(Full Outline: INVENTION EUTHANASIA: The 2017 Tax Bill)
(PDF)
Its near the end of 2018 and we have also seen much of the patent searching businesses fall-off because those costs are not instantly expensible. Patent business has fallen off because of the lack of the ability to write off patent creation costs. As far as is known, Canada continues with similar pre-2017 policies and at the present time, businesses with a footprint in Canada, and who give due care to export restrictions, can still get favorable Canadian tax advantages.
Premise: "Tax Cuts and Jobs Act" bill eliminates
"asset" status for patents and copyrights and thus eliminates capital gains. The
effects will be far reaching.
Disclaimer: Educational Only: This outline
is Educational Only and no part of this presentation can be considered as
federal or state tax advice, opinion, or position and is not intended or written
to be used, and may not be used, for the purpose of (I) avoiding tax-related
penalties under the internal revenue Code or (ii) promoting, marketing or
recommending to another party any tax-related matters addressed herein, nor
(iii) constituting guidance on any tax or criminal matter. Cases listed are for
educational purposes and have not been checked to see if they have been
overturned on appeal. Do not rely upon these cases until or unless they have
been Shepardized.
Table of Contents
I. TWO PARAGRAPHS FROM THE TAX
CUTS & JOBS ACT (TCJA)
II. HOW DID WE GET HERE?
A. TAX
HISTORY
B. TECHNICAL HISTORY
C.
PAINFUL RETURN TO REASON
D. "PATENT TROLL" PERCEPTION
E. NON-INVENTIVE COMPUTER PROGRAMMING
F. PATENT SYSTEM IS
BEING MINIMIZED
III. TACTICAL CHECKLIST
A. PRIOR TO
DECEMBER 31, 2017
B. AFTER/ASSUMING (TCJA) NON-ASSET
STATUS
C. THE CHECKLIST
IV. QUESTIONS FOR THE FUTURE
V. COMPARISON OF OPTIONS
I. Two Paragraphs from the Tax Cuts & Jobs Act
(TCJA):
"This provision amends section 1221(a)(3), resulting in the
exclusion of a patent, invention, model or design (whether or not patented), and
a secret formula or process which is held either by the taxpayer who created the
property or a taxpayer with a substituted or transferred basis from the taxpayer
who created the property (or for whom the property was created) from the
definition of a "capital asset." Thus, gains or losses from the sale or exchange
of a patent, invention, model or design (whether or not patented), or a secret
formula or process which is held either by the taxpayer who created the property
or a taxpayer with a substituted or transferred basis from the taxpayer who
created the property (or for whom the property was created) will not receive
capital gain treatment."
"The provision repeals section 1235. Thus, the
holder of a patented invention may not transfer his or her rights to the patent
and treat amounts received as proceeds from the sale of a capital asset. It is
intended that the determination of whether a transfer is a sale or exchange of a
capital asset that produces capital gain, or a transaction that produces
ordinary income, will be determined under generally applicable principles."
II. HOW DID WE GET HERE?
A. Tax History
The United States has
historically embraced the individual. It was believed that individual rights,
individual achievement and individual betterment were part of the American
Dream. Rather than set up give-aways to those who would simply come to America
and do nothing more than and sponge up benefits, our country made a long ago
deal with innovative inventors. Work smart and the reward would be a brief
monopoly. America needed more inventors in order to develop with new industries,
economically flourish with the nation and help us compete against other
countries for industrial dominance.
As an added incentive, we have had
over the past decades a mechanism that especially benefitted the most prolific
of our inventors with "instant capital gains." You invent on a Monday, file the
patent on Wednesday, and sell the invention on Friday to collect sales proceeds
that were instantly available for capital gains. Inventors could even share the
risk of businesses by receiving licensing sale proceeds over time based upon how
well the annual sales of a business was proceeding.
Instant capital gains
required the inventor to actually "sell out" and give the buyer an independent
free hand in exploiting the new product or service. This was a valuable
mechanism, because the actions and decisions of business need not be burdened
with the often whimsical personal ideas of inventors as to how the business
should proceed.1 There are a host of good advantages for separating the inventor
from the for-profit business.
First, a really prolific inventor creates
wealth, both personally, and for the world economy, by inventing. Once a product
or service is invented, a number of different people are required to exploit it.
