As of the date of this publication, the US House of Representatives and the Senate have passed the “Tax Cuts and Jobs Act” as reconciled by the conference committee. Now that the President has signed the Republican tax bill into law, IP owners may find the tax bill will impact sales of certain intellectual property.
Originally, the US House of Representatives passed its version of the bill on November 16, 2017 (the “House Bill”), which included a provision that would significantly impact the sale of intellectual property. The original corresponding legislation passed by the US Senate (the “Senate Bill”) did not have a similar provision. The reconciled bill generally takes the position of the original House Bill. The legislation was signed into law by the President, with the Tax Cuts and Jobs Act taking effect on January 1, 2018.
The effect of the bill is currently unclear, however, because as drafted the provision creates a clear conflict, it is likely that the Conference Committee’s bill (the “Conference Bill”) will result in the sale of certain intellectual property being taxed at ordinary income tax rates, instead of capital tax rates. Interested taxpayers should take action by the end of the year if: (1) they hold the rights to a self-created patent, invention, model or design, secret formula or process, and (2) are looking to monetize the asset in the near future.
New laws that could affect your disposition of intellectual property as certain self-created property no longer to be treated as a capital asset
Currently, a self-created patent, invention, model or design (whether or not patented), or secret formula or process is treated as a capital asset. Thus, any gain or loss recognized as a result of a sale, exchange, or other disposition of the property is taxed at the capital gains rate, a rate more favorable than ordinary income tax rates, provided an asset is held for more than a year. In addition, a creator of musical compositions or a taxpayer who holds a copyright in musical works created by their personal efforts may elect to treat that property as a capital asset.
Prior to the actual commercial use of a patent, both an individual who creates a patent and an unrelated individual who acquires a patent from its creator may treat any gains on the transfer of the patent as long term capital gains. In order to qualify, the transfer must be of substantially all of the rights to the patent and cannot be by gift, inheritance, or devise.
House Tax Bill:
The House of Representative’s version of the Tax Cuts and Jobs Act (H.R. 1) amends I.R.C. Section 1221(a)(3) to exclude certain patents, inventions, models or designs, and secret formulas or processes from the definition of “capital assets.” Thus, any gain or loss from the disposition of a self-created patent, invention, model or design, or secret formula or process will be subject to ordinary income tax rates rather than capital tax rates. However, creators of musical compositions and copyrights in musical works will continue to be able to elect to treat such self-created property as capital assets.
Furthermore, the rule under IRC Section 1235, which allows creators of patents or those who have acquired the patent from its creator to treat the transfer of the patent as a capital asset, would have been repealed and transfers of a patent by the creator would be taxed according to ordinary income tax rates.
How does this reconcile with the Senate Bill from December 1st, 2017?
The Senate Bill does not contain provisions amending IRC 1221(a)(3) and 1235. Since the Senate and House passed two separate and distinct tax bills, a temporary conference committee was created to resolve the difference between the two bills. The committee is tasked with creating one tax bill to send to both chambers for final approval and vote before a final bill is sent to the President for signature. There are specific rules on how the committee can compromise on areas of disagreement. Both the Senate and House leaders chose members to be on the committee that will negotiate the provisions of the tax bill. The House’s committee consists of nine Republicans and five Democrats and the Senate’s committee consists of seven Democrats and eight Republicans. See Conferees to the House-Senate Conference Committee for the Tax Cuts and Jobs Act, U.S. H.R., for a full list of leaders named to the House and Senate’s conference committee.
On December 15, 2017, the conference committee completed its first task, reconciling the two tax bills into one tax bill. The next step is for each chamber to approve the Conference Bill. In this instance, because the House requested the conference committee first, it has the opportunity to approve the Conference Bill or send the bill back for further negotiations. If the House accepts Conference Bill then the Senate can either accept it or reject it, however, the Senate is not permitted to send it back for further negotiations. If both the House and Senate accept the Conference Bill then both the House and Senate vote on it. The House passed the Conference Bill along party lines on December 19, 2017.
Conflict in the Conference Bill:
The Conference Bill follows the House Bill and would include self-created patents, inventions, models or designs (whether or not patented), or secret formulas or processes under IRC 1221(a)(3), which lists the types of assets that are not capital assets. Since the above listed assets would be excluded from the definition of capital assets, they would no longer receive capital tax rate treatment, which is more favorable, and instead would be subject to ordinary income tax rates. However, the provision under IRC 1221(a)(3) only applies to taxpayers whose efforts created the property.
