INTELLECTUAL PROPERTY TAX
Updated 4/25/06
By Curtis L. Harrington


Overview of Intellectual Property

From a tax standpoint, the intellectual property groupings are patents/trade secrets/know-how; trademarks; and copyrights.

Patents

Patents include the design of the exterior of a useful article. Examples: the "look" of an automobile, computer, tennis shoes, vacuum cleaner, etc. Plant patents protect plants which have been reproduced to have desirable characteristics and possibly beauty. Examples: varieties of orchids, roses, flowers, and other agricultural plants. The main type of patent is the utility patent. Utility patents are for inventions relating to machines, processes, compositions of matter. Examples: circuits, machines, chemicals, processes, in short, protection for things and the way they work.

Utility and Plant patents may be ranked together for several reasons. (1) They were both formerly allowed a term of 17 years and currently allowed a term of 20 years. (2) Utility and Plant patents are not subject to copyright overlap, as may only sometimes be the case with design patents. However, software can be subject to copyright overlap with utility patents.

Trade Secrets/Know-How

Trade Secret Definition: Information, including a formula, pattern, compilation, program, device, method, technique or process, that: (1)Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and (2)Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

Improper means, includes theft, bribery, misrepresentation, breach or inducement of breach of a duty to maintain secrecy, or espionage through electronic or other means. Reverse engineering or independent derivation alone shall not be considered improper means.

It is illegal to acquire a trade secret of another by a person who knows or has reason to know that the trade secret was acquired by improper means. There is a companion definition in the penal code which makes trade secret theft a felony.

The key to protecting a trade secret is not only in keeping it secret, but the systematic steps and procedures you take to keep it secret. You could conceivably hide something in your drawer with the result that no one discovers it, however evidence of the locking of doors the assignment of keys and the segregation of personnel based on a need to know will be dispositive in determining whether you have acted to keep secret your valuable trade secret. This area of law cuts a fine distinction between control of persons and their ability to use the knowledge gained from an employer, and a persons right to use their skills and knowledge, apart from the specifics of the trade secret, in a specialized area. This is carefully weighed by the courts, especially where the secret is related to the specialized area of knowledge.

Know-How Definition: No formal definition is accepted as universal, but a loose definition is gleaned from the cases and includes secrecy an any other secret information as to a device, process, formula and in general in the nature of patentable subject matter whether or not actually patentable under the patent laws.

Trademarks

Trademark Definition:

  1. Any word, name, symbol, device, or any combination thereof which is used in connection with goods or services to help consumers identify those goods and services as different from the goods and services of a competitor.
  2. Federal Trademark: Any word, name, symbol, or device or any combination thereof used by a person, or which a person has bona fide intention to use in commerce and applies to register on the principal register established by this chapter (15 U.S.C. Sec. 1127) to identify and distinguish his or her goods, including a unique product, from those manufactured or sold by others and to indicate the source of the goods, even if that source is unknown. Trademarks are applied to goods and Service marks are applied to advertising used in conjunction with the provision of services.

Copyrights

Rights in the copyright owner:

These rights can be retained or licensed as the copyright owner sees fit. Multiple rights can be had in any tangible medium. It is the multiplicity of these rights which is measured in each fragmented medium to determine if the copyright owner is making an outright sale of the copyrighted work, or is merely making a license. If any of the above rights are retained for any given medium, a license will result.

The fact that the payment to the author can be based upon sales, extended over time, or made in a lump sum is not determinative as to the existence of a license or sale, but rather the rights granted and retained. Agreements, whether a sales or a license agreement, can also contain other broad provisions as in any ordinary contract. For example, the contract can require a licensee or buyer of rights to pay money or perform other duties in exchange for the license. For example, the ability to exclusively perform the work is especially important for playwrights who receive royalties not only from the publication of their plays but also from the performance of their plays.

Deduction of Development Expenses

Sec. 174 of the Internal Revenue Code permits a taxpayer to deduct expenses which are paid or incurred during the taxable year in connection with a trade or business associated with the technology. The term "in connection with" is deliberately less stringent to distance the application of Sec. 174 from the requirement of having an ongoing business concern, which was previously required in order to deduct development expenses.