Marketers, supply chain professionals, CPA's and shop keepers may all get
involved at different times and to different extents. Stated rudely, trying to
turn an inventor into a shop keeper helps no one. Inventors that wanted to
immerse and control business related to the invention were forced to either
become "creative" in hiding a control relationship, or else give up any "instant
capital gain" tax rates for ordinary income tax rates (and in some cases self
employment tax as well).
Second, the U.S. tax benefits for inventors
were an incentive that should have operated to attract foreign inventors to the
U.S. For 2013 and prior, the capital gains rate was a flat 15% for patents. For
a given invention, an inventor could generate sale royalties and keep 85%
federally. For an inventor living in a non-state-income-tax state, the total
capital gains tax in 2013 was 15%. Obama administration changes boosted the
capital gains rate for patents to about 25%, although it could have been less
based upon a lower total overall income.
Even Canada applies a combined
federal and provincial rate after a 50% reduction in capital gain income (all
major provinces in Canada have an income tax). This resulted in 2016 in a
combined federal and provincial capital gain rate from 23.85 to 27%. Unlike the
U.S., Canada doesn't allow for expensing of most patent costs, and Canada also
provides for recapture of any depreciation on sale. Thus the overall marginal
rate on sale is higher, although the total tax is smaller where prior
expenditures are return of capital.
Other U.S. tax advantages included an
expensing for patent costs and research and development which were not recorded
under any particular capital account. The result was the ability to deduct all
research and patent costs against ordinary income, and to take every capital
gain sale dollar at the capital gains rate. Another U.S. tax advantage for the
individual inventor, was the ability to "sell" the patent rights in every
country individually to create a stream of capital gains income directly into
the personal pocket of the inventor. This was useful in enabling the inventor to
avoid having to enter a presence into each country, and set up a corporation for
holding the patent in the event that the business containing the patent were
sold after one year of holding (and all of the FBAR and FATCA tax reporting
necessary -- but more on that later).
So, even a Canadian inventor with a
combined capital gain rate of from 23.85 to 27% still had an incentive to come
to the U.S. Research and patent acquisition were expensible / deductible against
ordinary income (not required to be carried as capital items) and, the capital
gains rates would be applied to all the amounts in the sale. Put another way
savings included (1) eliminating a capitalized a cost of about 8% of the
capitalized balance [interest free loan to the government], (2) a possibility of
keeping ordinary expenses completely isolated from capital gain income, and (3)
capital gains from each country of sale, directly into the inventor's pocket.
Individual country capital gains were also useful for sculpting income
from residual countries not exploited by a major licensee. An example might
include a large corporate licensee that has activities in all of Europe and
India. The inventor could still license the Pacific Southern Hemisphere and as a
boost to the inventor's worldwide income, possibly with leaving the licensee to
create the foreign country patents. How much of this could be done in Canada,
without having a hard asset to sell, I have not researched. The point is that
even a Canadian inventor had some additional motivation to come to the U.S., to
do research in the U.S. and to exploit from the U.S. Without capital gain
treatment, it may be that none of the most prolific inventors will want to come
to the U.S.
A 37% income tax rate for ordinary passive income in the
proposed new U.S. tax bill loses to Canada by 10-13%. And this is for U.S.
inventors that have a 0% state income tax rate. For California inventors, for
example, the incentive to go to Canada to invent increases to from about 23% to
26%. The thought that someone could move from California to Toronto and save 23%
to 26% of their income from tax is abhorrent. There are a lot of new, positive
aspects to the proposed new U.S. tax bill. Disincentivizing our current and
future most prolific inventors is not one of those positive aspects. Is Canada
prepared for an influx of immigrating U.S. inventors? But is America prepared to
further accelerate its loss of competitive edge?
B. Technical History
The continued infusion of digital and the internet has diluted innovation in the
United States. Prior to 1999, the development of computers and computer
invention intimately tied into the patent system. Innovators used the patent
system to as a directional guide post to dope semiconductors to higher density
packages, to make smaller, sturdier, hard drives, and improve computer
reliability.
Patent "intellectual rules" included a prohibition on
business methods, and a general prohibition on close-ended math and database
functions not having a real-time functional advantage. A series of philosophical
patent cases filled in precise sub-rules that defined the limits of what was and
was not permissible. Inventions with open math functions like Fourier transforms
that operated as summing functions in real time were favored. Computer data-base
sorting and manipulations were not favored. Close-ended math functions that
operated in real time to improve sound quality were favored.
