A). Wages must be for research or direct supervision or support of the research. "Supplies" must be tangible property and does not include land or improvements thereto and does not include depreciable property. The statute doesn't disallow depletable property.

Contract research

     "Contract" research expenses means 65% of any amount paid to another for qualified research. This includes amounts paid or incurred during the taxable year for research to be conducted the following year.

     The IRS requires that payment be made regardless of whether the research is successful and that the taxpayer have rights to the results. Treas. Reg. 1.41-2(e)(2), (3). It is the patent attorney's job, therefore, to ensure that such a provision appears in the R&E contract.

Qualified research

     Research expenditures that qualify for the Section 41 credit must meet all of the following criteria:

A. It must qualify as a research expense under Section 174;

B. the research is for discovering information that is (i) technological in nature and (ii) is intended to be useful in the development of a new or improved business component of the taxpayer; and

C. relates to (i) a new or improved function, (ii) performance, or (iii) reliability or quality;

but in no instance will the credit be allowed for improvements in style, taste, cosmetic, or seasonal design factors; nor will the credit be allowed for (a) research performed after commercial production of the business component, (b) the adaptation of the business component to a particular customer's need, (c) the mere duplication of an existing business component, (d) surveys, studies, market research and the like, (e) development of computer software for internal use unrelated to the research, (f) research conducted overseas, (g) research related to the social sciences, arts, or humanities, or (h) research funded by any other source. IRC 41(d)(1), (3), (4).

Business component

     A "business component" means any product, process, computer software, technique, formula, or invention that will be sold, leased, licensed or used in the taxpayer's trade or business. IRC 41(d)(2)(B).

     As can be seen, Section 41 is rather more restrictive than Section 174 and will require more detailed accounting. If the client intends to utilize Section 41, when drafting R&D contracts it is a good idea to include a provision prohibiting use of the funds for the purposes listed in the italicized paragraph above.

Basic research

     The complex restrictions of Section 41 are avoided with respect to contract payments for "basic research" made to a qualifying tax-exempt institution, such as an institution of higher learning. IRC 41(e). "Basic research" means any research to advance scientific knowledge so long as it is not conducted outside the United States and does not involve the social sciences, arts or humanities. IRC 41(e)(7)(A). The catch is that only corporations are eligible for this credit, S-corporations, personal holding companies, and service organizations are excluded from taking advantage of the exception. IRC 41(e)(7)(E). It is not necessary that the research have a commercial purpose. IRC 41(e)(7)(A).

Section 167 Depreciation

     Whatever expenditures remain in obtaining a patent that are not deductable, or were not chosen to be deducted, under any of the above provisions are depreciated under Section 167.

Summary

When drafting research & development contracts with an outside party:

1. Include in each and every such agreement a boilerplate provision that requires the entity performing the research to keep detailed records of all research costs and requiring that the records clearly distinguish between pure research costs and the costs of (a) acquiring depreciable property, (b) acquiring depletable property, and (c) labor, construction, materials, and installation of any depreciable property. The provision should also require the entity to provide such records to the taxpayer at regular intervals (e.g., quarterly);

2. If the taxpayer intends to take a Section 41 credit instead of a Section 174 deduction:

A. Include a provision that payment be made regardless of whether the research is successful and that the taxpayer has rights to the results;

B. For each and every business component that is the subject matter of the contract, include a provision prohibiting use of the research funds for improvements in style, taste, cosmetic, or seasonal design factors and prohibiting expenditures for (a) research performed after commercial production of the business component, (b) the adaptation of the business component to a particular customer's need, (c) the mere duplication of an existing business component, (d) surveys, studies, market research and the like, (e) development of computer software for internal use unrelated to the research, (f) research conducted overseas, (g) research related to the social sciences, arts, or humanities, or (h) research funded by any other source.

C. If the taxpayer is a corporation making payments for basic research to a qualifying tax-exempt institution (such as a college or university), include a provision prohibiting use of the research funds for any research (a) conducted outside of the United States or (b) related to the social sciences, arts, or humanities.