Capital Gains Treatment Upon Sale of the Technology

Sec. 1235 of the Internal Revenue Code allows a patent to have long term capital gain treatment even to a professional inventor, and regardless of holding period. With most properties it is required that the owner hold the property for a year in order to obtain capital gains treatment. With patents, an invention made on one day can be sold the next day and still receive capital gains treatment. The key to capital gains treatment is to be a "holder" as defined in the Internal Revenue Code. A holder can be the inventor, or one who bought from the inventor, but not those who are merely in privity with the inventor. A holder is defined as one who obtains an interest in the technology before it is actually reduced to practice. Investment partners and investment co-owners who contribute capital can qualify as holders so long as the contribution is made before actual reduction to practice. Constructive reduction to practice does not apply to the Internal Revenue Code definition. Reg Sec. 1.1235-2(d)(3)

The right to deduct research and development expenditures as set forth in above is even more critical to new technology ventures since the tax advantage of these deductions are not recaptured if the technology is later sold. For example, if a developer of technology spends $500,000 for research activities, this amount can be deducted against ordinary income in the year in which the funds were expended. If the technology is later sold for $1,000,000 by a holder of the technology, all of the sales price will be taxed at the capital gains rate, currently 15%. The first $500,000 of the sales price will not be recaptured because the deduction was for the purposes of encouraging research and is therefore not related to the later sale of the patent. To illustrate the recapture case for contrast, the first $500,000 would have been taxed at the ordinary income rate, and only the remaining $500,000 would be taxed at the lower capital gains rate.

A patent can have its rights divided among others with a license agreement by geography, type of product, time duration, and the like. An agreement for the sale of a patent, rather than a license, must involve the sale of substantially all of the rights in the patent. Only then can capital gains treatment be afforded. Otherwise, the monies received will be treated as ordinary income. In other instances the taxpayer may have divided the patent rights in a series of non-exclusive licenses. Where the taxpayer is highly involved in administering the licenses and is involved sufficiently to consider it as a business, self-employment tax will have to be paid.

Trade secrets appear to have characteristics which are patent-like and yet which can also be treated generally as property under general principles of exchange of property. In some cases the sale of property which has potential patentability may come within Sec. 1235 enabling the owner to realize capital gains on the sale of the property even when held for less than a year.

The ability to treat trade secrets and know-how as patent-like comes from the emphasis on development and the favorable treatment given to investment which occurs before the trade secrets and know-how are reduced to practice. In the landmark case Gilson v. Commissioner 48 T.C.M. 922, a creator of 82 designs was allowed design patent tax treatment even though only two of the designs were patented. Gilson is also cited by some for the premise that so long as copyright protection is not sought, the property may be treated as patent-like.

Other similar principles apply to the transfer of know-how and trade secrets. Where a taxpayer develops or collects and sells trade secrets in the course of business, ordinary income will arise under the inventory principle. In other cases, an attempt to determine if there has been a sale or merely a license. As in the case of patents, the Internal Revenue Service requires a transfer of all substantial rights in the trade secret or know-how. However, since a trade secret can have an indefinite life much like a trademark, the transfer should be without any term of years limitation. Of course if the trade secret becomes generally known, it will cease to exist at that time.

With regard to fragmentation, the trade secret or know-how sold should be as complete as possible to enable an independent singular commercial exploitation. The contract of sale should recite what the buyer will be enabled to do, even perhaps in the form of a guarantee, to insure that the technology will be an enabling package.

Tax Treatment of Trademarks

Expenditures to develop, acquire and defend a Trademark cannot be properly expensed. Since a trademark can last forever, it has no determined life period over which to depreciate or amortize its cost. Costs of advertising which in fact develop the trademark are expensible as are any form of advertising under Sec. 162 of the Internal Revenue Code.

Further, Sec. 179 which allows the amortization of start up costs does not apply to expenditures for trademark development and acquisition. Even payments to a competitor to buy out their use of a name or to get them to contractually agree to avoid using a name are capitalizable.

