The Perturbing New Treatment of Patents Under the Tax Cut & Jobs Act (TCJA)
A US Taxpayer called me all concerned that the proceeds from selling her patents and other projects would now be considered ordinary income for tax purposes. YIKES!
This is true, PATENTS are, because of the TCJA, now specifically excluded from the tax code 'definition' of capital asset. The TCJA further amended IRC 1221 to also exclude inventions, models or designs (whether or not patented), and secret formulas or processes which are held either by the inventor/creator.
Patents were specifically denied capital gain status in clause (a)(3) of section 1221, but only if they were held by their creators or by third parties that had become owners of those assets in a tax-free manner.
In 2018 my client assigned her patents to an existing LLC in which she was a member, the assignment was tax-free but the patents are not a capital asset in the hands of that LLC. By contrast, when the LLC sold the patents, the transaction was taxable and the patents became a capital asset in the hands of the new owner.
So why is this such a big deal?
It speaks to the arrogance of money politics. It speaks to the fact that reporting our income to the US government did not get more simple under the TCJA. It wreaks of deep pocketed & connected lobbyists working last minute to circumvent legislative intent.
The legislative intent of our 'elected' republican controlled 115th Congress - was that the general definition of a capital asset is to be narrowly applied and the categories of exclusions are to be broadly interpreted similar to the decision in Corn Products Refining Co. v. Commissioner, 350 U.S. 46, 52 (1955).
The principle behind §1221(a)(3) was supposed to be that someone whose occupation is the creation of intellectual property should pay ordinary income on its sale much the way a doctor or a lawyer or an Enrolled Agent like me pays ordinary income on fees charged for the creation of their work.
Great! That makes sense.
However in a piece of wordsmith brilliance only a tax nerd could love, Internal Revenue Code § 1235 (which was surprisingly NOT ultimately repealed by the TCJA) says that under certain circumstances a patent can be “considered” to be a capital asset even though it is not:
"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 capital asset held for more than 1 year"
1235 asserts that patents are to be treated as capital assets when transferred.
1221 specifically removes 'Patents' from the definition of Capital Asset
While Congress has revised the internal revenue code (1221) so that inventors may not claim that their patents “are” capital assets, it left intact a provision (1235) that allows patents to be “considered” capital assets upon disposition, preserving the benefits of capital asset treatment.
So lets see if I got this right...
Patents are NOT treated as capital assets when held by their creators as per IRC 1221 but they are treated as long term capital assets when disposed of as per IRC 1235.
IRC 1221 conflicts with IRC 1235. Queue graphic 'Lil Kim lyric of your choice here. Why again is this so important?
In last minute conference committee negotiations leading up to the TCJA the repeal of IRC 1235 was reversed allowing the statute to remain in force. As a concerned taxpayer this is frustrating. Many US patent holders are confused if their patents are capital assets or not.
As a tax practitioner and member of the National Association of Enrolled Agents Government Relations Committee I found the last minute lobbying activity around 1235 to be a brilliant show of brinkmanship, simultaneously fascinating and disgusting. Clearly someone got in the head of Senate Republicans on the tax conference committee. A 'deal' was struck, a quid-pro-quo no doubt.
This was the final proof I needed to be convinced that we no longer live in a republic democracy. We live in an oligarchy where money buys power via timely influence.
Political wonks aside, how does the preservation of IRC 1235 help my client?
- She historically licensed her patents and collected royalties that were treated as ordinary income.
- When she sold her patents releasing her from substantially all right to the patents, §1235 permits her to treat the royalty income stream going forward as long term capital gain.
What are the constraints of §1235 on my client:
- Patents as 'deemed' capital assets are subject to the additional 3.8% Net Investment Income Tax reported on IRS Form 8960 when sold.
- She had to dispose of “all substantial right” in her patents in order to receive the capital gain treatment.
- If she assigns the patent to a corporation, the benefit of §1235 is lost.
- So she needed to pay particularly close attention to business formation and how she comported herself.
If you've made it this far - thank you fellow tax nerd! Two juicy tidbits:
- Capital gain treatment under Code Sec. 1235 is presumably not available for inventions, models or designs, secret formulas or processes that are not patented.
- Any self-created intangible that is excluded from the definition of a capital asset under Code Sec. 1221(a)(3) is also NOT treated as a business use asset subject to capital gain-ordinary loss rules under Code Sec. 1231.
For more on this please feel welcome to contact me.