Tax Planning for the Development and Licensing of Patents and Know-How, written by Charles Edward Falk, Esq., of Moore Stephens, P.C., discusses the tax implications of developing and licensing patents and know-how. It is intended to provide tax guidance to the developer and the adviser. While patents and know-how represent an elusive type of property, the tax consequences of licensing can have profound economic effects on both developers and licensees. 

Tax planning for the development and licensing of patents and know-how must start before the taxpayer begins developing the product. A taxpayer may choose from several methods of treating research and development (R & D) expenditures and must make the election the first tax year he/she pays or incurs the expenditures. After the patent or know-how is developed, the licensor/taxpayer, by choosing the type of rights he/she conveys to the licensee, determines if the payments to be received will be taxable as capital gain or ordinary income. 

Tax Planning for the Development and Licensing of Patents and Know-How reviews the law concerning research and development expenditures and analyzes in detail the rules of §1235 whereby certain transfers of patents will be accorded long-term capital gains treatment without regard to the holding period.  

This Portfolio also examines the interrelationship of §1235 with other provisions which confer capital gain treatment.  The sale of a patent can give rise to long-term capital gain either under §1235, a special provision for patent “holders,” or under general sale or exchange principles. How a patent is sold and what rights are transferred and retained determines the character of the income received. While no special provision exists for know-how, capital gain also can result from its sale. Defining know-how is often uncertain, and a transfer of know-how must include certain rights to constitute a sale. 

In addition, this Portfolio 

• discusses §197, which provides greater certainty as to the amortization of intangibles. 
• presents an overview of treatment of R & D expenditures. Among the subjects discussed are the §174 deduction for R & D expenses and the §41 research and development credit. 
• covers the tax treatment of patents, including both exclusive and non-exclusive licenses and the important tax differences between them. This section presents an extensive discussion of the differences between sales qualifying under §1235 and generic sale principles. Also discussed in this section are professional inventors and the legislative history of §1235. 
• focuses on “know-how,” including the definition of the term, the bundle of rights that must be transferred to constitute a sale, and the tax treatment of the payor and the payee. 
• discusses some of the tax considerations of inbound/outbound transfers. 
• presents ancillary considerations such as installment sales and imputed interest, assignment of income, and personal holding company status. An understanding of these general tax principles is important for developing a comprehensive tax plan. 

Tax Planning for the Development and Licensing of Patents and Know-Howallows you to benefit from:

• Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area
• Invaluable practice documents
  
• Plain-English guidance from world-class experts
• Real-world and in-depth analysis that lets you explore various options
• Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more
• Alternative approaches to both common and unique tax scenarios

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which covers every federal tax topic with expert, in-depth analysis, and offers commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more. 

