Tax Basics of Intellectual Property
| Author | Elizabeth V. Zanet - Stanley C. Ruchelman |
| Position | Elizabeth V. Zanet is an associate with Ruchelman P.L.L.C. in New York City, where she advises clients on U.S. and international tax matters, including outbound and inbound tax planning for individuals and companies. Stanley C. Ruchelman is the chairman of Ruchelman P.L.L.C., concentrating his practice in the area of tax planning for... |
| Pages | 41-66 |
Published in Landslide® magazine, Volume 10, Number 6, a publication of the ABA Section of Intellectual Property Law (ABA-IPL), ©2018 by the American Bar Association. Reproduced with permission. All rights reserved.
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
Like most assets developed, used, and sold in
business, intellectual property (IP) is subject to
important tax considerations. For purposes of
U.S. federal tax law, intellectual property is part
of a broader category of assets called “intangible
assets.” Intellectual property specically addressed
in the Internal Revenue Code (I.R.C.) includes
patents, copyrights, formulas, processes, designs,
patterns, know-how, format, trade secrets, trade-
marks, trade names, franchises, and computer
software.1 This article presents a brief overview
of the basic U.S. federal tax considerations of events that may
occur over the life cycle of intellectual property, from its cre-
ation to its acquisition, exploitation, licensing, and transfer. It
begins by discussing important general tax concepts such as
tax basis, capitalization, amortization, and asset characteriza-
tion, in the context of intellectual property. Certain new rules
introduced by the Tax Cuts and Jobs Act of 2017 (TCJA)2 are
also addressed, including a new tax regime applicable to off-
shore intellectual property.
Tax Basis as the Starting Point
A taxpayer’s tax basis in an asset generally reects the eco-
nomic cost of the asset to the taxpayer. For example, if a
company acquires a patent from an unrelated patent inven-
tor for cash, the company’s tax basis in the patent will be
the amount paid to the inventor. The tax basis will be the
company’s starting point for computing any amortization
deductions, which involves computing the annual amortiza-
tion deduction as a percentage of the company’s tax basis
in the intellectual property over its useful life. If the com-
pany sells the intellectual property, its gain or loss on the
Tax Basics of
Intellectual
Property
By Elizabeth V. Zanet and Stanley C. Ruchelman
ElizabethV. Zanet is an associate with Ruchelman P.L.L.C. in
New York City, where she advises clients on U.S. and international
tax matters, including outbound and inbound tax planning for
individuals and companies. StanleyC. Ruchelman is the chairman
of Ruchelman P.L.L.C., concentrating his practice in the area of tax
planning for transnational business operations, with an emphasis
on intercompany transactions. They may be reached, respectively, at
zanet@ruchelaw.com and ruchelman@ruchelaw.com.
Image: iStockPhoto
Published in Landslide® magazine, Volume 10, Number 6 , a publication of the ABA Section of Intellectual Property Law (ABA-IPL), ©2018 by the American Bar Association. Reproduced with permission. All rights reserved.
This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
40 LANDSLIDE n July/August 2018
sale generally is computed by reference to its tax basis or
its adjusted tax basis if the basis was adjusted, for example,
downward to reect amortization deductions. To compute
any gain or loss, the company would subtract its adjusted tax
basis from the consideration received on the sale. As for the
inventor in the example, its tax basis in the intellectual prop-
erty depends on whether it was allowed to deduct or required
to capitalize the costs attributable to creating the intellectual
property. These issues are considered in more detail below.
Tax Basis in Self-Created IP: Deduction or Capitalization?
A taxpayer that creates and utilizes intellectual property as
part of a protable ongoing business likely will prefer deduct-
ing the costs attributable to creating the intellectual property
because that allows the taxpayer to receive a current tax ben-
et for the tax year during which the research and development
(R&D) costs were paid or incurred. I.R.C. §162 permits a cur-
rent deduction for all the ordinary and necessary expenses paid
or incurred during the tax year in carrying on any trade or busi-
ness. To be deductible under §162, a business expense must
not be subject to any provision of the I.R.C. that requires capi-
talization, as discussed below.
