Two Roads to Capital Gains for Patent Sales

As the new economy presses forward, innovative technologies are being developed at a rapid pace. Many of these technologies are patented and then transferred in some capacity to companies that will attempt to commercialize them. At times, a transfer involves an outright sale of the patent; sometimes, it involves only a lease of the technology in exchange for royalties. These transactions can sometimes be complex or unusual from a tax perspective. A company often wants to acquire the exclusive right to use a technology, but it is difficult to determine a fair purchase price for a patent that may or may not prove to have commercial applications. A common solution is a contract that grants the acquiring company a permanent and exclusive right to use and develop the technology in exchange for royalties based on sales of any commercial applications that use it.

From the vantage point of transferors, these transactions have many elements of sales. They have permanently transferred all of the economic rights to their patents and are left only with legal title to a technology that they can no longer use, sell or lease. They would certainly like the transaction to be taxed as a sale (subject to capital gain rates), rather than taxed as royalty income at ordinary rates. However, transactions in which legal title to an asset does not change hands are not usually taxed as sales. Fortunately, Sec. 1235 addresses these types of transactions and treats them as long-term capital gains. Unfortunately, Sec. 1235 is fairly complex and not all taxpayers will be able to take advantage of its safe harbor provisions. Sec. 1235(a) 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, regardless of whether or not payments in consideration of such transfer are—

(1) payable periodically over a period generally coterminous with the transferee's use of the patent, or

(2) contingent on the productivity, use, or disposition of the property transferred. (Emphasis added.)

Capital gain treatment is available if the transferor can meet the Sec. 1235(a) requirements. The first unique term is "all substantial rights to a patent." Regs. Sec. 1.1235-2 basically requires that the transferor permanently give up all rights to control creation of income from the patent. The transferee's use cannot be restricted geographically or by industry, limited only to certain inventions using the patent and of shorter duration than the life of the patent. Rights the transferor may specifically retain include legal title and the right to reclaim all patent rights in the event of nonpayment. Any other rights retained are to be considered in the context of the entire contract and not individually when determining if they constitute a substantial right. Regs. Sec. 1.1235-2 mentions retention by the transferor of the right to prohibit subleasing and the failure to transfer the right to sell or use the patent property as rights that would need to be considered in the context of the agreement as a whole.

The second step in determining if Sec. 1235 applies is to determine if the transferor meets the definition of "holder."

Sec. 1235(b) defines a holder as:

(1) any individual whose efforts created such property, or

(2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither the employer of such creator, nor related to such creator. (Emphasis added.)

Per Regs. Sec. 1.1235-2, this clause restricts favorable treatment to individuals, which includes partners in a partnership that would qualify as the original inventor or joint inventor under U.S.C. title 35. This restriction could prove to be problematic in many cases. Patents are always issued to individuals. However, the employment contract of many researchers requires that any patents developed in the course of their employment be assigned to their employer. This mechanism would preclude the subsequent transfer of all subsequent rights to the patent by the employer to qualify for Sec. 1235 treatment, unless the employer was a partnership.

It may seem at first glance that a corporation could never qualify as a "holder." Consider, however, an S corporation whose sole shareholder would qualify individually as an inventor or joint inventor along with one or more of the corporation's employees. If it were a partnership with the same set of facts, the partner would be a holder. The Senate Committee Reports for the Subchapter S Revision Act of 1982 summarize that the revised S corporation rules "generally follow the present law rules governing the taxation of partners with respect to items of partnership income and loss." This may open the door to a line of reasoning that S corporations are included in the regulations' reference to partnerships. Also, consider that throughout the Code and regulations, S corporations are taxed as individuals and specifically precluded from tax advantages afforded regular corporations. The question is whether an S corporation can take advantage of a provision afforded only to individuals? There is no specific guidance on this issue. While clearly an aggressive position, it may be a viable alternative when the transaction is already complete and cannot be structured as taxable at the individual level.

Given the problems with corporations qualifying under Sec. 1235, it seems wise to consider whether or not capital gain treatment is available without Sec. 1235. The Senate report on the enactment of Sec. 1235 indicates that the treatment of exchanges involving patents was not clear at the time, and that the purpose of Sec. 1235 was to provide a safe harbor for holders to qualify for capital gain treatment but not necessarily to exclude nonholders. Regs. Sec. 1.1221-1(c) indicates that a patent may qualify as a capital asset. However, inventory held primarily for sale in the ordinary course of business is not a capital asset under Sec. 1221(1). It is critical that taxpayers be able to establish that they are not in the business of selling patents or patent rights. This position could even be taken by a business in the research and development business, as long as it does not normally sell patents outright. If it normally contracts with researchers or enters into joint ventures to commercialize its own inventions, the occasional sale of a patent would probably be treated as the sale of a capital asset. Courts have ruled both ways on this issue numerous times. Taxpayer-favorable decisions include Beach v. Shaughnessy, 126 F Supp 771 (1954) and Perkins, 216 F Supp 618 (1963). Taxpayer-unfavorable decisions include Lockhart, 258 F2d 343, (3d Cir. 1958) and Lamar v. Granger, 99 F Supp 17 (DC Pa. 1951). The overriding factor in most of the cases seemed to turn on the volume of exchange transactions over the most recent years.

Accrual-basis taxpayers may have to deal with another issue if they pursue capital gain treatment without the benefit of Sec. 1235. Currently, recognizing income under the installment sale rules is not an available option to accrual-basis taxpayers. This could create a tax liability years before the cash is received. However, many of these agreements contain enough contingencies that they may qualify as "open transactions" under Temp. Regs. Sec. 15A.453-1T. An "open transaction" is one in which the fair market (FMV) value of the obligation cannot be determined and, therefore, the recipient is taxed as the payments are received. Only in rare and extraordinary cases involving sales for a contingent payment obligation in which the obligations' FMV cannot reasonably be ascertained will the taxpayer be entitled to assert that the transaction is open. While it may be uncomfortable to take a position that the regulations state is available only in rare circumstances, a transfer of a patent not yet reduced to practice, involving unproven technology, for a royalty stream should be the type of transaction the regulations allow to be treated as open.

In summary, qualifying under Sec. 1235 is the preferred method of qualifying for capital gain treatment, because it will eliminate the question of whether a taxpayer is in the business of selling patents, any holding period requirement and the "open transaction" issue. However, for the many taxpayers that cannot use Sec. 1235, Sec. 1221 may be a viable alternative.

From Kevin M. Krantz, CPA, MT, Cohen & Company, LLP, Cleveland, OH