Intellectual Property

<div class="Section1"><br /> <br /> For years, the IRS asserted that IRC Section 351 nonrecognition treatment with respect to transfers to corporations (and, therefore, Section 721 for transfers to partnerships) did not apply to a transfer of patent (and other intellectual property) rights unless the transaction would rise to the level of a sale or exchange under Section 1001. Thus, the transferor would have to relinquish &ldquo;all substantial rights&rdquo; to the patent in order to qualify. According to the IRS, the retention by the transferor of substantial rights in the patent or other intellectual property would constitute a license of intellectual property rights and, therefore, not an exchange of property.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS did not treat the transfer of a license as a transfer of &ldquo;property&rdquo; under Section 351, because a similar transfer to a third party would not constitute a sale or exchange pursuant to Section 1001 for purposes of realizing gain or loss on the transaction.<br /> <br /> The IRS claimed that because the language in Section 1001 is similar to the language in Sections 351 and 721 (i.e., &ldquo;exchange&rdquo;), the transfer had to satisfy the same test as under Section 1001&mdash;meaning that all substantial rights had to be transferred&mdash;in order to qualify for nonrecognition treatment under those two sections.<br /> <br /> The IRS asserted its &ldquo;all substantial rights&rdquo; argument to the Court of Federal Claims in 1973 and lost.<a href="#_ftn2" name="_ftnref2">²</a> In that case, Du Pont was engaged in the domestic sale and exportation (to France, among other places) of urea herbicides. Du Pont organized a wholly-owned French subsidiary, Du Pont de Nemours (France) S.A., to manufacture the herbicide in France. Du Pont granted to the subsidiary a royalty-free, non-exclusive license to make, use and sell urea herbicides under the French patents. Du Pont gave up its right to assert patent infringement against the subsidiary&rsquo;s products for the duration of the license, which was for the remaining life of the patents. The subsidiary had the right to sublicense manufacturing for its own needs, but any other sublicensing could only be done with the parent&rsquo;s consent. In exchange for this grant, and in lieu of royalties, Du Pont received stock in the subsidiary valued at $411,500.<br /> <br /> The Court of Claims found that Section 351 embodies the same notions as the capital gains provisions and found that the purpose of the capital gains provisions is to allow capital gain treatment when a person divests substantially all of its rights in property to a third person, whereas the purpose of Section 351 is to ensure that a transferor avoids immediate taxation when it rearranges its business assets and affairs by contributing certain assets to corporations.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> After finding the capital gains &ldquo;sale or exchange&rdquo; provision irrelevant, the Court of Federal Claims had no problem accepting the nonexclusive license as &ldquo;property&rdquo; for purposes of Section 351. The Court of Claims found the nonexclusive license constituted &ldquo;property&rdquo; for purposes of Section 351 as &ldquo;one chunk of rights was permanently severed from the main property&mdash;the patent.&rdquo; Thus, the Court of Federal Claims found that the contribution of the license to the corporation should be treated as a nonrecognition event.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.Rev. Rul. 69-156, 1969-1 CB 101.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.<em>Du Pont v. United States</em>, 471 F.2d 1211 (1973).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.<em>H.B. Zachry Co. v. Comm.</em>, 49 TC 73 (1967).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.See <em>Du Pont</em>, above.<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 />

<div class="Section1"><br /> <br /> No. In Revenue Ruling 68-499,<a href="#_ftn1" name="_ftnref1">¹</a> the IRS analyzed a situation where a company paid royalties to five individuals for licenses to manufacture certain articles to which the individuals held the patent. Three of the individuals were employees of the company. The licensing contracts were separate and distinct from the employment contracts governing the employment relationships with these individuals. The royalties were not paid for services performed for the company by any of the five individuals.<br /> <br /> Under Sections 3121(a) and 3306(b) of the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA), the term &ldquo;wages&rdquo; means all compensation for employment, including the cash value of any property paid as compensation to the employee. The term employment generally means any service performed by an employee for his employer.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Based on the definition of wages, the IRS found that the royalties were paid for licenses to manufacture certain articles, rather than as compensation for services rendered in the course of an employment relationship. Thus, the IRS held that the royalty payments were not wages for FICA and FUTA tax purposes (so that the payments were not subject to general employment tax withholding that applies to wages).<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.1968 C.B. 421.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.IRC &sect;&sect; 3121(b), 3306(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.Rev. Rul. 68-499, 1968 CB 421.<br /> <br /> </div></div><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 />