In 1999, the
State Street Bank2 case came along. The PTO had just denied another data base
program allowable claims and they appealed to the Court of Appeals for the
federal circuit (CAFC), commonly known as the patent appeals court. What should
have been a denial turned into unbelievably new law. The court held that (1) all
software is potentially patentable if it meets the usual criteria, and (2) the
200 year old prohibition on business method patents is eliminated. The latter
was not really part of the case, and I had thought that this lapse of reality
would be quickly remedied with a later reversal. It never happened.
To
me, it appeared as if some persons had cast their gaze to "liberal Europe" and
viewed with some envy the breadth of computer claims that were being allowed in
patents there. There may have been a fear of loss of innovative businesses to
Europe. The reasons for "inventing liberal case law" will forever be pure
speculation. No jurist would admit what they were thinking at a prevaricative
"left turn" away from the weight of developed technological jurisprudence and
200 years of tradition.
Liberalization of computer software/business
methods unexpectedly continued into the 2000's with brakes beginning to be
applied in 2008 and ending with the 2014 Alice case3. Alice was extreme and
contra to the 2000's. Alice brought up the �101 definition of statutorily
patentable subject matter (machine, process, composition of matter & article of
manufacture) and stated or implied that the patents applied for since 1999
relating to non-scientific, non real-time dependent, etc. software "might be"
invalid, and perhaps might be re-submitted for the PTO to check. Alice's 2014
date compared to 1999 represented 15 years of patents, substantially close to a
generation (seventeen to twenty years) of patents. The vast majority of
applicants or issued patent owners would not and did not begin a wave of
re-submissions.
C. Painful Return to Reason
The return to reason would
have been more effective if the authors of the State Street Bank decision could
have simply withdrawn it after announcing "My Bad". The decade after State
Street Bank represented a painful and uncertain path back to a state more
clearly similar to the state of the law before State Street Bank was decided.
When the millions spent on patent cases and appeals is considered, along with
the uncertainty of not knowing a proper level of protection to be sought for
computer related inventions, the path to Alice was painfully expensive, and
expensively wasteful.
The "out of nowhere" blessing for business method
claims doubled the pain and contributed to anger directed at the patent system.
The most noteworthy topic for generation of anger were "tax patents." Although
these were inherently structurally ineffective as a monopoly, they were
effective in generating anger. The few who pursued tax patents spent their time
in seminars threatening the attendees not to use the techniques they were being
taught. Tax patents were an easy media focus: "Americans could be prevented from
tax exclusions from income and from tax deductions for fear of being sued by a
tax patent holder." Legislation prohibiting tax patents was signed into law in
September 2011.
D. "Patent Troll" Perception
The perceived rise of the
"Patent Troll" may have been the impetus for the extreme de-assetization of
patents. A most conservative definition of "Patent Troll" is an entity that
attempts to press greater rights than it has. I contend that the main perception
of "Patent Troll" is some non-operating entity or person that obtains a patent
but does not operate to manufacture or import a good or service related to that
patent. It is my belief that a desire to see only operating companies hold
patents that caused tax bill legislation that included a de-assetization of
patents, especially against so long a history in the U.S. to reward individual
innovation.
De-assetization doesn't prevent the pressing of a patent case
against an infringer, but it does make it more difficult and less rewarding if
the result of settlement is the sale of the patent to the accused infringer. As
an asset, the sale by an individual could have resulted in capital gains rate of
from 0 to 25%. If the settlement was a sale of the patent that depended upon the
sale of a product for 20 years, a royalty of about $40,000 per year for 20 years
could have been received tax free if the inventor had no other source of income.
Otherwise, the annual capital gains tax would range between 10% and 25%.
E. Non-Inventive Computer Programming
The bulk of this generation of people
in the computer industry are focussed on non-technical and non-inventive
programming. The term "Application" or "App" has commonly come to mean a program
that will provide "some" non-essential non-engineering information to a user of
the Internet. For the most part, these "Apps" are related to advertising, or
personal needs or recreational interests. Most of these "Apps" are monetarily
driven by advertising dollars spent and received. Advertising dollars are most
generally always ordinary income and expense.
