Intellectual Property

<div class="Section1"><br /> <br /> A design patent covers a new, original, and ornamental design of an article for a period of 15 years.<a href="#_ftn1" name="_ftnref1">¹</a> Historically, design patents were thought to be of relatively minor, marginal importance. However, in recent years the value of design patents has grown exponentially. First, in 2008, a Federal Circuit decision, <em>Egyptian Goddess v. Swisa</em>,<a href="#_ftn2" name="_ftnref2">²</a> made it easier for a design patent owner to establish infringement by one whose product used the same or a similar design.<br /> <br /> Second, and resulting from the holding of <em>Egyptian Goddess</em>, companies started obtaining more and more design patents and enforcing them. For example, in the Apple-Samsung litigation, Apple relied heavily on design patents which covered not only the static design of its devices, but also the on-screen graphic user interfaces.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.Previously 14 years. Extended to 15 years, effective December 18, 2012, PL11211, 112th Cong., 2nd Sess., 2012, &sect; 102(7).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.543 F.3d 665 (Fed. Cir. 2008).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Under the preemption section of the copyright law,<a href="#_ftn1" name="_ftnref1">¹</a> if the copyright law provides a given right, there cannot be concurrent identical trade secret protection. However, if a choice does exist and the work lends itself to being kept secret, one might pursue the trade secret route. On the other hand, if the product is one which, when entering the marketplace, is easily observed and hence cannot be kept secret, then at least as between trade secrets and copyrights, copyrights may provide the only viable means of protection.<br /> <br /> A primary distinction between patents and trade secrets on the one hand and copyrights on the other hand, is that both patents and trade secrets protect a basic idea, whereas the copyright law protects only an expression of an idea but not the idea itself. For example, if blueprints of a machine were copyrighted, this would not prevent one from copying the machine itself, if in making the copy of the machine reference was not made to the copyrighted blueprints. A copyright on a basic video game having, for example, a pattern of moving objects would probably not prevent others from making and selling a video game having an altogether different pattern with similar movements of the objects. It would probably be concluded that the latter merely copied the basic idea of the game, and not the author&rsquo;s copyrighted expression thereof.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.17 USC &sect; 301.<br /> <br /> </div></div><br />

<div class="Section1">Under the central &ldquo;gross income&rdquo; statute, IRC Section 61, gross income received from the licensing of intellectual property, versus the sale of intellectual property, is treated as a royalty and characterized as ordinary income. The licensee may be entitled to a deduction for the royalty payments, and the licensor entitled to all the tax attributes that come with ownership of the asset.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Due to the difference in tax rates, the IRS may challenge those situations where a licensing arrangement is disguised as an outright sale of the intellectual property.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.<em>Watson v. Commissioner</em>, 222 F.2d 689 (10th Cir. 1955).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The creator of software generally has three options for recovering expenses incurred in creating software. First, the taxpayer may deduct the costs in full under IRC Section 174(a). Pursuant to this option, the expenses must be research or experimental expenditures that were paid or incurred by the taxpayer in connection with his or her trade or business. This option may be elected without consent for the first year in which the expenses are incurred, or with the consent of the Secretary of Treasury at any other time.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Second, the taxpayer may choose to depreciate the costs over a three-year period under IRC Section 167. Generally, if a depreciation deduction is allowable for computer software, the straight-line method of depreciation is used, and a useful life of 36 months is applied.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Finally, if the expenses are not deducted under Section 174(a), the taxpayer may elect to amortize the costs over 60-month period under IRC Section 174(b), beginning with the month in which the taxpayer first realizes benefits from the expenses. As with the deduction permitted under Section 174(a), such costs must be incurred in connection with the trade or business. Further, to elect amortization under Section 174(b), the research or experimental expenses must be chargeable to a capital account, but not subject to depreciation or depletion.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> Of course, whichever option is chosen can have an impact on the character of the gain or loss (as ordinary income or loss, or capital gain or loss) upon a subsequent sale or exchange of the software.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.IRC &sect; 174(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.IRC &sect; 167(f)(1)(A).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.IRC &sect; 174(b).<br /> <br /> </div></div><br />

<p class="PA">An IP holding company is generally a company that holds only rights to intellectual property and then licenses the rights to related parties, as well as to third parties. Many large and small taxpayers use IP holding companies in order to consolidate management of their portfolios of intellectual property, including patents and trademarks.<p class="PA">Further, if the IP holding company is located in a jurisdiction with lower income tax rates than that of the related party-licensees, the company may save significant taxes on a company-wide basis as the IP holding company will report the royalties at a lower tax rate. The licensee will reduce its income tax liability because of the deduction that arises from the payment of the royalty. The IP holding company, therefore, can generate savings with respect to state, federal, and global income taxes.</p></p><br />

<p>In many instances, a company&rsquo;s most valuable asset is its portfolio of intellectual property. Intellectual property assets include patents, trademarks, trade secrets, formulas, domain names, software, etc. Many tax and business issues must be analyzed to determine who should own the intellectual property (holding company, etc.) and where (what country or state). The tax issues involving intellectual property are extremely complex. While many issues impact the taxation of intellectual property, five of the primary tax issues that a tax advisor must be familiar with when dealing with intellectual property are:<br /> <ol><br /> <li>The most tax effective way to utilize the costs incurred in developing or creating the intellectual property. While a current deduction may be most advantageous, in many instances that option is not available. The IRC Sections that may apply include Sections 162, 174, 263, and 263A. Note that certain sections, as well as state laws, may impact the deductibility of certain costs paid to a related party.</li><br /> <li>Existing tax credits for the research and development expenses incurred by the business. The Internal Revenue Code Sections that may apply in this area include Sections 38 and 41, as well as state-level credits.</li><br /> <li>How to treat the costs incurred when acquiring or selling intellectual property. The primary Internal Revenue Code Sections to consider in making this determination include Sections 167, 197, 263, 267, 1001, 1231, 1235, 1239, as well as other common sections applicable to the sale or exchange of an asset.</li><br /> <li>The character of income received from a licensing arrangement.</li><br /> <li>The character of income received from the outright sale of intellectual property.</li><br /> </ol></p><br />

