Tax issues for individuals who create intellectual property.

• Author: Kelley, Claudia L.

Intellectual property is increasingly becoming a significant contributor to U.S. economic growth. Often, the work of creative individuals results in a copyright, patent, or other form of intangible property. Understanding the legal and tax aspects of intellectual property can be daunting. While large companies have the expertise to appropriately account for intellectual property, few individuals understand its legal aspects, despite its important role in our economy. Consequently, creative individuals, as well as their tax advisers, are often unfamiliar with the specific tax issues applicable to their professions. Proper reporting and planning for income from intellectual property can significantly affect an individual's tax liability.

This article discusses the unique tax issues facing creators of intellectual property, particularly federal income tax treatment for individual taxpayers. Although basic estate and gift issues are mentioned, coverage of these implications is beyond its scope.

Income From Intellectual Property

Factors affecting the federal income tax treatment of income related to intellectual property include whether to classify a creative activity as a trade or business, the timing and characterization of income received, and who owns the property. In general, copyrights and patents generate royalty income reported on Schedule E, Supplemental Income and Loss, unless it is characterized as business income reported on Schedule C, Profit or Loss From Business (Sole Proprietorship). However, who owns the intellectual property, i.e., the creator or the party who requested its development, also determines the type of income reported. The proper classification of royalties also affects the recipient's tax liability in other ways, including self-employment tax, investment interest deduction limitations, and the new 3.8% net investment income tax on unearned income.

Royalty Income

Royalties are payments received for the right to use intangible property and do not include payments for services.' In general, a royalty is paid to the creator of intellectual property by an assignee or licensee with respect to sales or income generated from the property. (2) Royalty payments are subject to the information-reporting rules in Secs. 6041 and 6050N and are reported on Form 1099-MISC, Miscellaneous Income.

Royalties may be classified as either business or nonbusiness income. Individuals engaged in the trade or business of writing, performing, or inventing report royalty income as business income. Whether an individual is engaged in a trade or business must be determined on the basis of all the facts and circumstances of a particular case. (3) Gross income derived by an individual from any trade or business includes income received in the tax year from a trade or business, even though such income may be attributable solely to services rendered in a prior tax year. (4) Therefore, the proper tax treatment for royalty income is determined by when the creative activity resulting in the royalty occurred.

The IRS has ruled that an individual who writes only one book as a sideline and never revises it is not regularly engaged in an occupation or profession, and the book royalties are not considered earnings from self-employment. (5) However, preparing new editions of the book and writing other books and materials reflect the conduct of a trade or business. Thus, a full-time professor who co-authors a textbook and does not engage in any other commercial authorship work while writing the

textbook and has no obligation to work on future editions is not engaged in a trade or business. (6) Even though an individual is retired and not currently involved in his or her creative pursuit of income, any royalties received are business income if the individual was engaged in the business at the time the material generating the royalties was produced. (7) In summary, royalty income should be classified as business income for individuals who were in the business at the time the intellectual property was created.

Advance Royalties

Paying advance royalties to an individual before a creative work is completed is a common practice. For example, to acquire the rights to a piece of music, a publishing company enters into a contract with a songwriter. Typically, the contract requires the songwriter to compose a certain number of songs over a specified period. In return, the songwriter receives incremental payments, i.e., monthly advance royalties intended to cover the songwriter's living expenses while he or she composes the music. The contract requires the songwriter to sell or transfer all his or her rights to the music to the publisher, who in turn markets the song. A typical contract also provides that the publisher will grant the songwriter a portion of the proceeds from the sales beyond the advance royalties paid.

Example: Publisher P pays advance royalties of $12,000 to songwriter S in exchange for the rights to 12 songs to be written over one year. Per the agreement, S will receive 60% of the proceeds received from the sale of the songs. P markets the songs for $50,000. In this example, the portion of proceeds allocable to S is reduced by the advance royalties previously received; thus, S will receive $18,000 [(60% x $50,000) - $12,000]. P is able to recoup a portion of the advance royalties, as long as the songs are marketed successfully. However, if the songs are unsuccessful, then S is not obligated under the terms of the contract to refund the advance royalties. Thus, the advance payments are not contingent upon the success of the songs.

Clearly, the songwriter's share of the receipts from the publisher is royalty income because it represents payments made by the copyright holder to the songwriter. However, what is the proper classification of the advance payments? Although the industry refers to them as advance royalties, they are not truly royalties for tax purposes. According to the claim-of-right doctrine, the songwriter must include the advance royalties in gross income in the year received.s Advance royalties paid to cover expenses of writers, recording artists, or other creative individuals should be reported as compensation for services on Form 1099-MISC (Box 7, Nonemployee Compensation), not as royalties.9 In a typical contract involving advance payments, the creative individual has no property interest in the work created because all rights in the created property belong to the publishing company. As a result, the individual does not have a property right in the property (i.e., song or book) that he or she could sell or license.

For example, in Boulez, the orchestra conductor Pierre Boulez was contracted to make a specific number of recordings for CBS Records. (10) CBS was the sole owner of the recordings and filed for copyrights on the works. Although the contract provided that Boulez would receive royalties based upon the percentage of recordings sold, the court determined that the payments received by the conductor were compensation income rather than royalty income. This classification was crucial to Boulez because royalties were exempt from U.S. tax under the United States--Germany tax treaty (Boulez was a resident of Germany), whereas compensation for personal services was taxable. (11) Tax advisers should review the contract between the parties to determine the proper tax treatment of the income. Ideally, taxpayers should be encouraged to allow their tax advisers to review all contracts before they are finalized.

From the standpoint of the publisher in the example on p. 815, the advance payments paid to the songwriter represent expenditures to acquire an intangible asset (copyright) with a useful life that extends substantially beyond the tax year. (12) The publisher should capitalize and depreciate or amortize this asset under Secs. 263, 167, and 197. (13) The advance payments are not loans. If the contract requires the writer to return advance royalties not covered by marketing proceeds, the writer would receive a deduction from gross income in the year he or she refunded the amount.

Employed Individuals

Individuals who create intellectual property as part of their employment duties face tax issues similar to those of the self-employed creator, specifically, whether the payments received are properly characterized as ordinary income or long-term capital gain. The crucial question is who owns the intellectual property at the time of its creation. The terms of the employment contract or separate licensing agreement must be examined to answer this question. Generally, if an individual is hired to create property, the employer owns the copyrighted or patented work, and the payments to the employee are compensation. Tax advisers with employed clients should review the tax authority, much of which is discussed in this article, to determine the proper tax treatment and to advise their clients regarding the structuring of future agreements.

Payments Through Agents

Creative individuals may be paid through agents to exploit their intellectual property. For example, the terms of a publisher's contract for the license to use an author's literary work may require the publisher to pay the author's royalties directly to the author's agent. Upon receiving the royalties, the agent subtracts his or her commission and expenses and then forwards the balance to the author.

The publisher and the agent are payers of royalties and are subject to the information-reporting requirements of Sec. 6050N. (14) The Form 1099-MISC instructions provide that the gross royalties (before reduction for fees, commissions, or expenses) paid by the publisher directly to an author or agent or paid by the agent to the author must be reported. Thus, although the agent may have subtracted commissions and expenses before making the payment to the author, the Form 1099-MISC must report the gross amount of royalties received from the...