The Conference Bill did not follow the House Bill with regard to IRC 1235. Thus, as currently drafted, IRC 1235 remains in effect and the Conference Bill would continue to allow holders of patents to treat the sale of the patent as a sale or exchange of a capital asset held for over a year. A holder is defined as (1) an individual whose efforts created the patent, or (2) an individual who has acquired the patent for consideration paid to the creator prior to its commercial use. Thus, transfers of patents by holders, as defined above, may be treated as a sale or exchange of a capital asset subject to long term capital tax rates.
The Conference Bill would result in a conflict between IRC 1221(a)(3) and IRC 1235. The Conference Bill amends IRC 1221(a)(3) and results in ordinary income tax treatment on gains or losses from the sale of self-created patents, inventions, models or designs (whether or not patented), or secret formulas or processes by a taxpayer, whose personal efforts created the property. Transfers of such self-created property by creators will no longer be treated as capital assets subject to capital tax rates. On the other hand, IRC 1235 allows holders of patents, which includes individuals whose personal efforts has created the patent, to treat the sale as a sale or exchange of capital asset. This is in direct conflict with the Committee Bill’s version of IRC 1221(a)(3). Therefore under the Committee Bill, as currently drafted, it is unclear whether the sale of a patent by a taxpayer whose personal efforts resulted in the creation of the patent will be subject to long term capital gain rates as under IRC 1235 or ordinary income tax rates as stated in IRC 1221(a)(3) of the Committee Bill.
Despite the lack of clarity with respect to the treatment of a sale of a patent by its creator, the Committee Bill is clear on the tax treatment of individuals who later acquire the patent for consideration. Under the Committee Bill, taxpayers who pay consideration for a patent from the creator, prior to commercial use, and later sell that patent are able to treat that sale as a sale of a capital asset under IRC 1235. Therefore, the sale of a patent by someone who acquired the patent in exchange for consideration will receive capital gain treatment for the sale of the patent rather than ordinary income tax rates.
In addition, the Committee Bill is also clear on the tax treatment of sales by a taxpayer whose personal efforts created an invention, model or design (whether or not patented), or secret formula or process. Under the Committee Bill, such taxpayers will no longer receive capital gain rates on the sale of the asset and instead the sale will be subject to ordinary income tax rates.
What does this mean for me?
Given that the Committee Bill directly contradicts itself with respect to the tax treatment of the sale of patents by taxpayers whose personal efforts created such property, it is unclear how this Bill will be implemented. It is unclear how gains or losses on a sale of self-created assets by a taxpayer who created a patent will be treated.
However, if you created an invention, model or design (whether or not patented), or secret formula or process, now is the time to act. The sale of such self-created assets by creators will no longer receive capital asset treatment. Therefore, the January 1, 2018 deadline for the proposed provision leaves a limited window of time for taxpayers who wish to benefit from the existing law to do so, since a sale of the above listed assets will be taxed at the ordinary income tax rates, which could result in a tax of up to 37% (compared to a tax of up to 20% for assets subject to long term capital gain rates).
In addition, while corporations do not benefit from reduced capital gains rates, trusts do. Depending on the tax status of their owners, income flowing through tax transparent entities (including S Corporations, LLCs, LPs, and other partnership type vehicles) may also benefit from reduced capital gains rates.
The implications of the Committee Bill is best illustrated by the following example: Fred Watson is the creator of a new soda formula that has not yet gone to market. Fred is considering selling the formula to an international corporation. If Fred sells the formula on December 31, 2017 for $10 million, the formula will be considered a capital asset and taxed at long term capital gain rates. In this case, Fred would pay up to $2 million in taxes on the $10 million sale. If Fred sells the formula on January 1, 2018, Fred could pay up to $3.7 million on the same transaction; paying double the taxes! Imagine, Fred would have taken home $1.7 million more if he had managed to close just one day earlier without the purchaser being out of pocket an additional penny.
Frankly, the delay better be worth the cost. For some inventors, this tax result may drive the sale. It is hard to increase the value sufficiently, find a better buyer or to negotiate a sufficiently better deal to overcome the tax drag.
Current ordinary & capital rates for taxpayers married filing jointly:
The following table illustrates the different tax rates that a creator considering selling their invention, model or design (whether or not patented), or secret formula or process will incur if the proposed law explained above is enacted, starting in 2018. For example, a person who created a formula that is in the highest income bracket will pay a 20% tax on the sale of a formula if the sale takes place before January 1, 2018. However, if the sale takes place on January 1, 2018 the creator will be taxed at a 37% rate (provided the proposed law is passed).
Accordingly, the ultimate tax cost will vary based on the magnitude of the sale and the income level of the inventor. However, in the new year, the main winner will be the US government.