Taxation of Patent Transfers

For federal tax purposes, a transfer of a patent may result in either capital gain or ordinary income to the transferor. A transfer that meets the requirements of Internal Revenue Code Sections 1221, 1231 or 1235 will result in capital gain to the transferor. A transfer that does not meet the requirements of Internal Revenue Code Sections 1221, 1231 or 1235 will result in ordinary income to the transferor.

1. Transfers Qualifying Pursuant to Internal Revenue Code Section 1235. Internal Revenue Code Section 1235 states that a "transfer" consisting of "all substantial rights" to a patent by any "holder" shall be considered the sale or exchange of a capital asset held for more than 1 year.

A "transfer" only occurs if the transferee acquires all of the substantial rights to a patent. The determination of whether a transfer occurs is dependant on all facts and circumstances and the agreement between the parties is not necessarily controlling.

"All substantial rights" means all of the rights that are of value at the time of transfer. These rights include the exclusive right to make, use and sell the patent. There is not a transfer of all substantial rights where the rights are limited: (i) geographically; (ii) in duration; (iii) to fields of use; or (iv) to less than all the claims or inventions covered by the patent which exist and have value at the time of the transfer. If the transferor fails to transfer all substantial rights, the transfer will likely be characterized as a license for the purposes of Section 1235 and not entitled to capital gain treatment.

A "holder" is an individual whose efforts created the patent or who acquired his or her interest in the patent in exchange for consideration in money or money's worth paid to the creator before the time when the invention to which the patent rights relate is actually reduced to practice. A partnership, corporation, trust or estate cannot qualify as a holder. Nevertheless, an individual partner may qualify as a holder as to his or her share of a patent owned by a partnership.

2. Transfers Qualifying Pursuant to Internal Revenue Code Sections 1221 and 1231. A transfer of a patent that does not qualify pursuant to Internal Revenue Code Section 1235 may still qualify for long-term capital gains treatment under either Internal Revenue Code Section 1221 or Section 1231.

Long-term capital gains treatment under Internal Revenue Code Section 1221 is available to a transferor who is a non-professional inventor who has held the patent for at least one year prior to transfer. A professional inventor cannot obtain capital gains treatment under Internal Revenue Code Section 1221 since any patent held by the professional inventor would likely be deemed to be an item of inventory.

Long-term capital gains treatment under Internal Revenue Code Section 1231 is available to a transferor of an amortizable patent used in the transferor's trade or business for at least one year prior to transfer.

As with Internal Revenue Code Section 1235, the transferor must transfer all substantial rights pertaining to the patent to qualify for capital gains treatment under either Internal Revenue Code Section 1221 or Section 1231. Nevertheless, unlike Internal Revenue Code Section 1235, the substantial rights pertaining to the patent may be limited to certain fields of use or geographical designations under Internal Revenue Code Section 1221 and Section 1231.

3. Transfers Not Qualifying Pursuant to Internal Revenue Code Sections 1221, 1231 or Section 1235. A transfer that does not qualify pursuant to Internal Revenue Code Sections 1221, 1231 or 1235 will result in ordinary income to the transferor of the patent. These transfers include express licenses of patents and transfers where the transferor fails to transfer all substantial rights pertaining to the patent.

Action Points: The availability of long-term capital gains treatment in connection with a transfer of a patent is dependant upon meeting the requirements of Internal Revenue Code Section 1221, 1231 or 1235. A person who wishes to obtain long-term capital gains treatment in connection with a transfer of a patent should ensure the following:

a. The person is an eligible transferor under Internal Revenue Code Section 1221, 1231 or 1235.

b. The person transfers all substantial rights to the patent. If the person wishes to limit the substantial rights by fields of use or geographically, the person will only be able to use Internal Revenue Code Section 1221 or Section 1231.

c. If the person intends for the transfer to qualify for long-term capital gains under Internal Revenue Code Section 1235, the person satisfies all of the associated definitional requirements.

d. The person must have held the patent for more than one year to qualify for long-term capital gains treatment under Internal Revenue Code Section 1221 or Section 1231. Note that Internal Revenue Section 1235 does not have a minimum holding period since all transfers pursuant to that Section are deemed to result in long-term capital gains.

Copyright © 2003, Fairfield and Woods, P.C.,
ALL RIGHTS RESERVED.

Comments or inquiries may be directed to:
John A. Leonard.