Patents and Taxes, Part II

     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.

     Patent property may be capital assets as negatively defined in Section 1221 of the Internal Revenue Code (hereinafter IRC) and their sale or other qualifying disposition might therefore receive favorable capital gains treatment. Most issued patents, however, will not qualify as a capital asset and will fall under the possibly less favorable capital gains treatment afforded by Section 1231 of the IRC. A long or short term capital gain or loss occurs if the patent is sold or exchanged within the time periods set forth in IRC Section 1222 and as computed in Section 1223. An exclusive license to "make, use, and sell" is considered a sale. In re Vincent A Marco, 108 U.S.P.Q. 92 (TC 1955). Under current tax law, a short-term capital gain will be taxed as ordinary income, so it is opportunities for long-term capital gains treatment that the practitioner is alert for. Before the sale of a patent right can be treated as a capital gain, however, the property transferred must first either (a) qualify as a capital asset under Section 1221 or (b) qualify under the "Patent Holder" exception of Section 1235. Patent property that fails to fall under either of these provisions will nevertheless qualify for capital gains treatment under Section 1231. Sales to controlled foreign corporations are specifically excluded from favorable capital gains treatment under Section 1249.

Section 1221 Capital Assets

     Section 1221 of the Internal Revenue Code negatively defines capital assets. That is to say, it defines what is not a capital asset rather than what is a capital asset. As long as the patent property transferred does not fall within any of the Section 1221 definitions, the property will be considered a capital asset and may qualify for capital gains treatment. The relevant portions of Section 1221, namely Sections 1221(1) and 1221(2) read as follows:

Subsection (1)

     The application of IRC Section 1221(1) was reviewed by the Supreme Court in a case involving real estate, Malat v. Riddell, 383 U.S. 569, 86 S.Ct. 1030, 16 L.Ed.2d 102 (1966), wherein the Court concluded that the term "primarily" was to mean "of first importance" or "principally" and was intended to "differentiate between the 'profits and losses arising from the everyday operation of a business' on the one hand . . . and 'the realization of appreciation in value accrued over a substantial period of time' on the other." Presumably, as long as the taxpayer is not in the business of selling patents, any patents he sells should qualify under this subsection. Nevertheless, with regard to issued patents, even if the patent property sold may qualify as a capital asset under subsection (1), it will still likely fail to pass the requirements of subsection (2).

Subsection (2)

     Subsection (2) is the most important provision of Section 1221 for patent analysis because all issued patents are Section 167 depreciable property and will fall under the provisions of IRC Section 1231 unless they otherwise qualify as capital assets or qualify for treatment under Section 1235. Is there any way around this? Not if a patent has issued. Note, however, that an "invention" or patent application does qualify. These are not depreciable assets because they have no definable lifetime. Contracts purporting to transfer rights to patent applications, "technology," or "trade secrets" representing inventions reduced to practice therefore represent a transfer of capital assets so long as the technology transferred also passes muster under subsection (1). The holding period for any such asset, whether an issued patent, patent application, or "invention" reduced to practice, but for which no application has been filed, begins on the date of reduction to practice. Lamar v. Granger, 99 F.Supp. 17, 90 U.S.P.Q. 58 (WDPA 1951); Treas. Reg. 1.1235-2(e).

Section 1235 Patent Holder Exception

     Section 1235 of the IRC was enacted to ensure that individual inventors received favorable long-term capital gains treatment for the sale of their patents, even if the sale was in the form of periodic royalty payments (e.g., for an exclusive license). Under Section 1235, any sale by a "holder" of "property" that consists of "all substantial rights" to a patent, or undivided interest therein, is treated as a long term capital transfer regardless of the holding period. A holder is defined in Section 1235(b) as:

     As can be seen, Section 1235(b)(2)(A) specifically excludes assignments by employees to their employers and Section 1235(b)(1) excludes anyone other than the actual living inventor(s). Section 1235 is truly for the "independent" inventor that one might picture working out of his garage.

     Transfers by "gift, inheritance, or devise" do not qualify under this section. IRC Section 1235(a).

Section 1231 Treatment of Capital Gain

     Section 1231 of the IRC is how most transfers of issued patents will be treated by the code and is of primary importance to corporate patent and tax counsel. Under Section 1231(a)(3), the total gains and total losses on sales and conversions of all depreciable property (i) used in trade or business or (ii) converted involuntarily or by compulsion (e.g., loss or theft) after having been held for more than one year, are added up and the net gain or loss thereby calculated. If there is a net loss, then all of the gains and losses are treated as ordinary gains and losses. IRC Section 1231(a)(2). If there is a net gain, then all of the gains and losses are treated as long-term gains and losses. IRC Section 1231(a)(1).

Summary

When drafting contracts transferring patents and/or technology:

1. Segregate the transferred property into two categories (a) issued patents and (b) patent applications and inventions not applied for;

2. Determine the holding period for each property (i.e., date of reduction to practice);

3. Identify property that qualifies as a capital asset under IRC Section 1221 or under the exception of Section 1235;

4. Identify remaining property (e.g., issued patents) that fall under the provisions of Section 1231.