Tax Tips
| Publication year | 1982 |
| Pages | 1851 |
| Citation | Vol. 11 No. 7 Pg. 1851 |
1982, July, Pg. 1851. Tax Tips
Colorado's natural resource boom economy has attracted many technologically oriented businesses. A natural consequence of this technological influx is the research and development tax shelter partnership which facilitates the raising of substantial venture capital while providing significant tax benefits to the limited partner investors. The purpose of this article is to highlight, for the practitioner, the general tax aspects associated with structuring a research and development tax shelter partnership, and the attendant tax benefits that may result from such a properly constructed investment financing vehicle.
Utilization of the limited partnership form is beneficial to both the inventor-originator (normally the general partner) of the proposed technology and the limited partner investor. Because limited partners are not permitted to engage in the every-day management affairs of the partnership, the inventor general partner can retain substantial control over the development of the technology as well as the terms and conditions regarding its ultimate exploitation, assuming the technology is eventually reduced to practice.(fn1)
Futhermore, due to the significant tax benefits available to limited and general partners, a portion of the risk associated with the research and development project is actually allocated directly to the federal government, which permits the investor to recoup a significant part of his original investment generally in the same year it is expended. If the technology is ultimately reduced to practice, the investor would normally be entitled to a share of the partnership's distributable cash flow which may be taxed as either ordinary income or capital gains, depending upon the circumstances surrounding exploitation of the technology.
Finally, investors may be entitled under the partnership agreement to obtain equity participation in the general partner upon final development of the technology if the general partner is permitted to acquire the technology. This
The classic research and development limited partnership is formed by an inventor-promoter (corporate or individual) who is seeking to raise sufficient funds to reduce a new idea to practice. Typically, the idea is not yet patented, although a patent application may be pending. The promoter-inventor generally transfers all his right, title and interest in the proposed technology to the partnership in exchange for a general partnership interest. Interested investors contribute to the partnership the necessary funds required for development in exchange for limited partnership interests.
Actual conduct of the research and development activities may be undertaken by the partnership itself or contracted out to third parties with the specification that certain technical requirements be met. Such research contracts generally require a substantial prepayment of funds on the grounds that the research entity undertaking the research and development work requires substantial working capital to begin its work.
Assuming the technology has been successfully reduced to practice, the partnership may either modify its structure from a financing vehicle to a manufacturing and marketing entity or dispose of the product and patent rights in exchange for future royalty rights or an equity participation in the acquiring party. Although the latter course is often selected, it is important for tax purposes that the ultimate sale of the technology not be prearranged and finalized prior to developing the technology.
If the ultimate purchaser of the technology also conducted the research and development activities, or is otherwise related to the general partner, special considerations arise in order to preserve the tax benefits associated with the transaction. Furthermore, the following factors should be considered in structuring the research and development tax shelter partnership.
A research and development limited partnership's investment appeal stems from the investor's ability to deduct a pro rata share of the partnership's expenses. As a result, it is imperative that the entity be classified as a partnership for tax purposes and not as an association taxable as a corporation. In this regard, the IRS has issued comprehensive regulations governing the characterization of a limited partnership as compared to an association taxable as a corporation.(fn2) With the exception of certain neutral factors,(fn3) these regulations indicate a partnership will be so classified if it lacks two of the following four characteristics normally associated with the corporate form of business: (1) continuity of life; (2) limited liability; (3) centralization of management; and (4) free transferability of interest.(fn4)
A limited partnership formed under state law which corresponds to the Uniform Limited Partnership Act "ULPA",(fn5) will normally be found to lack continuity of life(fn6) and limited liability.(fn7) However, it is often advisable to seek a ruling from the IRS on this issue if assurance is desired.
The general partner can be a corporation or an individual or a combination of
The research and development partnership normally enters into a contract with the entity or party who will perform the research and development activity. The research and development contract usually requires a substantial prepayment to fund the contractor's project development. In many situations, the party who will conduct the research and development activity is also the general partner and/or the party who holds ultimate rights to acquire and exploit the technology in the event the research and development activity yields a valuable technology. Under such circumstances, the partnership carries a substantial burden of proof in establishing the business purpose and legitimate status of prepaid research and development costs. Especially in the context of related parties, the increasingly growing volume of case law and administrative interpretations in the prepayment area should be studied carefully and applied cautiously.(fn9)
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