Tax Issues for Individuals Who Create Intellectual Property
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Amounts received by individuals who create intellectual property may be royalties or compensation, depending on whether they own and license the property or create it for an employer. Royalties may be either business or nonbusiness income. 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 individualโs 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 recipientโs 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.1 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 songwriterโs 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% ร $50,000) โ $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 songwriterโs 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.8 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 StatesโGermany 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 publisherโs contract for the license to use an authorโs literary work may require the publisher to pay the authorโs royalties directly to the authorโs 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 publisher.15 The author should report the agentโs commission as a business expense.
Costs to Create Intellectual Property
Ordinary and necessary business expenses of authors, composers, musicians, and other creators of intellectual property are deductible under Sec. 162. Additionally, costs incurred by writers (including musical composers), photographers, and artists in creating writing (including musical compositions), photographs, pictures, paintings, sculpture, etc., are exempt from the uniform capitalization rules that govern the treatment of costs incurred in the production of property for resale.16 On the other hand, patent creation costs must be capitalized under Sec. 263 or in certain cases may be deductible as research expenditures under Sec. 174.17
Individuals who have not yet generated income from their creative activities should make sure that their business deductions are not limited by the hobby loss rules in Sec. 183. Generally, an activity is presumed to be a hobby if a profit is not earned in at least three tax years of a consecutive five-year period.18 However, a taxpayer can overcome this presumption if she or he can show the activity was operated with the intent to make a profit. Fortunately, the courts recognize that economic success in the creative arts frequently takes longer to achieve and thus focus on the manner in which the taxpayer pursues the activity to determine profit motive.19
Regs. Sec. 1.183-2(b) lists factors to be considered to determine whether the taxpayer is seeking to make a profit. A detailed explanation of these factors and the case law is beyond the scope of this article. The reader should consult IRS Publication 535, Business Expenses, and Audit Technique Guide IRC ยง 183 Activities Not Engaged in for Profit for additional guidance.20 Historically, the IRS has aggressively litigated hobby activity cases. However, taxpayers in the creative fields who have shown they operated the activity in a businesslike manner (maintained business records and appropriate documentation) and had relevant expertise have been able to prove profit motive.21
Self-Employment Tax on Income From Intellectual Property
Creative individuals report sole proprietor business income on Schedule C, where the net earnings are subject to self-employment tax. Generally, a person regularly engaged in an occupation or profession for profit and who is not an employee is engaged in a trade or business for self-employment tax purposes. Sec. 1402(a) provides that the term โnet earnings from self-employmentโ means the gross income derived by an individual from any trade or business carried on by the individual, less the deductions allowed under the Code that are attributable to the trade or business. Because the term โtrade or businessโ is not defined in the Code and the regulations, whether a certain activity of a creative individual constitutes a trade or business depends upon the facts and circumstances. This determination may be especially difficult because, often, the activities of creative individuals involve recreation and pleasure.
According to the Supreme Court, a business occupies the time, attention, and labor of a person for the purpose of livelihood or profit.22 An isolated or occasional activity is not a business. An individual may engage in several trades or businesses independently of, or in connection with, his or her principal trade or business. In determining whether an individual is engaged in a trade or business, factors to consider include (1) continuity and regularity of activities, as distinguished from occasional activities, and (2) whether the primary purpose of the activity is to generate income or profit.23
Rev. Rul. 91-1924 states that a payment is derived from a trade or business for self-employment tax purposes where there is a nexus between the payment and the carrying on of the trade or business. For purposes of the self-employment tax, a person may be engaged in a part-time business in addition to his or her regular job as an employee.25 Tax advisers of creative individuals should advise their clients about the tax consequences of business versus nonbusiness income and assist their clients to structure, carry on, and document their activities for the desired result.
