Royalties on pharmaceutical technology taxable as ordinary income, Tax Court holds.

• Author: Golightly, Kim
• Position: 2017 memorandum decision in Spireas v. Commissioner

In Spireas, T.C. Memo. 2016-163, the Tax Court held that royalties received by an S corporation under a license agreement are taxable as ordinary income to the S corporation's individual shareholder. Sec. 1235 capital gain treatment does not apply because the taxpayer retained substantial rights in the technology.

Facts

Spiridon Spireas is an inventor with a doctoral degree in pharmaceutical technology. Together with his former faculty adviser, Sanford Bolton, Spireas developed a "liquisolid" technology The technology was designed to enhance the bioavailability of water-insoluble drugs and nutritional supplements. Spireas and Bolton obtained several patents on the technology. In 1997, they formed an S corporation, Hygrosol--of which each owned a 50% share--to pursue the business potential of the technology and associated patents.

In 1998, Hygrosol entered into a licensing agreement with an unrelated pharmaceutical company, Mutual Pharmaceutical Co. Inc. (Mutual), whose business involved developing and marketing new and generic drugs. After several months of negotiations, the agreement the parties reached granted Mutual rights to use the liquisolid technology on a product-by-product basis to develop, produce, and sell drugs. The agreement provided that any products for development had to be "unanimously selected" by Hygrosol and Mutual. With respect to any such unanimously selected products, Mutual was granted exclusive rights. However, Hygrosol retained rights to use the technology for nutritional supplements not requiring FDA approval, as well as for any pharmaceutical products not agreed to by the parties, and for products that were agreed to but that Mutual ultimately declined to develop. Mutual contracted to pay quarterly royalties equal to 20% of the gross profits on sales of products containing the technology.

After screening about 100 drugs, Hygrosol and Mutual agreed to pursue further development of 20 products. For each, the parties executed short engagement letters committing themselves to the pursuit of the product. In accordance with the licensing agreement, Mutual paid Hygrosol $10,000 each time the parties agreed to pursue a product. In addition, for any product that Mutual ended up selling, Mutual would pay Hygrosol 20% of the net profit. Two of the agreed-to products ultimately went on to become financially successful products in the marketplace.

On his 2007 and 2008 tax returns, Spireas reported royalties received under the...