I.R.C. §174 provides a current deduction for certain
types of research and experimental (R&E) expenses. R&E
expenses are R&D costs in the experimental or laboratory
sense; that is, activities intended to discover information that
would eliminate uncertainty concerning the development or
improvement of a product.3 Thus, for example, the cost of
creating a patentable pharmaceutical product, including the
costs of obtaining a patent such as attorney fees, may be cur-
rently deducted under §174.4 Under §174, a taxpayer may
elect to (1)currently deduct all R&E expenses made in con-
nection with the taxpayer’s trade or business, or (2)amortize
the expenditures over a period of not less than 60 months
beginning with the month in which the taxpayer rst realizes
benets from the expenditures. For taxpayers operating at a
loss, such as a new venture starting up operations, the defer-
ral of the 60-month amortization period may provide a more
valuable tax benet than a current deduction. Further, §174
applies more broadly than §162 because it is available to tax-
payers that are not yet engaged in a trade or business.5 As a
result, it may be a valuable deduction for startups that may
not yet be considered “engaged in a trade or business” within
the meaning of I.R.C. §162. Note, however, a §174 deduc-
tion likely is not available to a taxpayer that invests in IP
development by funding the R&E expenses of a third party
because such expenses likely would not be considered con-
nected with the trade or business of the investor.
Under the TCJA for any tax year starting in 2022, I.R.C. §174
expenses will not be deductible, but will continue to be amortiz-
able as described above, and foreign R&E expenses (i.e., research
conducted outside the United States, Puerto Rico, or any U.S. pos-
session) will have to be amortized over a 15-year period.6
Another useful provision for startups is I.R.C. §195,
which allows taxpayers to elect to defer deducting certain
expenses incurred before the business becomes active and
to deduct such expenses over a 15-year period beginning
with the month in which the active business begins. Startup
expenses are limited to costs that would be deductible if the
business was already an active trade or business.
If the costs paid or incurred by a taxpayer in the cre-
ation of intellectual property are currently deductible under
the I.R.C., the accelerated tax benet prevents the expendi-
ture from being part of the taxpayer’s basis in the intellectual
property. Consequently, a taxpayer may have zero basis
in self-created intellectual property if all the costs were
deducted. If the I.R.C. requires the costs paid or incurred by a
taxpayer in the creation of intellectual property to be capital-
ized, the capitalized costs will form the taxpayer’s tax basis in
the self-created intellectual property.
Case law and I.R.C. §263 require the capitalization of a busi-
ness expense if that expense will create or enhance a separate
and distinct intangible asset or create or enhance a future benet
beyond the tax year in which the expense is incurred. The Trea-
sury Regulations (Regulations) under §263 generally require
that amounts paid to create or acquire an intangible asset must be
capitalized.7 Amounts paid to facilitate the creation or acquisition
of an intangible asset also must be capitalized.8 The Regulations
list some of the costs related to self-created intangible assets that
must be capitalized. Some of the most signicant in the con-
text of intellectual property are (1)costs incurred to obtain rights
from a governmental agency, such as costs to obtain, renew,
renegotiate, or upgrade rights under a trademark, trade name, or
copyright; and (2)costs to defend or perfect title to an intangible
asset, such as the cost to settle a patent infringement lawsuit.9
I.R.C. §263A requires the capitalization of a variety
of costs attributable to property produced by a taxpayer or
acquired for resale in a trade or business or an activity con-
ducted for prot. For the purposes of §263A, “property” is
dened to include tangible property, which would seem to
exclude intellectual property. However, tangible property
under §263A includes lms, sound recordings, videotapes,
books, and similar property that is intended to be produced
on a tangible medium and mass distributed in a form that is
not substantially altered. Thus, for example, the cost of writ-
ing a book, including the cost of producing a manuscript and
obtaining a copyright or license for the project, must be capi-
talized pursuant to §263A.
Under the TCJA, certain property, referred to as “quali-
ed property,” is eligible for a temporary 100 percent bonus
deduction under I.R.C. §168(k). The term “qualied prop-
erty” was expanded to include “qualied lm or television
productions,” which generally means a lm or television pro-
duction in which 75 percent of the total compensation is paid
to actors, directors, and producers for services performed
in the United States and which meets the placed-in-service
requirement, i.e., its initial release or broadcast is before
December31, 2026.
Tax Basis in Acquired IP: How to Allocate Purchase Price
among Assets
A taxpayer’s tax basis in an acquired asset generally is the
amount paid for the asset. In an arm’s length transaction, the
amount paid should be the acquired asset’s fair market value
(FMV). In such case, if the taxpayer acquires a single asset, the
basis of that asset will be the purchase price. In the case of an
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