Expenditures for trademark development can only be recovered when the trademark is ceased to be used or when the trademark rights are sold. However, expenditures to challenge another's right to a trademark in litigation have occasionally been held to be expensible. Monies expended to defend a trademark are capitalizable.

Sale and License Transactions

Licensing revenues represent ordinary income to the recipient and are deductible to the payor. The sale of a trademark is treated as the sale of a capital asset by the seller. Since the trademark capital account is not deductible, a question of recapture should not exist. Payments to purchase a trademark are a capital expenditure of the buyer and thus not deductible by the buyer.

In some close situations, the grant of a perpetual right to exploit and use a trademark can be considered to be a sale. Sec. 1253 of the Internal Revenue Code was enacted to clearly distinguish a sale from a license. Sec. 1253 states that "A transfer of a franchise, trademark or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name."

The significant rights include (1) the right to disapprove of any [further] assignment of such interest, (2) a right to terminate at will, (3) the right to prescribe the standards of qualify of products used or sold, or of services furnished, and of the equipment and facilities used to promote such products or services, (4) the right to require that the transferee sell or advertise only product or services of the transferor, (5) a right to require that the transferee purchase substantially all of his supplies and equipment from the transferor, and (6) a right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred, if such payments constitute a substantial element under the transfer agreement. (IRC Sec. 1253(b)(2)

In short, any retained right outlined above will be enough to characterize the payment as a license. In this case any payments will be deductible by the licensee and includible as ordinary income of the licensor.

Tax Treatment of Copyrights

Deduction of Development Expenses.

Although Sec. 174 of the Internal Revenue Code is drafted broadly to enable current expensing of research and experimentation, most copyrightable property will not qualify. Current regulations prohibit the deduction of expenditures for "literary, historical or similar projects." Sec. 174, when read in conjunction with Sec. 263A, require capitalization of expenditures in connection with copyrightable subject matter.

A partial saving provision can be found in Sec. 195 of the Internal Revenue Code which permits the amortization of the otherwise capitalizable startup costs. The costs are amortized over a period not to exceed 60 months. This provision will allow some accelerated cost recovery, but it is not nearly as favored as the treatment of patents.

Worse still for creators of copyright property, Sec. 1221 of the Internal Revenue Code excludes copyrights from capital asset status to (1) a taxpayer whose personal efforts created the copyright property, (2) a taxpayer for whom such property was prepared or produced, and (3) a taxpayer in whose hands the basis of such property is determined for the purposes of determining gain from sale or exchange... Under these circumstances, cost expenditure can be recovered under Sec. 195, but the work itself will have a zero basis in the hands of the taxpayer. Of course, if the taxpayer is in the business of creating copyright property, and where the copyright property is inventory for sale, (the taxpayer is already in business) current expenses of running the business are deductible. Even when the taxpayer is in business, specific project expenditures relating to the acquisition of copyrightable property have been held to be capitalizable rather than expensible.

Further, since the property is not a Sec. 1221 (capital) asset in the hands of the creator, the sale of the property by its creator or one who commissioned its creation will not result in capital gains treatment. The same is true for a taxpayer who obtained the property by gift or inheritance from the creator. Of course, a taxpayer who subsequently purchases the copyright property will purchase a capital asset. The purchased capital asset can then be depreciated under Sec. 167 of the Internal Revenue Code.

Depreciation where the copyright work is not made for hire can be taken over a 35 year period. This 35 year period represents the minimum time before an author or his successor can unilaterally terminate the transfer under 17 U.S.C. Sec. 203. Where the economic life can be shown to be less than 35 years, and various computational methods can be used to properly depreciate the copyrightable property.

Fragmentation by medium enables a copyright owner author to sell a copyright work in a single medium, while retaining rights in other separately identifiable media, even though such separately identifiable media is related to the medium sold. The copyright of an earlier version of a computer program can be retained while the copyright to a later version of a computer program can be sold in its entirety. An author of a novel can also create a screenplay based upon the novel, and then sell both to a buyer. The buyer holds both as capital assets. The buyer can then sell one without the other and the sale will not be treated as a license, even though the two are creatively related.