Detailed Analysis

I. Introduction

A. Overview

B. Capital Gain Treatment to Licensor

II. Research and Experimental Expenditures

A. General

B. Section 174 Deductions

1. What Expenses Qualify

2. In Connection with a Taxpayer's Trade or Business

3. Costs of Research Performed by Others

4. Recapturing Deductions

5. The Election to Expense or Amortize

6. Reasonableness Requirement

C. Amortization Under § 197

1. General

2. Patents and Know–How as § 197 Intangibles

D. Section 41 Credit

E. Passive Loss Limitations Under § 469

III. Patents

A. Overview

B. Substantive U.S. Patent Law

1. The Patent Grant

a. The Patent Application

b. The Issued Patent

2. Reduction to Practice

3. Assignments and Licenses

C. Types of Licenses

D. Professional Inventors

E. Qualifying Under Section 1235

1. Overview

a. Background

b. Section 1235 and Loss Recognition

c. Formalities

d. Exclusivity of Section 1235

2. Definition of a Patent

a. General

b. Options

3. Definition of Transfer

a. Payments to an Employee

(1) General

(2) Shop Rights

b. Successive Transfers

c. Gift, Inheritance, or Devise

4. All Substantial Rights

a. General

b. Transfers that are Limited in Scope

(1) Geographical Limitations

(2) Limits on Duration

(3) Field of Use Fragmentation

(4) All Claims and Inventions

c. Right to Defend Against or to Sue for Infringement

d. Rights Which May Be Substantial

e. Rights Which Are Not Considered Substantial

f. Prior Transfers

g. Right to Terminate

(1) At Will

(2) On Condition Subsequent

h. Retention of a Right to Use

5. Undivided Interests

6. Definition of a Holder

a. General

b. Individuals

(1) Creator of Property

(2) Partners as Inventors

(3) LLC Member as Holder

(4) Trust Beneficiary as Holder

c. Fiduciaries and Personal Representative

d. Financial Backers

e. Related Parties

7. Payments to a Holder

a. Treatment of a Holder

b. Treatment of the Payor

(1) Overview

(2) Payments Outside Section 197

(3) Payments Under Section 197

c. Interest

8. Depreciation of Patent Applications

F. Sales and Exchanges Qualifying Outside Section 1235

1. Section 1221

2. Section 1231

3. Professional Inventors

4. Holding Period

5. What Must Be Transferred

a. Make, Use and Vend

b. Geographical and Field of Use Limitations

c. Duration Limitations

d. Right to Sue for Infringement

e. Prior Transfers

f. Retention of a Right to Make, Use or Vend

6. Undivided Interests

7. Payments

a. Treatment of Payee

b. Interest

c. Payments for Infringement

d. Transfers of Multiple Assets and/or Services

e. Treatment of Payor

(1) Overview

(2) Payments Outside Section 197

(3) Payments Under Section 197

8. Depreciation of Patent Applications

IV. Know–How

A. Definition of Know–How

1. The IRS Position

2. Court Interpretations

3. Payments for Services

4. Unpatented Technology and Computer Software As Trade Secrets

B. Licenses of Know–How

1. Licenses Not Constituting Sales or Exchanges

2. Transfers by Employees

3. Transfers Constituting Sales or Exchanges

a. Capital Asset Status

b. Holding Period

c. What Must Be Transferred

d. Undivided Interests

C. Payments for Know–How

1. Payments for Licenses Not Constituting a Sale

2. Payments for Transfers Constituting a Sale

a. Payee's Treatment

b. Payor's Treatment

(1) Overview

(2) Application of Section 174

(3) Payments Outside Section 197

(4) Payments Under Section 197

V. Foreign Related Transfers

A. Overview

B. Outbound Transactions

1. Non–Sales or Exchanges

a. Personal Holding Companies

b. Foreign Personal Holding Companies Under Prior Law

(1) Controlled Foreign Corporations

(2) Former § 551

2. Sales or Exchanges

a. Controlled Foreign Corporations

b. Section 367(d)

c. Former § 1491

d. Section 1249

C. Inbound Transactions

1. Non–Sales or Exchanges

2. Taxation of Sales or Exchanges

D. Section 482

E. Section 936

VI. Ancillary Considerations

A. Installment Sales - Section 453

B. Imputed Interest - Sections 483 and 1274

C. Gain from the Sale of Depreciable Property Between Certain Related Taxpayers - § 1239

D. Sales or Exchanges to Controlled Partnerships - § 707(b)

E. Assignment of Income Problems

F. Size of Retained Royalty Interest on Sales for Contingent Payments

G. Personal Holding Company Issues - Section 541

1. General

2. Computer Software Payments

H. Certain Computer Software Company Stock

I. Alternative Minimum Tax

J. Charitable Contribution Issues

Working Papers

Table of Worksheets

Other Resources

Worksheet 1 Assignment of Patent and Assignment of Application.

Worksheet 2 Patent License Checklist.

Worksheet 3 Report of the Senate Committee on Finance to Accompany H.R. 8300 (Internal Revenue Code of 1954), S. Rep. No. 1622, 83d Cong., 2d Sess., 438–441 (1954).

Worksheet 4 Conference Committee Report to Accompany H.R. 3838, (the Tax Reform Act of 1986) , H.R. Rep. No. 841, 99th Cong., 2d Sess., II–68–76 (1986)

Bibliography