Intellectual Property

Are you a business using intellectual property – such as software, trade secrets, trademarks or tradenames, copyrighted materials, patents, or other intellectual material? Strategies for US tax-savings for your intellectual property may add substantial value to your business!

Strategy 1:
Take advantage of special federal tax deductions and tax credits, as well as capital gain tax rates, for intellectual property (IP).

You can amortize and deduct costs to develop or acquire several types of IP, qualify for tax credits for such expenditures, or receive reduced capital gain taxation on dispositions of IP, by paying attention to special federal tax rules. The challenge here is that over the years Congress’ interest in different types of IP has fluctuated– as such the allowable tax benefits associated with various types of IP will frequently differ!  Here are brief summaries which omit several technical rules and exceptions:

General rules
The US Supreme Court decided in 1971 that expenditures which create or enhance a separate and distinct asset – including an item of IP – generally cannot be deducted from income but must be capitalized and amortized by deduction over the useful life of the asset. The Court in 1992 extended this treatment to expenditures which give rise to future benefits, not just to a separate and distinct asset. However, this treatment can be and has been altered by Congressional statutes covering specific assets or expenditures – for example, many US research and experimentation expenditures are required beginning in 2022 to be amortized over five years, unless more immediate deductions are permitted by new legislation.

As noted in several examples below, dispositions of IP are often taxed as capital gains, whether in lump-sum sales or as installment sales which can spread-out taxable gains to the seller.  However, such treatment often does not apply for sale to a related party owned more than one-half by the seller.

Software
Expenditures for software research or development may qualify for deduction in the year spent under pre-2022 rules for which tax returns are open or amortized over five years, or qualify for tax credits of up to 20% of such expenditures (plus certain state tax credits).

Acquisition of software may qualify for immediate expense deduction or be amortized and deducted over 36 months for off-the-shelf software or 15 years. Alternatively, software license royalties are deductible currently.

Disposition of software by an individual creator may be taxed at capital gain rates.

Trade Secrets
Expenditures which create trade secrets generally are part of ordinary and necessary deductible expenses. Acquisition of trade secrets may be amortized by deductions over 15 years.

Disposition of trade secrets may be taxed at capital gain rates (except on recapture of amortized deductions).

Trademarks and tradenames
Expenditures to create – or to acquire – a trademark or tradename generally may be amortized over 15 years.

Disposition of a trademark or tradename may be taxed at capital gain rates (except on recapture of amortized deductions).  However, such treatment often will not apply where the disposition is subject to seller’s retained powers over acquiror’s use or includes payments contingent on acquiror’s use of the mark or name.

Copyrighted materials
Expenditures to create – or to acquire – copyrighted material generally may be amortized over 15 years.

For an individual creator, disposition of copyrighted material may be taxed at capital gain rates only for self-created musical works.  For a non-individual creator, most dispositions of copyrighted material used in its trade or business can qualify for capital gain treatment. This treatment may even apply to a separate acquisition limited to one or more media of expression, rather than all rights. (However, in any case capital gain treatment does not apply to recapture of amortized deductions.)

Patents
Expenditures to develop a patent generally may be amortized over 15 years.

A patent acquiror may amortize its cost over 15 years or – in the case of a patent acquired separately and not as part of a trade or business acquisition– over a shorter useful life calculated by a permitted method.  Alternatively, royalties under a non-exclusive license may be deducted currently.

Disposition of substantially all rights in a patent – or just all rights within a separate geographical area or field of use – may be taxed at capital gain rates (except on recapture of amortized deductions).  However, this treatment does not apply for sale to a related party owned more than one-quarter (rather than one-half) by the seller.

Other IP
Domain names:  While a domain name’s initial reservation and renewal costs are often quite modest, the perceived value of a domain name may increase substantially based on markets to which it relates.  Disposition may be taxed at capital gain rates and – if the name functions as a trademark – an acquiror may amortize its price over 15 years.    

Goodwill:  Similar to expenditures which create trade secrets, expenditures which create business goodwill generally are part of ordinary and necessary deductible expenses.

Disposition of goodwill – generally as part of a trade or business disposition – will ordinarily be valued as the residue of total business sale proceeds, less proceeds allocated to acquire other assets of the business. (This is best done by the parties in their disposition agreements, otherwise they may well use different allocations, which may trigger tax audits.)  Such goodwill disposition proceeds are generally taxed as additional capital gain, with the acquiror amortizing such goodwill over 15 years.

Additional Strategies: 
In a subsequent blog, we will describe two additional Strategies providing IP tax-savings for businesses operating across multiple US states or  across international borders.

Please feel free to contact us with questions or comments on the above points on our website at RJS LAW or by phone at (619)595-1655.

IRS Circular 230 Notice:  Any advice contained in this communication (including any attachments) does not constitute a formal opinion of the author or her/his Firm and is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding or reducing penalties that may be imposed by the Internal Revenue Service or any other governmental authority or (b) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Written by John I. Forry