An I-phone is a computer
with telephone and wireless capability. Small, hand-held computers have the
capability to perform much the same tasks as any computer, namely, a computer
using open-ended math functions, statistical evaluation capability, and much
more. The average programmer tends not to program to create a system across
different devices; they stick to established program manual of a given device
and limit themselves to programming simple instructions within the device. Most
device programmers shy away from computational programming.
F. Patent
System is being minimized
In 2016, further legislation was passed to inhibit
a patent plaintiff's ability to select a favorable jurisdictional
(pro-plaintiff) forum for patent infringement. The PTO has taken on the task of
"transparency" which typically means that there will be more resistance to
allowing patents. But because the slowdown will be done "openly" perhaps no one
will notice? PTO has opened small offices in various cities, in the U.S. and
overseas, ostensibly to help make patenting more available to the populace. My
own experience is that over the past two years, the patent examiner's are less
willing to engage on a technical level and are forcing applicants that are
intent on receiving their full share of claims into threatening and filing
appeals.
III. TACTICAL CHECKLIST
A. Prior to December 31, 2017
When inventors had "instant capital gains", the patent itself was a capital
asset that drew capital gains on sale immediately after creation (trade secret)
or after filing. If the "Tax Cuts and Jobs Act" (TCJA) is signed into law,
patents, trade secrets and copyrights will lose the ability to become capital
assets. Most copyrights have traditionally not been capital assets in the hands
of the creator, but could have become capital assets on first sale. Patents and
trade secrets were typically capital assets upon an earliest articulation of the
technical details of the asset.
Until December 31, 2017, purchasers may
hold the patent as a capital asset under IRC �1221(where it is not used in
business) or IRC �1231 (if used in a business). Further, these capital assets
were not subject to recapture, generally because the expensing of costs related
to patent assets were divorced from the assets under the "related to" language
of IRC �174 enables a taxpayer to deduct patent development costs as a separate
research item. It is always a challenge to allocate costs of research to the
patents to which they relate, so this provision has other advantages. Expensing
costs against ordinary income meant that most patent assets ended up as a zero
basis item in order to capture all of the value on sale as a capital gain, with
no recapture of the expenses of research and development deductions.
B.
After/Assuming (TCJA) non-asset status
Research is required to be capitalized
under IRC �174. It remains to be seen whether patent attorney costs may be
deducted under IRC �174. However, the new IRC �174 requires 5 year amortization
for research expenditures. 5 year amortization is a major slow-down and cost, by
delaying expenses. What it means is that research expenses will be not unlike
buying a hard asset-- the taxpayer will need to justify the cash flow needed to
exceed be net present value of the tax loan made to the government.
The
patent or copyright asset should be thought of as a pencil or piece of paper.
They usually have no asset value, but if owned by a corporation, it is the
corporation that gets asset treatment when it is sold (assuming that its not a
"disregarded entity."
C. The checklist
1. It may be expedient to
assign a patent into an entity that will not experience disregarded entity
status. So, LLC's and other pass throughs perhaps should be avoided.
2.
The entity should be selected to hold the patent and nothing more. Buyers
typically want to buy assets because they don't want to take any chance on the
tax history of any corporation purchased. As such, the creation of a
corporation, the entry of a patent asset, and the business history of the
corporation up to and including sale, should be provably free of any significant
activity. The books and records of the ideal corporation created and used to
transfer the patent should be so simple that it could be contained on a simple
sheet of paper.
3. Corporation cost of acquisition and annual minimum
franchise tax should be considered carefully. California's $800 annual minimum
franchise tax will cause the budgeting of over $1000 per year expense that will
be like keeping the patent in a storage unit. Other states that have a lesser
cost should be considered, especially since simple asset ownership will not
probably not contribute to any undue ties to the jurisdiction of that
corporation.
4. I have historically taught that trademarks should be kept
in a separate corporation rather than risk the loss of value should the business
entity be sued. In the past, because patents had instant capital gains rights
they may have been best kept out of a well separate corporate entity if the
business was small. Now, an entity will be needed, (a) not only for separation
for liability insulation, but (b) also for any capital gains upon sale of the
corporation.
5. After (TCJA), any sale, exclusive or not, will result in
ordinary income. This might facilitate more non-exclusive licenses from the
platform of a corporation owning the patent. If the separate corporation holding
a patent is a licensing business, ordinary income flows can be increased and
accumulated so that the corporation might then be sold for a capital gain rate.
