Two roads to capital gains for patent sales.

• Author: Bakale, Anthony

As the new economy presses forward, innovative technologies are being developed at a rapid pace. Many of these technologies are patented and then transferred in some capacity to companies that will attempt to commercialize them. At times, a transfer involves an outright sale of the patent; sometimes, it involves only a lease of the technology in exchange for royalties. These transactions can sometimes be complex or unusual from a tax perspective. A company often wants to acquire the exclusive right to use a technology, but it is difficult to determine a fair purchase price for a patent that may or may not prove to have commercial applications. A common solution is a contract that grants the acquiring company a permanent and exclusive right to use and develop the technology in exchange for royalties based on sales of any commercial applications that use it.

From the vantage point of transferors, these transactions have many elements of sales. They have permanently transferred all of the economic rights to their patents and are left only with legal title to a technology that they can no longer use, sell or lease. They would certainly like the transaction to be taxed as a sale (subject to capital gain rates), rather than taxed as royalty income at ordinary rates. However, transactions in which legal title to an asset does not change hands are not usually taxed as sales. Fortunately, Sec. 1235 addresses these types of transactions and treats them as long-term capital gains. Unfortunately, Sec. 1235 is fairly complex and not all taxpayers will be able to take advantage of its safe harbor provisions. Sec. 1235(a) states:

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are--

(1) payable periodically over a period generally coterminous with the transferee's use of the patent, or

(2) contingent on the productivity, use, or disposition of the property transferred. (Emphasis added.)

Capital gain treatment is available if the transferor can meet the Sec. 1235(a) requirements. The first unique term is "all substantial rights to a patent" Regs. Sec. 1.1235-2 basically requires that the transferor permanently give up all rights to control...