<div class="Section1">Under IRC Section 167, a taxpayer may be entitled to a depreciation deduction of intangible property, such as a patent or copyright, used in a trade or business or held for the production of income over the useful life of the property, if that property has a limited useful life that can be reasonably estimated.<a href="#_ftn1" name="_ftnref1">¹</a> The taxpayer may choose to depreciate over a useful life of 15 years as a safe harbor, but this safe harbor generally only applies to intangibles acquired or created as a part of the acquisition of a trade or business (so that self-created intangibles are generally excluded).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.IRC &sect; 167(g)(6); Treas. Reg. &sect; 1.167(a)-3(a).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Generally, if the transferor is treated as a professional inventor, gain (or loss) from the sale or other disposition of his or her patents does not qualify for capital gain treatment, because the patents will be treated as inventory, rather than as capital assets under IRC Section 1221. Under Section 1221(a)(1), inventory and property held primarily for sale to customers are excluded from the definition of a capital asset. The IRS takes the view that an inventor develops his or her inventions in order to eventually sell these products to customers and, thus, income from their sale should be taxed as ordinary income.<br /> <br /> In order to determine whether the inventor holds his or her patents for sale in the course of a trade or business, all of the facts and circumstances of the individual case must be analyzed.<a href="#_ftn1" name="_ftnref1">¹</a> The inventor must, essentially, determine whether the number of inventions created, and subsequently sold or licensed, would rise to such a level that it was substantial enough to be treated as inventory or assets held for sale to customers.<a href="#_ftn2" name="_ftnref2">²</a> While the activity need not occupy all of the inventor&rsquo;s time, evidence of continuity of sales and sales activity over a period of time is an indicator that the taxpayer is carrying on a trade or business of selling or licensing patents, so that capital gains treatment would be inappropriate.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.See, for example, <em>Higgins v. Comm.</em>, 312 U.S.212 (1941).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.<em>Lockhart v. Comm.</em>, 258 F.2d 343 (3d Cir. 1958).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.<em>Snell v. Comm.</em>, 97 F.2d 891(1938); <em>Dunlap v. Oldham Lumber Co.</em>, 178 F.2d 781 (1950).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> In some cases, the owner of intellectual property may wish to transfer ownership of that property to a corporation or other business entity in order to obtain the benefits that corporate ownership can confer, or to conduct a business through that entity. IRC Section 351 provides that gain or loss on the transfer of property to a corporation will not be recognized if such property is transferred in exchange for stock in the corporation.<br /> <br /> While other limitations apply, the nonrecognition treatment under Section 351 only applies when the transferor (or multiple transferors) owns at least 80 percent of the stock of the transferee company immediately after the transfer, as measured by voting power and by each class of nonvoting stock.<a href="#_ftn1" name="_ftnref1">¹</a> However, if property or cash is exchanged (in addition to the corporate stock), gain will be recognized to the extent of the value of the property or the amount of cash involved in the exchange.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Therefore, assuming this control test is satisfied, the contribution of legal ownership, including all substantial rights to the intellectual property, should qualify for nonrecognition treatment and no gain or loss will be recognized upon contribution to a corporation (or a partnership for similar reasons under Section 721) in exchange for its stock.<br /> <br /> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8170">8170</a> for a discussion of the results if less than all substantial rights to the intellectual property are transferred.<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; 351(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.IRC &sect; 351(b).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The term &ldquo;trademark&rdquo; should be distinguished from the term &ldquo;trade name.&rdquo; A trade name refers to the name of a business, and nothing more. Ownership rights of a trade name are governed strictly by common law or specific state statutes, based on adoption and actual use by the company. Even before such use has been established, the trade name can be registered at the state level. There is no federal registration of a trade name. Of course, some famous trade names are also used as trademarks and, if this occurs, then that name can be federally registered as a trademark.<br /> <br /> The term &ldquo;trademark&rdquo; is used generically and will be used throughout this text to encompass an actual &ldquo;trademark,&rdquo; which is applied to goods as well as a &ldquo;service mark,&rdquo; which is used to identify services. Both are capable of being federally registered.<br /> <br /> The essential purpose of a trademark is to identify all goods or services derived from a common source so that a purchaser, entering the marketplace after seeing an advertisement or returning to the marketplace after having already purchased certain goods or services, will be able to select and purchase the item seen in the advertisement or the same item as previously purchased. Quite often, the purchaser, when making the decision to purchase goods or services under a given trademark or service mark, does not actually know the name of the business. In fact, the purchaser is usually less concerned with the identity of the business than with the fact that the product or service being purchased is the same as seen in the advertisement or previously purchased.