<p>The essential advantage of both patents and trade secrets is that they protect the underlying idea.<br /> <br /> A trade secret has an advantage over a patent because, so long as secrecy is maintained, the trade secret has an indefinite life (the Coca-Cola formula is more than 100 years old), whereas a patent has a limited life during which the patentable invention is public knowledge, thereby providing potential copiers an opportunity to consider ways to take evasive action to bypass the protection afforded by the patent.<br /> <br /> Of course, a major defect of a trade secret is that the protection does not exist if the secret becomes known publicly (through no violation of contractual or fiduciary rights), or if others independently arrive at that information. By contrast, a patent protects the invention even though it necessarily becomes known publicly and even if others independently arrive at that invention.<br /> <br /> A decision will generally be made on a case-by-case basis as to whether a given invention or body of information should be maintained as a trade secret or made the subject of a patent. For example, if secret information is quite valuable but not sufficiently new to be entitled to patent protection, it will be maintained as a trade secret. On the other hand, many inventions, by their very nature, cannot be commercialized in any way without publicly revealing the nature of the invention. In these situations, a patent would provide the only possible means of protection.</p><br />

<p class="PA">With regard to becoming &ldquo;property,&rdquo; there is only one important stage in the development of a copyright, namely the point in time when the work is fixed in a tangible form. Prior to that point in time, the idea is not property and is not protectable under the federal copyright law. Upon its creation, the copyright is a Section 197 intangible, but not an amortizable Section 197 intangible.<p class="PA">If a copyright is sold with a business, it is an amortizable Section 197 intangible and its purchase costs are amortized over 15 years. If it is sold separately from a business, it is not considered a Section 197 intangible, and its purchase costs are depreciable under prior law, primarily under IRC Section 167.</p><p class="PA">The moment that a work is fixed in a tangible form, it is a property right protectable under the federal copyright laws for a limited period of time and hence it is a depreciable, intangible capital asset. Of course the limited life is very long, either the life of the author plus 70 years or in the case of a work for hire, 95 or 120 years. However, the fact that a copyright sold separately from a business is a depreciable property is significant in determining its tax treatment. For example, the mere fact that a copyright is classified as a depreciable asset will qualify it under special provisions that permit depreciating its costs over a period of time shorter than its actual legal lifetime.</p><p class="PA">In the copyright law, when dealing with a copyright sold separately from a business, it is often important to distinguish between the intangible copyright and the tangible medium on which that copyright is expressed. This is also important from a tax point of view because the tangible medium may be important enough to have a life of its own.</p><p class="PA">For example, if the expression is in the form of a painting, it may truly have an indeterminate life that cannot be characterized as a depreciable asset.</p></p><br />

<p>Generally the acquisition of an intangible asset which is held in connection with the conduct of a trade or business must be amortized under IRC Section 197. Section 197 does not apply to self-created intangibles. While most consider &ldquo;goodwill&rdquo; as the primary intangible asset subject to Section 197, other intangible assets subject to Section 197 include property that has value but cannot be touched, such as any patent, copyright, formula, process, design, pattern, know how, format, franchise, trademark, or trade name.<br /> <br /> Section 197 entitles taxpayers to an amortization deduction with respect to these intangibles. The amount of the deduction is determined by amortizing the adjusted basis (for purposes of determining gain) of such intangible ratably over the 15-year period beginning with the month in which such intangible was acquired.<br /> <br /> Computer software is a Section 197 intangible asset if acquired in connection with the conduct of a trade or business. However, computer software is excluded from Section 197 (and therefore may be depreciated), even if acquired in connection with the acquisition of a business, if it:<br /> <ul><br /> <li>Is readily available for purchase by the general public;</li><br /> <li>Is subject to a nonexclusive license; and</li><br /> <li>Has not been substantially modified.</li><br /> </ul><p><br /> Computer software not subject to Section 197 may qualify for the Section 179 deduction and special depreciation allowances.<br /> <br /> Other costs associated with purchasing intellectual property may not be currently deductible and instead are subject to capitalization rules under Section 263.</p></p><br />

<div class="Section1"><br /> <br /> If the payment is made pursuant to a sale of intellectual property, the seller should be entitled to capital gains treatment. The principal inquiry is whether the &ldquo;sale&rdquo; can be classified as a sale of the asset or a license. As for patents, Section 1235 provides that a transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a long-term capital asset regardless of whether the payments are: (i) payable periodically over a period generally coterminous with the transferee&rsquo;s use of the patent, or (ii) contingent on the productivity, use, or disposition of the property transferred. Section 1235 excludes employers and relatives of the creator from the definition of holders and instead gives capital gain treatment to &ldquo;any individual whose efforts created&rdquo; the patent or certain individuals who acquired an interest in the patent for consideration during the early stages.<br /> <br /> The 2017 tax reform legislation provides that gain or loss from the disposition of a self-created patent, invention, model or design, or secret formula or process will be taxed as ordinary income or loss. The election to treat musical compositions and copyrights in music as capital assets was not changed.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.IRC &sect; 1221(a)(3).<br /> <br /> </div></div><br />