Use of LLCs by Joint Patent Owners

The IRS recently issued three Letter Rulings (200506008, 200506009 and 200506019) on applying Regs. Sec. 1.1235-2(d)(2) to limited liability companies (LLCs), which provide joint inventors some comfort (although not authoritative guidance) that they will not lose the potential benefits of Sec. 1235 if they seek to aggregate their patent into an LLC in accordance with the rulings’ facts.

Patent Law

A patent for an invention is the grant of a property right to the inventor, issued by the U.S. Patent and Trademark Office (PTO). In the language of 35 USC Section 154(a)(1) and of the grant itself, this is “the right to exclude others from making, using, offering for sale, or selling the invention” in the U.S. or “importing” it into the U.S. The right is not to make, use, offer for sale, sell or import, but to exclude others from doing that.

According to the PTO, only the inventor may apply for a patent (with certain exceptions). If a person who is not the inventor applies, the patent, if granted, would be invalid. An applicant who falsely states that he or she is the inventor would be subject to criminal penalties. If two or more persons develop an invention jointly, they would apply for a patent as joint inventors; a person who makes only a financial contribution is not a joint inventor and cannot be joined in the application.

A patent may be owned jointly by two or more persons when the patent is granted to joint inventors or part of the interest in the patent is assigned. Any joint owner, no matter how small the interest, may make, use, offer for sale, sell and import the invention for his or her own profit, provided that person does not infringe another’s patent rights, without regard to the other owners. A joint owner also may sell the interest or any part of it, or grant licenses to others, without regard to the other joint owner, unless the joint owners have made a contract governing their relation to each other. Accordingly, it is inadvisable to assign a part interest without a definite agreement between the parties as to the extent of their respective rights and their obligations to each other, to avoid the above result.

Use of LLCs

One common approach is to hold a joint patent in the form of an LLC. That way, managing the patent is controlled by a majority of the managing members or by some other mutually determined means.

Because of the nature of patent rights, patent owners cannot “sell” their patent, but may grant licenses to others. Because the patentee has the right to exclude others from making, using, offering for sale, selling or importing the invention, no one else may do any of these things without the patentee’s permission. A patent license agreement is, in essence, a promise by the licensor not to sue the licensee. No particular form of license is required. A license is a contract and may include whatever provisions the parties agree on; it usually includes how to handle royalties.

Capital Gain Treatment

For Federal income tax purposes, the lack of a true sale or exchange generally would preclude gain from a patent from being characterized as capital gain, even when the patent is a capital asset in the inventor’s hands. However, Sec. 1235(a) allows certain taxpayers to receive long-term capital gain treatment if “all substantial rights” or an “undivided interest” therein is transferred.

Sec. 1235’s characterization provisions are limited to individuals and to individual holders whose efforts created the property. Although a partnership is not a qualified holder, Regs. Sec. 1.1235–2(d)(2) allows each partner who is an individual to qualify as a “holder” as to his or her pro-rata portion of a patent owned by the partnership. Presumably, an LLC treated as a partnership under Regs. Sec. 301.7701–3(b)(1)(i) should receive the same look-through treatment; if so, an LLC member who is an individual inventor should qualify as a “holder” as to his or her pro-rata portion of a patent owned by the LLC.

Favorable Results

Recently, the IRS issued three letter rulings confirming that conclusion. Letter Rulings 200506008, 200506009 and 200506019 each deal with similar situations in which multiple individuals make an invention jointly, apply for a patent as joint inventors and immediately transfer it to a newly formed LLC. In each letter ruling, the IRS concluded that following the transfer of each individual’s interest in the patent to the LLC, he or she will retain status as a “holder” for Sec. 1235 purposes. Provided the other Sec. 1235 requirements are satisfied, such individual’s share of any subsequent gain recognized by the LLC on a transfer of an interest in the patent will qualify under Sec. 1235 as long-term capital gain, the letter rulings concluded.

From David S. Burnett, CPA, Charlotte, NC