<br /> <br /> Trademarks may take many different forms. The more conventional forms include words, phrases, or groups of letters (such as IBM). However, trademark coverage is far more extensive. For example, a federal trademark registration has been granted for the shapes of such items as the Jeep front grill, the Coca-Cola bottle, or even building designs such as the McDonald&rsquo;s golden arches. Or trademarks can cover ornamental color or design such as the design on Nike tennis shoes, the black and gold combination on a Duracell battery, or even Levi&rsquo;s small tag on the left side of the rear pocket of their blue jeans. Trademarks also include catchy phrases such as &ldquo;You deserve a break today.&rdquo; Still further, trademarks can cover a sound, such as the NBC chimes, or a smell, such as the aroma of knitting yarns (but not a smell that is the essence of the product, such as in the case of perfume).<br /> <br /> Protection for famous trademarks is enhanced by the Federal Trademark Dilution Act, enacted in 1996,<a href="#_ftn1" name="_ftnref1">¹</a> which, like numerous state trademark dilution acts (in approximately half of the states), allows the owner of a famous trademark to prevent others from using a similar mark, even in the absence of competition between the parties. This act allows the trademark owner to enjoin parties from using or even registering Internet domain names similar to a famous trademark of another.<a href="#_ftn2" name="_ftnref2">²</a> In <em>Moseley v. V Secret Catalogue, Inc.</em>,<a href="#_ftn3" name="_ftnref3">³</a> the United States Supreme Court held that the Federal Trademark Dilution Act required a showing of actual dilution, not a likelihood of dilution. However, the Court also stated that a showing of actual dilution did not require a showing of the consequences of such dilution such as actual loss of sales or profits. This holding of the Supreme Court was specifically overturned by legislation in 2006, which explicitly stated that the owner of a famous mark need demonstrate only the likelihood of dilution, as opposed to actual dilution, in order to claim relief under the statute.<a href="#_ftn4" name="_ftnref4">⁴</a> The federal dilution statute was intended to allow owners of a federal trademark registration to assert that registration as a defense to a claim brought under a state dilution law. Because of a clerical error in the 2006 legislation, that defense was made possible in response to a dilution claim based not only on state dilution law, but also brought under the federal dilution law. That error was corrected in 2012 to limit that defense to only a dilution claim brought under state law, and not a dilution claim brought under federal dilution law.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> Under the Trademark Cyber Piracy Prevention Act included in 1999 intellectual property legislation, so-called &ldquo;cybersquatters&rdquo; are prohibited from registering the name of another in order to cause mischief or extract payment from the rightful owner of that mark.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> Federal trademark law also provides protection for &ldquo;trade dress,&rdquo; which is the distinctive appearance of an article, a package, or a place of business.<a href="#_ftn7" name="_ftnref7">⁷</a> Although such trade dress protection is provided under the federal trademark law, one does not generally apply for an actual federal trademark registration to cover trade dress. Rather, under the trademark law, protectable rights are based on the distinctive nature of the trade dress plus its use over time in the marketplace. The scope of trade dress protection was expanded by the United States Supreme Court in the case of <em>Two Pesos, Inc. v. Taco Cabana International</em>,<a href="#_ftn8" name="_ftnref8">⁸</a> which held that where trade dress is inherently distinctive and nonfunctional, it is protectable under the federal trademark law even without the establishment of a reputation (known as secondary meaning). Conversely, in <em>Wal-Mart Stores v. Samara Brothers</em>,<a href="#_ftn9" name="_ftnref9">⁹</a> the United States Supreme Court held that a product design trade address cannot be inherently distinctive so it is protectable only upon a showing of secondary meaning.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.15 USC &sect; 1125(c)(1); Pub. L. No. 104-98, 104th Cong., 2d Sess. (Jan. 16, 1996).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.<em>Panavision International v. Toeppen</em>, 945 F. Supp. 1296, 40 USPQ2d 1908 (1996), <em>aff&rsquo;d,</em> 141 F.3d 1316, 46 USPQ2d 1511 (9th Cir. 1998); <em>Intermatic v. Toeppen</em>, 947 F. Supp. 1227, 40 USPQ2d 1412 (N.D. Ill. 1996).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.537 U.S. 418, 123 S. Ct. 1115 (2003), <em>rev&rsquo;g,</em> 259 F.3d 464, 59 USPQ2d 1650 (6th Cir. 2001).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.Pub. L. No. 109-312, 109th Cong., 2nd Sess. (Oct. 6, 2006).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.Pub. L. No. 112-190, 112th Cong., 2d Sess. (Oct. 5, 2012).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.15 USC &sect; 1125(d); Pub. L. No. 106-113, 106th Cong., 2d Sess., S 1948, Title III, &sect;&sect;3001&ndash;3010 (Nov. 29, 1999).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.15 USC &sect; 1125(a).<br /> <br /> <a href="#_ftnref8" name="_ftn8">8</a>.505 U.S. 763, 112 S. Ct. 2753, 120 L. Ed. 2d 615 (1992).<br /> <br /> <a href="#_ftnref9" name="_ftn9">9</a>.529 U.S. 205, 120 S. Ct. 1339, 146 L. Ed. 2d 182 (2000).<br /> <br /> </div></div><br />