Category: Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Background Taxpayer created a patentable invention. Prior to filing the patent application and before the any working model of the invention had been created, investor's put up money to fund the taxpayer's work in exchange for a percentage of any profits realized on sale of the invention. Two of the three investors are unrelated to the taxpayer. One of the investors is the taxpayer's brother. The taxpayer's efforts were successful in producing a workable product, and after a suitable patent search, a patent application was filed. The taxpayer then sold the patent application. All existing rights with respect to the patent were sold. The taxpayer and investors retained nothing. Issues 1. Does the inventor get capital gains treatment for sale of the patent? 2. What about the unrelated investor? 3. What about the brother? 4. Is the capital gain eligible for the 20% rate? Answers All the parties are eligible for capital gains. Literal reading of the statute indicates gain from the sale of a patent would only be subject to the maximum 28% rate, but an as-yet-to-be-enacted technical correction would allow the 20% rate. Discussion Section 1235 grants capital gain treatment to the holder of a patent who sells all substantial rights to the patent. Section 1235(a) provides that such a holder is treated as having sold a capital asset held for more than one year. It is assumed that all existing rights in the patent were sold. The questions seem to be as follows. 1) Is a patent applicationrather than an actual patenteligible for Section 1235 treatment? 2) Are all the parties considered holders? 3) Does the language of the statutesale of a capital asset held for more than one yearsubject the gain on sale of the patent to the 28% rate rather than the 20% rate applicable to assets held for more than 18 months? Section 1235 clearly covers the right to obtain a patent. Reg. Section 1.1235-2(a) provides that it is not necessary that the patent or the even the patent application be in existence if the requirements of Section 1235 are otherwise met. Also, the 1954 committee reports surrounding enactment of Section 1235 provide that Section 1235 covers the inchoate right to obtain a patent. Senate Report No. 1622, 83d Congress 2d Session 439 (1954) Section 1235(b) deals with the holder issue. A holder is a person whose efforts created the patent. Clearly this covers the inventor. Also, a holder is anyone who acquires his interest in the patent from the creator in exchange for consideration in money or money's worth prior to the patent's actual reduction to practice. The phrase "actual reduction to practice" is a term of art of U.S. patent law which means, as I understand it, the earlier of A) filing a patent application; or B) production of a working model of the invention. In this case, the investors acquired their interests very early, long before there was a working model or a patent application. Section 1235(b)(2)(B) prohibits certain parties related to the creator from being holders. Section 1235 defines related parties in terms of Section 267(b). Ordinarily, that would include the inventor's brother in this case and prevent the brother from being a holder. However, Section 1235(d)(2) provides that the family attribution rules under Section 267(b) should be read as only including the creator's spouse, ancestors, and lineal descendants. Thus, the brother would not be a related party and can be holder under Section 1235. Based on the foregoing, it seems that the taxpayer and all the investors should be treated as holders and thus eligible for capital gains treatment. Now the issue is what is the proper rate for taxing the capital gains? The purpose of Section 1235 was to provide long-term capital gain treatment for the disposition of patents by certain favored individuals. Over the years, the holding period for long-term capital gain has been six-months, nine-months, and one year. The language of Section 1235 has been modified over the years to conform to whatever the long-term holding period was at the time. Yet in 1997, when the 20% capital gain rate was enacted and the holding period was increased to 18 months, there was no change to Section 1235. Even though it could be argued that this was simply a Congressional oversight, the statute still says what it says. Absent a law change, the taxpayers would not be eligible for the 20% capital gains rate. There is a pending technical corrections bill that would fix this problem. Notice 97- 59, IRB 1997-45, acknowledges the bill and effectively says that until further notice, the IRS will behave as if the proper rate with respect to 1235 transaction is 20%. Obviously, hoever, if the technical corrections bill does not ultimately pass, the taxpayers in this case will not be able to utilize the 20% maximum capital gains rate for this transaction. |
