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Taxation of Patent Sales

Aug 11, 2009
Richard J. Crow

Even innovation answers to Uncle Sam

page 1 of 2

This article focuses on the tax consequences of the sale of a patent, as opposed to the sale of a license to use the patent. Subject to a few limited exceptions, in order to constitute a sale of a patent, you must transfer substantially all of your rights in the patent, including the right to make, use, and sell the invention. Your retention of any of these rights likely will result in a license rather than a sale. The distinction is important because payments you receive for the sale of a license are taxed at the higher, ordinary income rate. In contrast, payments you receive for the sale of a patent may result in either ordinary income or capital gain treatment, depending on whether certain requirements of the Internal Revenue Code (the "Code") are satisfied.

Encouraging Innovation: Transfers under Section 1235 of the Code

Because of the relaxed requirements for obtaining long-term capital gain treatment under Section 1235 of the Code ("Section 1235"), qualifying the sale of a patent under Section 1235 often is easier than qualifying under other Code sections because long-term capital gain treatment under Section 1235 is available to you whether you are a professional or non-professional inventor and does not depend on the period of time that you held the patent prior to the transfer.

Section 1235 was enacted by Congress in 1954 to encourage the development of inventions by individual inventors who, prior to 1954, often were subject to ordinary income tax rates upon the sale of their patents. Prior to the enactment of Section 1235, the IRS frequently took the position that the sale of a patent by a professional inventor was the sale of the inventor's inventory and, therefore, was not entitled to capital gain treatment. If the IRS determined you were a professional inventor, your sale was taxed at the ordinary income rate. The IRS would use the following factors to determine if you were a professional inventor: (i) the number of inventions you created, (ii) whether your patents were used in your business or sold to other parties, and (iii) the scope of your devotion to patent development.

In contrast, Section 1235 provides that:

“A transfer (other than by gift, inheritance, or devise)… 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, regardless of whether or not payments in consideration of such transfer are payable periodically over a period generally coterminous with the transferee's use of the patent, or contingent on the productivity, use, or disposition of the property transferred.”

In other words, under Section 1235, your transfer of all substantial rights in or to a patent held by you will be given long-term capital gain treatment regardless of whether the payment you receive from the sale is contingent on the use or productivity of the patent or payable over time in connection with your buyer's use. While these requirements seem straightforward, they have been the subject of extensive court cases and IRS guidance.

Section 1235 applies to all sales of patents by you that are a "transfer," which is determined by all of the facts and circumstances surrounding the sale. Although the words and terms of an agreement generally control in other areas of contract law, the words and terms of your agreement with your buyer does not necessarily control the determination of whether your sale is a transfer under Section 1235. The best illustration of this point is the case of an employee who receives payments for services performed under an employment contract that requires the employee to transfer the rights to any invention developed by the employee to the employer. The employer's payments to the employee generally will not be characterized as received with respect to a "transfer" of a patent because the employee, who was paid to invent, cannot transfer something in which the employee has no right. Payments in this context likely will be considered payments for services, and not in connection with the transfer of a patent.

Additionally, the transfer must be "of all substantial rights to a patent." This phrase means all rights which are of value at the time the rights to the patent are transferred. While a court will consider all of the facts and circumstances surrounding a transfer of a patent to determine whether all substantial rights have been transferred for Section 1235 purposes, there is clear guidance on what does not constitute a transfer of all substantial rights. All substantial rights have not been transferred if: (i) the rights are limited geographically within the country of issuance, (ii) the transfer is limited in duration to a period less than the remaining life of the patent, (iii) the transfer grants rights in certain fields of use which are less than all fields of use covered by the patent, or (iv) the transfer grants less than all the claims or inventions covered by the patent.

Finally, any transfer of all substantial rights to a patent must be made by a "holder" of the patent. A holder is the individual who creates the property or acquires the property before the invention is actually reduced to practice in exchange for consideration paid to the creator. The creator's employer, persons related to the creator, corporations, partnerships, trusts, and estates cannot qualify as a holder (although an individual partner may qualify with respect to that partner's share of a patent owned by the partnership).

Your qualification for long-term capital gain tax treatment under Section 1235 does not require that you be a non-professional inventor or that you hold the patent for any period of time prior to sale, and is not affected by your method of payment (i.e., lump sum payment, periodic payments, or contingent payments based on revenue from the sale of the patented inventions). As a result, and as intended by Congress, Section 1235 makes it much easier for you, as an inventor or other "holder," to obtain the more beneficial long-term capital

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