Intellectual Property Monetization And Tax Efficiency

• Published date: 08 January 2025
• Law Firm: Gray Reed & McGraw LLP
• Author: Mr Brian A. Clark, CPA and Joshua D. Smeltzer

1. Overview: The Treasury's Take

Developing intellectual property requires both skilled labor and large amounts of capital. Recouping the developer's initial investment and earning profits typically requires monetizing the assets by either sale of license. In addition to general business concerns like asset and market share protection, developers should plan for the tax¹ consequences of their monetization transactions because, at its core, tax planning is cash planning. Legitimate federal income tax planning under the Code usually² involves two levers. The first lever is structuring a transaction to achieve a specific character of gain or loss. Second, thoughtful planners might utilize techniques to accelerate or defer a taxpayer's recognition of gain or loss.³ Courts have long recognized the application of careful rulesbased tax planning:

The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted... But the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.⁴

Intellectual property taxation is a complex and constantly evolving area of the law. Understanding the current rules is key to staying within the judicial boundaries of reasonable (and not aggressive or frivolous) tax planning. Like most areas of tax, the sale of intellectual property is usually required to (x) be taxed at capital gains rates and (y) use an asset's tax basis to reduce gain on the sale. In contrast, royalties are taxed at ordinary rates with no basis offset. To provide a materiality context for the capital gains versus ordinary income distinction as to non-corporate taxpayers, capital gains are taxed at a maximum 20% rate while ordinary income is taxed at a maximum 37% rate. That 17% rate differential is sufficient to drive many intellectual property holders to monetize through sales.⁵

Unfortunately, there are several hurdles to structuring intellectual property sales to be taxed at capital gains rates. First, no matter the type of intellectual property at issue (i.e. patents, copyrights, know-how, etc.), a taxpayer has to transfer enough rights in the asset to no longer be considered the tax owner. This alone may make a sale a non-starter if business exigencies require the owner to prioritize preservation and retention of trade or patent secrets. Second, in some cases, the Code expressly limits the types of intellectual property that can be sold at capital gains rates. For example, certain "self-created" inventions were excluded from the Code's primary capital asset (or recharacterization) definitions following the Tax Cuts and Jobs Act (TCJA) and therefore need a different statutory basis to receive preferential capital gains rates.⁶ Third, even the special statutory bases for receiving capital gains rates can be quite limited.⁷ Finally, defense and enforcement costs should be considered. Incorrect characterizations can be costly so front-end planning is strongly advised.

Because of the breadth of intellectual property taxation, this article covers only two primary topics. Section 2 discusses monetization and taxes, specifically the general principles distinguishing a sale and a license, as well as select methods by which capital gains are either precluded or potentially achievable. Section 3 discusses a special type of enforcement risk and the taxation of intellectual property recoveries.

2. Sale Structuring and Capital Gains Issues

A. Sale vs. License

A highly simplified example can be used to illustrate the basis offset benefit. Assume that Owner owns a self-created patent not eligible for capital gains taxation with a $1 million tax basis and a $1.25 million value. Owner sells the patent to Buyer. Upon sale, Owner has a $250,000 gain, taxed at a 37% rate,8 resulting in a $92,500 tax bill. In contrast, assume Owner licensed the same patent for annual $250,000 payments for five years. Royalty payments under the license agreement are taxed at ordinary rates with no basis offset, so the gross tax bill, without considering any time value benefits of receiving payments over five years, accounting convention issues, or deductions is $462,500.⁹

A sale, in contrast to a license, requires the owner of intellectual property to transfer "all substantial rights"10 or all "significant powers, rights, or continuing interest"¹¹ to the property. For example, in the patent context, substantial rights are those that provide the transferee the exclusive right to make or use the patent or sell for the life of the patent. The gating question is whether the transferor retained any rights, which in the aggregate, have substantial value.¹² The transfer of intellectual property is unfortunately an area of tax law with a large body of cases that dictate the contours of the "sale versus license" question, and some of those cases make very fine (perhaps nebulous) distinctions. Despite the heavy jurisprudential overlay, it is worth mentioning that in simple cases no real analysis is required. For instance, assume Owner signs an agreement transferring a patent to Buyer for a single lump sum payment, with Owner retaining no rights, and Buyer can use, license, sell, or operate the patent in any way it wishes post-transaction. In such a case, it is difficult to see how the transaction could be something besides a sale. However, when the transferor limits the transferee's scope of use, or perhaps retains minor rights, the picture is muddied and simply following the Code's sale provision will not suffice. It is in that context that a deeper dive into case law and supplemental guidance is required.

Some examples of when transferor retained rights or transferee restrictions resulted in licenses are useful, though the authors note that planners must always consider the type of intellectual property being monetized, because case law support may vary depending on whether the asset is a patent, knowhow, copyright, etc.:

• A transfer that allows the transferor the unconditional right to terminate the transfer looks more like a license.¹³
• Transfers that provide the transferor the right to prevent the transferee from assigning the asset or controlling the prosecution of infringement suits are more likely licenses for tax purposes.¹⁴ For example, if only the transferor has the right to sue for infringement in the transferor's capacity and name, the retained...