2006 Fall, Pg. 26. Federal Income Tax Treatment of the Development, Acquisition and Disposition of Intellectual Property.

AuthorBy Attorneys Peter T. Beach and Christopher J. Hamlen

New Hampshire Bar Journal


2006 Fall, Pg. 26.

Federal Income Tax Treatment of the Development, Acquisition and Disposition of Intellectual Property

New Hampshire Bar Journal Fall 2006, Volume 47, No. 3Taxes, Trusts, Judicial Review, and more. . .Federal Income Tax Treatment of the Development, Acquisition and Disposition of Intellectual PropertyBy Attorneys Peter T. Beach and Christopher J. HamlenThe federal income tax treatment of intellectual property has evolved gradually over time and today involves a patchwork of significant statutory, administrative and common-law elements. Pulling all the rules together to determine the right tax treatment in a particular situation can be difficult. Adding to the complexity is the fact that the treatment selected during development or at the time of acquisition can affect the treatment that applies on disposition.

As with most tax issues, however, a systematic approach can remove a great deal of the uncertainty around tax planning for intellectual property transactions. Factors like the kind of intellectual property involved, the manner in which the property is developed, acquired or disposed of, and the nature of the consideration exchanged for the property are critical and provide useful anchors in what can otherwise be a bewildering sea of requirements. Even this factor-driven approach, however, cannot provide a simple decision tree for every situation. Rather it provides a framework in which to consider the appropriate tax treatment for broad categories of intellectual property in the context of three basic types of transactions - development, acquisition and disposition.

Types of Intellectual Property

Definitions of intellectual property typically refer to concepts like "intangible property," "knowledge and ideas," and "rights or entitlements" and then go on to list some or all of the following as examples of intellectual property: patents, copyrights, know-how, trade secrets, trademarks, trade names, and computer software. While the Internal Revenue Code of 1986, as amended, (the "Code") contains many references to the types of property on this list, it did not contain the phrase "intellectual property" until the American Jobs Creation Act of 2004 added Section 170(m)(fn1) to address charitable contributions of intellectual property. Not surprisingly, the Code defines intellectual property for this purpose by reference to types of property: "any patent, copyright (other than a copyright described in section 1221(a)(3) or 1231(b)(1)(C), trademark, trade name, trade secret, know-how, software (other than software described in section 197(e)(3)(A)(i)), or similar property, or applications or registrations of such property."(fn2)

To engage in tax planning for the development, acquisition or disposition of intellectual property it is helpful to be generally familiar with the following types of intellectual property.

Patents. Patents are not defined in the tax law. They take their meaning from other laws that create the rights that are referred to as patents. Under US law, a patent is an intellectual property right conferred by congressional legislation and authorized by the Constitution.(fn3) A grant of a patent under these laws is a "negative" right in that it accords no authority to make, use, or sell the subject invention, but rather, the right to exclude others from making, using, or selling the invention.(fn4)

Copyrights. Copyrights are not expressly defined for tax purposes either, but instead take their meaning from both the common law treatment of copyrights as well as treatment under federal statutory law.(fn5) The Internal Revenue Service ("IRS") has by regulation defined when the transfer of copyrighted materials constitutes the transfer of a copyright right.(fn6)

Know-how and Trade Secrets. Know-how has been defined for tax purposes, but the defining elements are more in the nature of directional signs than precise descriptors. For example, the Internal Revenue Service will characterize secret processes or formula used in a trade or business as property that may be subject to the Section 351 nonrecognition of income allowance upon transfer to a controlled corporation or partnership so long as the process or formula is held secret and the laws of the jurisdiction of the transferee provide the transferor with legal protection against the unauthorized disclosure of such information.(fn7)

Trademarks and Trade Names. Trademarks are not defined for tax purposes, but instead derive their meaning from US statutory law defining and addressing trademarks. The basic definition of a trademark is found in 15 U.S.C. 1127, where the term is defined to include "any word, name, symbol, or device, or any combination thereof (1) used by a person, or (2) which a person has a bona fide intention to use in commerce and applies to register on the principal register established by this chapter, to identify and distinguish his or her goods, including a unique product, from those manufactured or sold by others and to indicate the source of the goods, even if that source is unknown."

Computer Software. Computer software is defined for different tax purposes using varying, though roughly equivalent, definitions. Thus, for example, Treasury Regulation section 1.861-18(a)(3) defines a computer program as "a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result." This definition is generally used for purposes of addressing the treatment of income from the disposition of computer software. For purposes of addressing the treatment of development costs of software, Revenue Procedure 2000-50 defines a computer program as any program or routine (i.e., any sequence of machine-readable code) designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine.

Development of Intellectual Property

The primary tax issue that arises in connection with the development of intellectual property concerns the research and development deduction or tax credit. A taxpayer has several methods to chose from when deciding how to treat research and development (R&D) expenditures for tax purposes. Once the decision is made, it is generally memorialized in the form of an election made for the first tax year in which the expenditure is paid or incurred.

Many taxpayers and their tax preparers pay much less attention than they might to maximizing the impact of the R&D expense deduction and the R&D tax credit. Many are simply unaware that they can reduce taxes based on the nature of their day-to-day activities and those who are aware may not understand the breadth of coverage. The fact is that many businesses today invest heavily in product or process improvement to meet market demands and, therefore, can take advantage of the R&D expense deduction and R&D tax credit, both of which are designed to allow taxpayers to recapture some of the money spent in this way.

The R&D expense deduction

Section 174 permits a taxpayer to deduct or amortize R&D expenses(fn8) that are paid or incurred during a taxable year in connection with a trade or business and which are not chargeable to a capital account. The taxpayer makes an election to deduct R&D expenses under section 174(a) or an election to amortize the expenditures under section 174(b). Amortization is allowed over a period not less than 60 months beginning with the month in which the process, formula or invention is first employed in an income-producing use.(fn9) In deciding whether to deduct or amortize under Section 174, noncorporate taxpayers must also consider whether they will be subject to 10-year (rather than 60-month) amortization under the alternative minimum tax.(fn10) Expenses for which no election is made (either to deduct or amortize) must be capitalized, i.e., included in the basis of the property or process being developed. The taxpayer must also substantiate the expenses if requested upon audit.

Not all expenses incurred in connection with research and development are covered by Section 174.(fn11) R&D expenses under Section 174 include only research and development costs(fn12) in the experimental or laboratory sense, i.e., costs that are incurred for activities intended to discover information that eliminates uncertainty as to the development or improvement of a product.(fn13) Uncertainty exists if the information that is actually available to the taxpayer (not the broader category of information that might be reasonably available) does not establish the capability or method for developing or improving the product, or the appropriate design for the product.(fn14) The regulations emphasize that whether an expenditure qualifies under Section 174 depends on the nature of the activity to which the expenditure relates not the nature of the product or improvement being developed, or the level of improvement that the technology represents.(fn15) Finally, Section 174 applies not only to costs paid or incurred by the taxpayer for R&D that the taxpayer undertakes directly, but also to costs paid or incurred by him for R&D conducted on his behalf by another.(fn16)

Whether R&D expenses are incurred in connection with a trade or business, another requirement of Section 174, is broadly construed. In Snow v. Commissioner,(fn17) the Supreme Court ruled that the test for R&D expenses under Section 174 is broader than...

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