As a tax lawyer, I often hear about how confusing people find the tax laws to be. If you’re reading this, you’re likely to be deeply involved in some industry other than tax, and you wish you could have the subject broken down to a digestible level. Hopefully, this article will serve as a useful primer detailing how intellectual property (IP) is taxed in a variety of situations. I will also illustrate the wide-ranging impact of the new Tax Cuts and Jobs Act on the tax treatment of IP.
IP in the Small Business
A small business’s IP-related costs can be treated in three different ways, depending on the nature of the costs.
Creation of IP – Costs are Capitalized
Any small business creating IP for its own benefit cannot deduct the costs of creating the IP. Instead, any costs incurred in creating a copyright, trademark, or patent will be “capitalized,” meaning they’ll be added up to form the asset’s “income tax basis.” Income tax basis is the reference point for determining (i) how much tax you’ll pay upon a sale or exchange of a given asset or (ii) how much you can deduct for purposes of depreciation or amortization over the useful life of the property. As an example, assume your business spends $50,000 designing a trademark and registering the trademark with the USPTO. This $50,000 expense may not be deducted; instead, the trademark’s income tax basis begins at $50,000. If the trademark is later sold, this $50,000 is subtracted from the purchase price to determine how much gain should be reported from the sale on the business’s income tax return.
Research and Experimentation – Costs are Deducted
While costs incurred to create or improve a specific asset must be capitalized, general “research and experimental” costs may be deducted instead. These costs are described in IRS regulations as “research and development costs in the experimental or laboratory sense,” meaning the costs are designed to “eliminate uncertainty concerning the development or improvement of a product.” For instance, costs incurred in testing a new or improved kind of bulletproof vest would be deductible; however, once the business knows the vest would work, any costs incurred in developing the vest for sale to customers would be capitalized into the income tax basis of the IP associated with the vest. The recently passed Tax Cuts and Jobs Act requires that all research and experimental costs be amortized over five years starting in 2022, meaning they will no longer be deductible.
Startup Expenses and IP Deployed for Business Use – Costs are Amortized
When you plan on entering a trade or business but haven’t yet done so, any expenses incurred in getting the business off the ground are not yet deductible. Instead, these “startup expenses” are eligible for an election to amortize over 15 years once the business officially starts. This results in an amortization deduction, which is an ordinary deduction usable to offset earned income.
Recall the concept of income tax basis discussed above – once this basis has been established for patents or copyrights, you can take an amortization deduction based on a 15-year useful life. When you take the amortization deduction each year, income tax basis for the corresponding asset is reduced accordingly. For instance, if your business owns a patent with a $150,000 income tax basis and takes a $15,000 amortization deduction, the patent’s income tax basis gets reduced by $15,000 to $135,000, and so on each year until the patent’s income tax basis reaches zero.
Only assets with a limited useful life may be amortized. The most common examples in IP are copyrights and patents. Since trademarks are typically renewable indefinitely, they are not amortizable because they do not have a limited useful life. The same goes for trade secrets, which are always kept confidential and usable indefinitely; and self-created goodwill, which has an indeterminate useful life.
IP in the M&A World
Sale of IP
Intellectual property used in a business used to be a “Section 1231 asset,” which allows for long-term capital gain treatment if the asset is held for more than a year and ordinary loss treatment. After the Tax Cuts and Jobs Act, IP is now generally treated as an ordinary asset, even if it’s used in a business. The only exception is an outright sale of a patent (or an undivided interest in all substantial rights to a patent), which still enjoys a special rule conferring long-term capital gain treatment if the patent was held for more than one year.
When IP used in a business previously enjoyed long-term capital gain treatment, taxpayers would differentiate between “recapture” of previous amortization deductions and pure appreciation in value; the former would be long-term capital gain, and the latter would be ordinary income. Recall the example from the previous section: when a patent with an original income tax basis of $150,000 gets amortized by $15,000, its adjusted income tax basis is now $135,000. Upon a sale for a $200,000 purchase price, the total gain is $65,000, but $15,000 was ordinary income because it represented recapture of previous amortization. The remaining $50,000 was long-term capital gain. With the new Tax Cuts and Jobs Act, this analysis is far less impactful because all income from the sale of IP is now ordinary.
License of IP
Prior to the passage of the Tax Cuts and Jobs Act, differentiating between types of licenses would also be critical to tax treatment. Usually, income from a license agreement involving IP would be treated as ordinary, not capital. But when an exclusive license included “all substantial rights” in the subject IP and looked more like a sale, taxpayers could claim sale treatment (and, therefore, long-term capital gain treatment). With the changes implemented under the new law, this sale vs. license analysis is no longer as sensitive.
Acquisition of IP
When a third-party buyer acquires IP, the buyer takes an income tax basis in the asset equal to its cost. As long as the asset has a useful life, the buyer may amortize the asset over a 15-year useful life. This includes acquired goodwill, as opposed to self-created goodwill, which is not amortizable. Before the Tax Cuts and Jobs Act, anti-abuse rules disallowed “churning” of amortization, in which a taxpayer would sell IP to a related party (at capital gain) and restart the amortization schedule of the IP anew (which would result in big ordinary deductions). Now that gain on IP will be almost exclusively ordinary, these anti-abuse rules will be far less of a concern for the IRS – the math on trying to “churn” depreciation simply won’t work out for the taxpayer.
Since the amortization of IP and goodwill could result in big deductions for an acquirer, buyers typically prefer to treat business acquisitions as asset sales, which “step up” the income tax basis of the acquired business’s IP. But the paperwork and costs involved in an asset sale will typically be much more painful than they would be in a stock sale, so sellers often prefer the latter. The IRS allows a “Section 336(e)” or “Section 338(h)(10)” election to help buyers and sellers in this situation. Under either election, the transaction can take the legal format of a stock sale but the tax format of an asset sale, allowing the buyer its coveted “step up” in the income tax basis of the IP and other assets. When the buyer and seller jointly agree to this election, the new income tax basis of each asset is determined by a formula set forth in the IRS regulations.
IP in a Lawsuit
Treatment of Recovered Funds or Settlement Proceeds
When you sue someone else for an IP-related cause of action and receive damages in victory or get paid via settlement, tax treatment depends on the exact nature of the lawsuit. Before the Tax Cuts and Jobs Act, this was a highly sensitive issue, but the new treatment of the sale or exclusive license of IP effectively eliminated taxpayers’ ability to get long-term capital gain treatment for these proceeds. If the cause of action was for the infringement of business IP, the proceeds could have been treated as long-term capital gain if the lawsuit were structured properly. Now, these proceeds are lumped in with those arising from lawsuits for lost profits, breached license agreements, and all other IP-related causes of action, which were always treated as ordinary income.
Treatment of Attorney’s Fees
What has not changed with the Tax Cuts and Jobs Act, however, is the tax treatment of attorney’s fees. If the cause of action was for infringement of business IP, legal fees are generally capitalized into income tax basis as costs to perfect title to the IP. If the cause of action was for lost profits or a breached license agreement, legal fees are deductible as general business expenses.
Matthew E. Rappaport, Esq., LL.M. is a sole practitioner concentrating his practice in taxation as it relates to closely held businesses, real estate, private equity, and trusts and estates matters. He is reachable at (212) 453-9889 or at firstname.lastname@example.org.