Further, simple license income will not usually complicate the tax history
enough to cause any reduction in value.
6. Regular corporate ownership
would seem to be best type of entity to own a patent because (a) it will be
given the greatest respect as a separate entity, (b) if it earns no money, the
real annual cost of holding the patent will be any minimum franchise tax and the
time to file a corporate tax return, and (c) if it earns money, it will be a
business unto itself and can be made to provide a salary and profit sharing at
pay the owners, and possibly provide benefits.
7. Tax liability for a
impermissible "type A" reorganization is an even greater danger. The typical
"type A" reorganization occurs when a larger corporation tries to obtain a tax
free transfer of assets from a smaller corporation by merger, usually in
exchange for a stock of the acquiring company in exchange for 100% of the stock
of the target company. Restrictions may exist, including (a) the acquiring
corporation should continue the target business for two years and the stock of
the acquirer is an even greater danger, (b) about half of the consideration to
the target shareholders should be stock, and there should be no arrangement to
re-acquire the stock so that it will not be considered an asset sale. In other
words, both target and acquirer will need to be in each other's orbit for a few
years in order for the target shareholders to insure that any capital gain
treatment is not un-done. Capital gains are generally 0%-15%-20% corresponding
to income less than about $75k, less than $480k, and over $480k.
8. Where
an inventor is not incentivized by a lower tax rate to maintain an arms-length,
separate, and passive stance as a licensor/seller, the inventor is likely to
become affiliated with the buyer. The inventor is likely to be cheated, swindled
and abused. The tax incentive gave the inventor an incentive to remain separate
and apart from the buyer/licensee. Remaining separate gave the inventor some
control over the patent, the product, and the business, to insure that he would
be paid. It will be easy now to hire the inventor for a pittance, pressure the
inventor to give up the invention, and then fire the inventor in order to
complete the fraud.
9. Any disagreements over the transfer of the patent
will end not with return of the patent, but with pittance damages to the
inventor and with the buyer/licensee leaving the patent with the transferee. If
the buyer/licensee fails the inventor will not be able to re-acquire the patent
and start again with someone else.
10. Large companies that create their
own patents and hold them to
aid the production of income will be largely
unaffected.
11. The United States may begin losing inventors to countries
with more favorable tax structures. Countries hungry for new industries may
offer inventor of the best inventions an immigration and tax free deal.
Inventors can free themselves from U.S. taxation by surrendering citizenship.
12. In surrendering citizenship, the IRS requires a "forced sale" of all
U.S. assets at the time of citizenship exit. Any valuable inventions that the
inventor commands and controls will be difficult to value, and even more
difficult to discover.
IV. Questions For The Future
Will inventors
and corporate shell creators work together to create year-old corporations for
inventors to purchase and place their patents in order to effectively achieve
rights similar to instant capital gains?
Is all of this done simply to
further nickel and dime small inventors in hope of discouraging their
creativity? Has someone in government made the value judgement that society will
function more effectively either (a) with a reduced number of patents, or (b) by
leaving patents to the exclusive realm of large corporations?
Is this
proposed change in the law a value judgement that real inventions are not as
prevalent and the majority of startup inventors are doing Internet applications
that should not be patentable in the first place? Or is this a governmental
policy preference to minimize sole proprietors in favor large corporations
employee status (from whom it is often easier to collect tax)?
V.
Comparison of Options
This section shows a chart from my previous
Intellectual Property Taxation outline which has been modified for simplicity.
(OMITTED)
POST (TCJA) INTELLECTUAL PROPERTY TAX TREATMENT
TABLE
Property Type Write
Off Method Capital Gain
Comments
Patent
Trade Secret
5-Year Capitalization
NO
§1235 is gone
(15-Year Capitalization
No Capital gains for creator
Foreign research)
Not available to creator or
later basis purchaser.§174
"unrelated" non-recapture gone
Copyright
General- Deduct as salary NO
Expense if paying others
if self-created.
Copyright was always the
worst, but now its equally
disadvantaged as patents.
Music copyright asset is gone
Trademarks Cap.
acquisition & costs
YES Dangerous
to hold personally
of defending. Amortize over
Use pass thru to collect sales
15 years if acquired after 9/9/93
proceeds.
(with some piece of business)
Copyright (C) 1996-2021 Harrington & Harrington ~ All Rights Reserved