References below to “sections” are to sections of the Internal Revenue Code of 1986, as amended. Tax laws and regulations change frequently. The following is intended to provide only a general overview, and does not constitute legal advice. Consultation with an attorney in Sunstein’s Business Practice Group or another tax professional is strongly recommended.
Tax considerations are often of critical importance in deciding upon a business structure and exit strategies. Some special considerations apply to companies developing, licensing, acquiring or selling intellectual property. Intellectual property includes intangible assets such as patents, trademarks, copyrights and trade secrets.
Research and experimental expenditures may be deducted currently, rather than capitalized under section 174(a). Or, the taxpayer may elect to amortize these costs over a period of 60 months or more, or to write them off over 10 years pursuant to sections 174(b), 59(e). Why would someone choose to spread the deduction over 10 years? Here’s an example.
Let’s consider the shareholder of an S Corporation that incurs research and experimental expenditures. If the corporation takes the deduction on its corporate income tax return, the deduction is passed through to the individual’s personal income tax return. Those expenses would be added back to his income for purposes of computing his alternative minimum tax (AMT). If that addback increases the shareholder’s tax, the benefit of the deduction may be lost entirely. In that instance, a case could be made for choosing to amortize the expenses over 10 years, in which case there is no addback for AMT purposes.
Computer software development expenses can be treated in a manner analogous to research and experimental expenditures. Trademark development costs cannot—they must be amortized over a 15-year period under section 197. See section 197(e)(3) (excluding software developed in-house from “section 197 intangibles”), 197(d)(1)(f) (including trademarks). Copyright development costs are generally deductible over the useful life of the copyright. Treas. Reg. section 1.167(a)-6(a).
If a taxpayer increases its research and experimental expenditures, section 41 provides for a federal research tax credit equal to 20% of the amount by which a taxpayer’s qualified research expenditures for a taxable year exceed a threshold based on its expenditures during previous years.
Licenses of patents and trademarks may have varying consequences, depending on a number of circumstances, including (1) whether the license is deemed a sale for tax purposes, (2) the nature of the property, (3) whether the property was self-created or purchased, (4) whether the property is deemed a capital asset, and (5) whether a foreign entity or a non-resident alien is involved in the transaction.
For example, if a company acquires an exclusive license to a patent, the transaction may be deemed a sale. In that case, if the license is acquired in connection with a purchase of assets constituting a trade or business (or a substantial part of a trade or business), then section 197 will require the licensee to amortize the acquisition costs ratably over 15 years; otherwise, the cost will be depreciated over the remaining useful life of the patent. See sections 197(e)(4), 167(f)(2). If the license is non-exclusive (and no sale is involved for tax purposes), the licensee will normally be able to deduct its annual royalty payments currently as an ordinary and necessary business expense.
In the case of a trademark license, section 1253(d)(1) permits current deductions only if the royalty payments are (a) contingent on the productivity, use or disposition of the mark, (b) payable at least annually, and (c) substantially equal in amount or payable under a fixed formula. Otherwise, section 1253(d)(2) requires trademark acquisition costs to be capitalized, making them eligible for 15-year amortization under section 197.
Trade secrets are generally treated in the same manner as other intellectual property, and a sale of trade secrets is usually treated as a capital gains transaction. However, capital gains treatment may be denied if the IRS finds that the confidential information sought to be protected does not rise to the level of a trade secret. Thus, both the buyer and the seller should take care that the seller preserves the confidentiality of the information. The IRS’s position has been that, absent secrecy or some other legal protection (such as copyright), business information that does not rise to the level of a trade secret does not constitute property, and thus cannot be a capital asset. The language of section 197, which specifically includes business information and know-how as a “section 197 intangible”, casts some doubt on this IRS position.
Sales of copyrights by the person who created the work can never qualify for capital gains treatment pursuant to section 1221(a)(3). Copyrights purchased from other sources may sometimes be resold as capital assets. Capital gains treatment may be denied under certain circumstances, such as if the seller is in the business of buying and selling copyrights, or the copyright was used in the seller’s business. See sections 1221(1), 1221(2).
The foregoing is only a very brief summary of some of the broad outlines of tax laws affecting intellectual property. Special rules apply to many types of transactions, including those involving foreign persons or entities, related persons, and installment sales. Moreover, these rules are based on federal laws that are subject to change, and additional taxes may be levied by certain states. You should consult a qualified business attorney, such as a member of Sunstein’s Business Practice Group, or another tax professional before committing to any course of action involving intellectual property.