The new Tax Cuts and Jobs Act (“Act”) significantly curtails the ability of inventors to obtain favorable capital gain tax treatment upon sale of their patents. The new law tightens the requirements for a patent holder to obtain capital gain treatment, and eliminates capital gain treatment altogether for sellers of self-created inventions, models, designs, secret formulas and processes that are not patented.
BEFORE TAX REFORM
Patents have long received more favorable tax treatment than some other forms of intellectual property. Section 1221(a)(3) of the Internal Revenue Code (“IRC”) denies capital asset status for a copyright, or a literary, musical, or artistic composition, in the hands of the creator or a person who acquired the property from the creator in a tax-free transaction. This rule effectively requires individuals engaged in the occupation of creating intellectual property to pay tax at ordinary income rates when they sell the property, similar to how individuals engaged in other occupations are taxed on their labor income. Patents, however, were not included in the list before the Act, so an individual who sold a patent held for more than one year would be taxed at the lower rates applicable to long-term capital gains.
CAPITAL GAIN TREATMENT
The Act amended Section 1221(a)(3) of the IRC by adding “a patent, invention, model or design (whether or not patented), [and] a secret formula or process” to the list of property that is denied capital asset status in the hands of the creator or a person who acquired the property from the creator in a tax-free transaction. The new law generally places individuals who create patents, inventions or the other forms of intellectual property newly added to the list on the same footing as individuals who create the forms of intellectual property that were already on the list.
Despite the extension of IRC Section 1221(a)(3) to patents, certain patent holders still have an opportunity to obtain capital gain treatment. IRC Section 1235 provides that under certain circumstances, patents are considered to be capital assets held for more than one year. Patents were capital assets under prior law because they were not denied capital asset status prior to the amendment of IRC Section 1221(a)(3). However, IRC Section 1235 did not simply confirm that patents were capital assets. Instead, for qualifying transfers of patents, IRC Section 1235 caused income that otherwise would be ordinary income or short-term capital gain to become long-term capital gain. For example, IRC Section 1235 causes royalties from qualifying transfers, which otherwise would be ordinary income, to become long-term capital gain. Also, IRC Section 1235 treated a patent held for one year or less as having been held for more than one year, causing income that otherwise would be short-term capital gain, taxable at ordinary income rates to become long-term capital gain taxable at lower rates.
Although the House version of the Act would have repealed IRC Section 1235, IRC Section 1235 was retained in the final conference version that was signed into law. Therefore, a patent transferred in a transaction that qualifies under IRC Section 1235 still should be considered to be a capital asset held for more than one year, even though the patent is not actually a capital asset due to amended IRC Section 1221(a)(3).
The transfer of a patent must satisfy several requirements in order to qualify for long-term capital gain treatment under IRC Section 1235. For instance, the holder of patent rights must be either the inventor or an unrelated individual who acquired an interest in the patent from the inventor before the invention covered by the patent was reduced to practice. The holder must transfer “all substantial rights” in the patent, either through a sale or through an exclusive license that lasts for the entire term of the patent. Also, the transfer cannot be to a person related to the holder.
IRC Section 1235 applies only to patents. Therefore, under the new law capital gain treatment will not be available for self-created inventions, models, designs, secret formulas and processes that are not patented. Although inventors who obtain patents still may be able to obtain long-term capital gain treatment under IRC Section 1235, the requirements to qualify are complex. Inventors should consult their tax advisors in order to prepare for the impact of the new law in light of their individual circumstances.