By Curtis L. Harrington
Favorable tax treatment for the creation and development of technology can be allocated to more than one business entity so long as each business entity has a reasonable expectation of entering into an ongoing business relating to exploitation of the technology.
The favorable tax treatment for the creation and development of technology is Sec. 174 of the Internal Revenue Code. 174 permits a taxpayer to deduct expenses which are paid or incurred during the taxable year in connection with a trade or business. Sec. 174's term "in connection with" is a deliberately less stringent connection to the requirement of an ongoing business concern, the standard required before the introduction of Sec. 174.
The right to deduct research and development expenditures is even more critical to new technology ventures since the deductions do not have to be recaptured if the technology is later sold. For example, if a developer of technology expends $500,000 in research activities, this whole amount can be deducted as ordinary income in the year in which the funds were expended. If the technology is later sold for $1,000,000 dollars by a holder of the technology, and assuming that the basis in the technology is zero, capital gains treatment will be given to the sales price. The current capital gains rate is 28%. 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.
In order to be able to expense the research and development expenditures among business entities, each business entity must have a "realistic prospect" of subsequently entering its own business in connection with the fruits of the research, if the research is successful. The recent case of Scoggins v. Commissioner 95-1 ustc 50,061; 46 F3D 950 (9th Cir) illustrates a typical, successful structuring. However, as this case also illustrates, it is not unusual for the IRS to challenge, and the Tax Court to uphold a denial of the deductibility of research and development expenditures, even where properly structured.
Before describing the structuring of Scoggins, be aware that the deductibility of research and development expenditures was denied in the case of Green v. Commissioner, 83 T.C. 667 (1984) which held that "where a limited partnership functioned only as a vehicle for injecting risk capital into the development and commercialization of inventions." Thus, the entity which seeks to claim a deduction should be one which is set up to have a chance to enter the regular business which relates to the technology development, rather than a business entity whose only function is to inject investment and collect profits.
In Scoggins, the inventors formed a partnership to hold rights in the technology, and to pay for the research. The inventors also formed a corporation, in which they held a 75% interest, which was paid by the partnership to perform the research. At issue in Scoggins is whether the partnership could take a deduction for the research expenditures which it paid to the corporation.
Further, the relationship between the partnership and the corporation included the grant of a non-exclusive license from the partnership to the corporation to market the technology for a 15 month period, and the grant to the corporation of an option to acquire the technology outright for $5 million. Although the Scoggins case considers only deductions of the partnership, it is clear that under the above circumstances that both the corporation and the partnership each have a realistic prospect of exploiting the technology in a business of its own.
Further, by utilizing a partnership to hold the technology, the individual partners have insured that they may qualify as "holders" of the technology and therefore eligible for capital gains treatment under Sec. 1235 of the Internal Revenue Code, if a sale of the technology is made. A "holder" is an individual who either created the intellectual property or acquired an interest before the invention physically constructed or carried out such that there is reasonable certainty that the invention will perform its intended function.
In conclusion, and in order to make use of the tax advantages afforded research and development, each entity should manifest both the objective intent to enter, as well as the capability to enter a business related to the research and development.
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