Current-year self-employment income includes business income received by cash-basis individuals, even though the income may be attributable in whole or in part to work or services performed in earlier years, and advance royalties.26 Individuals may receive a grant to conduct research, and the grantor foundation reserves certain rights in any patents resulting from the research. In these cases, the individual is considered an independent contractor, and the income for his or her research services constitutes income from self-employment.27
Transfers of Intellectual Property
A disposition of intellectual property may produce ordinary income, capital gain or loss, or a charitable contribution deduction, or it may allow income from the property to be assigned to another taxpayer. The primary criterion determining whether a sale or transfer of intellectual property has occurred is to what extent the creator has given up rights to the intellectual property. Income from transfers that are not sales is generally ordinary income from a license.
To determine whether the transfer of a patent or copyright is a licensing arrangement or a sale for tax purposes, the IRS looks to the terms of the contract transferring the right and not to the form of the payment to determine whether the creator has retained a property interest.28 Patents seem to have received the most attention in case law, and many of the principles in these cases apply to other types of intellectual property. Thus, the latter part of this section discusses specific authority related to the transfer of patents.
Sale or Exchange of Intellectual Property
Whether amounts paid to a creative individual are income from the performance of personal services or income from the sale, license, or rental of the personโs work is not always clear; consequently, this issue has often been addressed by the IRS and the courts. In Cory, author George Santayana gifted his autobiography to Daniel Cory, his friend and secretary, who in turn entered into an agreement that provided a publisher the exclusive right to publish the work in the United States and Canada during the terms of the copyright and renewals.29 The publisher agreed to pay Cory a percentage of the retail sales. Cory retained the serial rights and did not grant the company publishing rights in other countries or other forms.
The Second Circuit concluded that a sale had not occurred because Cory did not transfer the entire bundle of rights conferred by copyright law and the amount that Cory would receive was wholly indeterminable at the time of the transfer. For authority that a transfer of a copyright for a price to be fixed by future profits can constitute a sale, see Hopkinson and TeLinde.30 However, unlike Cory, in both these cases, the taxpayers transferred the entire bundle and retained no interest in the copyrights.
In Waterman, the agreement gave the licensor the right to manufacture and sell an invention but not expressly the right to use the invention. In the absence of the latter factor, the agreement was not a sale; rather, the Supreme Court held, it was a license.31 The Tax Court also has long held that where only the right to make and vend has been granted without the right to use, the transfer constitutes a license.32 If the agreement limits the exclusive rights to within a certain district, the agreement is a license.33
The IRS has ruled that a grant of an exclusive right to exploit a copyrighted work in a particular medium results in a sale of the property, regardless of the form of the purchase price. In other words, even if the consideration received is measured by the percentage of receipts from the sale, performance, exhibition, or publication of the copyrighted work or by the number of copies sold or performances given of the copyrighted work, the transfer of the exclusive right to exploit a copyrighted work during the life of the copyright in a medium of publication or expression is treated as a sale rather than a rental.34
Except in the case of certain self-created musical works, most copyrights and literary or artistic compositions are not capital assets in the hands of their creator.35 Additionally, these items are not capital assets in the hands of a taxpayer whose basis for determining gain from the sale of such property is determined in whole or in part with reference to the basis of the creator.36 Thus, for the creator of a copyright, whether or not a transfer of all substantial rights has occurred is less significant (except in the case of a donation, which is discussed later) because the income from both a sale and a license is ordinary. Congress grants patent creators more favorable capital gain treatment, which is discussed in the following section.
However, Sec. 1221(b)(3) provides an exception allowing a taxpayer to elect to treat the sale or exchange of musical compositions or copyright in musical works created by the taxpayerโs personal efforts (or having a basis determined by reference to the creatorโs basis) as a sale of a capital asset. The election is made separately for each musical work sold or exchanged during the tax year and must be made by the due date (including extensions) of the income tax return for the year of the exchange.37 To revoke the election the taxpayer must file a ruling request with the IRS. Alternatively, Regs. Sec. 1.1221-3(c) provides an automatic six-month extension to revoke the election if the taxpayer within the six-month extension period files an amended return and treats the sale as the sale of a capital asset.