A subsequent sale may qualify for capital gains, but not if the seller is in the business of holding such properties for sale to customers. This is similar to the treatment of inventory, which is not allowed to be capitalized. The authority for this is under both Sec. 1221(1) pertaining to stock in trade and Sec. 1231(b)(1)(A) & (B) pertaining to the definition of property used in the trade or business.

Other dispositions will probably result in a finding that the transaction is a license. The exception and limit is an exclusive license for the life of the copyrightable work, which is considered a sale. Rev.Rul. 60-226, 1960-1 C.B. 26.

patentability/copyrightability overlap

Sec. 1.1221-1(c)(1) states "for purposes of this subparagraph, the phrase 'similar property' does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law." Thus property which is only patentable is excluded from operation of Sec. 1221 of the Internal Revenue Code and thus is treated as a capital asset in the hands of the creator.

This is still an unsettled area of the law, but has been considered in the area of design patents versus copyrights and in the area of utility patents versus copyrights. In most cases, design patents are distinguishable from copyrights by a showing that the design patent protects the design of a useful object. Conversely, where the Copyright Office can ascertain that a submitted design has a utilitarian function, the copyright may usually be rejected. However, since the Copyright Office's examinations are brief, it is not unusual for many utilitarian designs to slip through and be copyrighted. The principles outlined above indicate that a developer should carefully consider the decision to register for copyright where design patent protection is possible.

In the software area, the overlap is much broader and the developer has a broader choice of protection. Since copyright protects the expression of the software, virtually any type of software can obtain copyright protection. As previously stated, software patents can usually be obtained for certain open-ended mathematical algorithms and for software which will be used to create a different sort of machine. Since copyright protection can be had without actually registering the copyright, it may be better for developers of patentable software to temporarily forego copyright registration and apply for a patent.

In the U.S., copyright registration is required to bring suit in federal court. In some cases, the holders of copyright rights have been known to delay registration until such registration was needed to go into court to stop infringers. The decision to delay should be based on each set of facts and circumstances and may be based upon timing constraints as well. The patent applicant can file a petition to make special to accelerate the examination process. Even with a petition to make special and a successful examination, the patent process will take a minimum of six to nine months. The copyright examination process typically requires less than 2 months until a registration certificate is obtained.

In cases where the developer will sell the patented or copyrighted product and retain ownership of the copyright and patent, the tax effect of having a copyright or patent or both should be minimal, except where expensing of development costs are concerned. As stated, patents are tax favored and attorney's fees expended in obtaining a patent are also expensible.

Also keep in mind that the sale of a depreciated copyright, even where the seller can treat it as a long term capital gain, is subject to recapture for the depreciation in excess of the sale price.

Relief for all intangibles Generally

Sec. 197 of the Internal Revenue Code has provided some relief to Trademark Owners. Sec. 197 allows the amortization of any intangible which is acquired by the taxpayer after August 9, 1993 which is held in the conduct of a trade or business within the meaning of Sec. 212.

Sec. 197 intangibles includes (1) goodwill, (2) going concern value, (3) work force in place including its composition and terms and conditions of employment, (4) business books and records, operating systems, or any other information base, (5) any patent, copyright, formula, process, design, pattern, know-how, format, or similar item, (6) any customer based intangible, (7) any supplier based intangible, (8) any other similar item, (9) any covenant not to compete, and (10) any franchise, trademark, or trade name.

However Sec. 197 specifically excludes (1) computer software which is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified, and (2) other computer software which is not acquired in a transaction involving acquisition of assets.

As can be seen, Sec. 197 has the greatest impact on Trademarks, since the capitalized amounts cannot be amortized outside of Sec. 197. Copyrights can be amortized under Sec. 197 but only where the copyrights were not created by the author or created as a work for hire for the taxpayer. For patents, the more lucrative treatment under Sec. 174, which allows the alternatives of (1) expensing the development costs, (2) amortizing over 60 months, or (3) depreciating under Sec. 167, will be preferred over the 15 year amortization provided under Sec. 197.


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