Sale of A Patent: Income Tax Treatment
Written by: Steven J. Fromm, J.D., LL.M. (Taxation)
The transfer of a patent by an individual is treated as long term capital gain if certain conditions explained below are met. Section 1235 of the Internal Revenue Code treats such sales of patents as a sale or exchange of a capital asset held longer than 1 year and as a result eligible for favorable long term capital gain treatment.
This long term capital gain treatment applies to your transfer of a patent if you meet all the following conditions.
- You are the holder of the patent.
- You transfer the patent other than by gift, inheritance, or devise.
- You transfer all substantial rights to the patent or an undivided interest in all such rights.
- You do not transfer the patent to a related person.
The following discusses some of these conditions in more detail:
Holder of the Patent Defined:
You are the holder of a patent if you are either of the following.
- The individual whose effort created the patent property and who qualifies as the original and first inventor.
- The individual who bought an interest in the patent from the inventor before the invention was tested and operated successfully under operating conditions and who is neither related to, nor the employer of, the inventor.
All Substantial Rights in the Patent:
All substantial rights to patent property are all rights that have value when they are transferred.
All substantial rights to a patent are not transferred if any of the following apply to the transfer.
- The rights are limited geographically within a country.
- The rights are limited to a period less than the remaining life of the patent.
- The rights are limited to fields of use within trades or industries and are less than all the rights that exist and have value at the time of the transfer.
- The rights are less than all the claims or inventions covered by the patent that exist and have value at the time of the transfer.
The payment may be made in lump sum, periodically during the transferee's use or are contingent on the productivity, use, or disposition of the patent and still qualify for long term capital gain treatment.
Note that holding a security interest (such as a lien or pledge), or a reservation calling for forfeiture for nonperformance, is not treated as a substantial right for these rules and may be kept by you as the holder of the patent.
This favorable long term capital gain tax treatment does not apply if the transfer is directly or indirectly between you and a related person. These related party rules can be extremely complex so care should be exercised before considering any sale with a related party.
The following is a list of related persons.
- Members of a family, including only your spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
- An individual and a corporation if the individual directly or indirectly owns more than 25% in value of the outstanding stock of the corporation.
- Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
- A trust fiduciary and a corporation if the trust or the grantor of the trust directly or indirectly owns more than 25% in value of the outstanding stock of the corporation.
- A grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
- Fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
- A tax-exempt educational or charitable organization and a person who directly or indirectly controls the organization, or a member of that person's family.
- A corporation and a partnership if the same persons own more than 25% in value of the outstanding stock of the corporation and more than 25% of the capital interest or profits interest in the partnership.
- Two S corporations if the same persons own more than 25% in value of the outstanding stock of each corporation.
- Two corporations, one of which is an S corporation, if the same persons own more than 25% in value of the outstanding stock of each corporation.
- An executor and a beneficiary of an estate unless the sale or exchange is in satisfaction of a pecuniary bequest.
- Two partnerships if the same persons directly or indirectly own more than 25% of the capital interests or profits interests in both partnerships.
- A person and a partnership if the person directly or indirectly owns more than 25% of the capital interest or profits interest in the partnership.
The important point here is that if a gain is recognized on the sale or exchange of the patent to a related person, the gain may be ordinary income even if the property is a capital asset.
Income Tax Planning Point:
In 2012, long term capital gains are taxed at a very modest 15% rate. In 2013, this tax rate is scheduled to increase. However, no one knows whether the tax laws will be amended to provide for this continuing tax break. For taxpayers contemplating the sale of patents, 2012 may be the ideal year to sell such property.
Summary and Caveat:
The above only provided an overview of the taxation of patents. In any event, prudence would dictate discussing and planning any such sale with tax counsel.
Copyright © 2012 - Steven J. Fromm & Associates, P.C., 1420 Walnut Street, Suite 300, Philadelphia, PA 19102. All rights reserved.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.