Intellectual property ("IP," as it's commonly called) is a class of assets widely recognized by those in the ever-expanding universe of technology-driven professions. Yet the attributes of intellectual property are less widely understood, particularly with respect to determining and planning for the tax consequences associated with the creation, acquisition, or disposition of IP. This is a natural and expected state of affairs, because the Internal Revenue Code is complicated, and most successful entrepreneurs are more appropriately focused on building viable businesses. Nonetheless, because the Internal Revenue Service ("IRS") is not generally known for its sympathy, failing to understand the consequences of dealings in IP provides no relief from unexpected tax liabilities.
To help prevent heartburn and regret, this article highlights five questions that entrepreneurs, CFOs, and IP managers should ask, each a guidepost to aid the reader in preserving the desired tax consequences and maximizing the value of the reader's IP strategy. This article is not intended to cover every nuance imaginable. Rather, these guideposts are offered merely as guiding principles for interacting with a vastly more complicated subject area.
Guidepost #1: What type of property do you have?
The natural starting place for learning about the tax consequences of IP transactions is defining and understanding the assets referred to under the umbrella of "intellectual property." U.S. tax law differs from U.S. IP law in how it identifies IP. IP law generally creates four categories of property (patents, copyrights, trademarks, and trade secrets), while tax law creates an additional, broader category of "intangible assets." Entrepreneurs must be somewhat bilingual, understanding that the classification of an asset for IP protection purposes may not coincide with its classification for tax purposes.
Guidepost #2: Who is the creator and who is the owner of the property?
Certain types of IP are classified as "self-created" if the creator of the IP is also its owner. This affects the character of income upon disposition, as well as the treatment of acquisition costs.
Guidepost #3: How will the property be acquired?
The method chosen to acquire IP dictates how the acquisition costs are treated for tax purposes. Generally speaking, IP can be acquired by license, purchase or internal development, or as a contribution to a company’s capital. Each method of acquisition bears its own attributes dictating whether the costs of acquisition may be immediately deducted, capitalized and recovered through amortization or other deductions, or capitalized and recovered on sale.
Guidepost #4: How will the property be monetized?
The method chosen to monetize IP dictates how the income from the IP is taxed. Generally speaking, there are two ways of monetizing intellectual property: by license and by sale. Licensing the IP results in royalty payments, which are taxed as ordinary income, while the sale of the IP generally results in ordinary or capital taxable gain. But it isn't always clear whether the IRS will treat a transaction as a sale or as a license, so every transaction should be evaluated based on its substance. Furthermore, the Tax Cuts and Jobs Act created conflicting taxation schemes for self-created patents, making the tax results of certain transactions even less clear.
Guidepost #5: Who are your partners?
A number of common IP-related agreements, if not carefully drafted, can cause the parties to be treated as a partnership for tax purposes. While this result might not be fatal in itself, classification as a partnership carries a number of attendant burdens, such as filing partnership tax returns and conforming to the partnership audit rules that went into effect January 1, 2018.
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David Brandon is a member of Miller Nash Graham & Dunn's tax and business teams. He regularly advises on entity choice, formation, sales and acquisitions of businesses, state and local taxation, and domestic and cross-border transactions. David can be reached by phone at 503.205.2372 or by email at firstname.lastname@example.org.