Recently, the IRS addressed an inconsistent treatment by parties to a transfer of intangible property.38 In the advice, the buyer/corporation treated the transfer as a license, thus allowing the payments to be deducted rather than capitalized into the cost of acquiring the property. The seller, however, treated the transfer as a sale resulting in a capital gain. The IRS concluded that the transfer was indeed a sale, as all the sellerโs rights to the property were transferred, according to the contract terms. As a result, the buyer was required to capitalize the acquisition cost and recover its costs ratably through amortization over the remaining useful life.39 The IRS emphasizes that the name given to an agreement, whether license or sale, is not conclusive as to the substance of the transaction. Parties negotiating a transfer of intellectual property should be aware that the transfer must be treated consistently by both parties to the agreement.
Transfer of Patents
Whether income from the transfer of a patent in exchange for a percentage of the sales resulting from the patent is ordinary license income or capital gain has been the subject of numerous court cases. The fact that a contract is termed a license, or that the parties are referred to as licensee and licensor, is not the determining factor; rather, the rights surrendered determine the character of the exchange. In Myers, the contract consistently referred to the parties as licensor and licensee, but the royalties paid pursuant to the contract were held to be income from the sale of a capital asset because all the inventorโs rights to the invention were transferred to the company.40 In Du Pont & Co., the Court of Claims noted that a transfer of all substantial rights to a patent could not occur if the owner retained the right to prevent others from manufacturing, using, and selling the invention, and thus the inventor remained the owner of the patent.41
Because of the difficulties addressed in case law for determining when an inventor of a patent has sold or merely licensed itโespecially when payments are made over time or contingent upon the use of the propertyโCongress enacted Sec. 1235 providing, โA transfer (other than by gift, inheritance, or devise) of property consisting of all the 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.โ42 This is true even if the transferor is a professional inventor43 and regardless of whether the payments received in the exchange are due periodically or are contingent on the use of the patent. The holder is the individual whose efforts created the patent or another individual who acquired an interest in the patent before its actual reduction to practice and who is not related to the creator or the employer of the creator.44 โActual reduction to practiceโ involves carrying out the invention to the point where there is substantial certainty that the invention will function in the way it was intended.45
This Code section does not eliminate the need to determine whether a transfer of all substantial rights to the patent has occurred, but it does clarify that payments received while the transferee uses the patent do not preclude a transfer of all substantial rights. Regs. Sec. 1.1235-2(b) defines the phrase โall substantial rightsโ to the patent as all rights that are โof value at the time the rights to the patent (or an undivided interest therein) are transferred.โ Basically, the transferor must assign the rights to make, use, and sell the patent. If the seller limits use of the patent by geographic area, length of use, or field of use, then all substantial rights have not been transferred, and the transfer is deemed to be a license.46 Further, a transfer of all substantial rights does not occur if the transferee is given less than all inventions covered under the patent.47
Inherited Intellectual Property
When the holder of intellectual property dies, questions arise as to the proper tax treatment for the decedentโs estate as well as for his or her heirs. Although an in-depth discussion of the estate tax issues for intellectual property is beyond the scope of this article, several fundamental issues must be considered. The fair market value (FMV) of the property at the date of death is included in the decedentโs estate for estate tax purposes.48 However, the valuation of intellectual property poses a challenge, as it often involves determining the future earnings from the property. Qualified appraisers who are knowledgeable and experienced with intellectual property should be used to determine FMV.
Often, the estate taxes on a valuable piece of intellectual property may be more than the liquid assets available in the estate to pay the tax; therefore, estate planning is crucial. If the creator dies while holding a copyright or patent, then the heirs have received a tax-free bequest with a new fair market basis.49 While a copyright in the hands of the creator is not a capital asset, a copyright received via inheritance is treated as a capital asset and receives a stepped-up basis.50 However, if the creator gives a copyright as a gift prior to death, the donee receives the creatorโs lower basis, and if the donee subsequently transfers the copyright in a taxable disposition, the gain on sale will be ordinary income rather than capital gain.51
It is possible that an artist did not own the intellectual property at the date of death but was receiving income from it. A pivotal determination for properly characterizing the income to the heirs is whether the original contract was for a right to use the property owned by the decedent, for the product of the artistic talents of the decedent, or for the decedentโs services. Taxpayers may infer that a decedent receiving royalties at the time of death is the owner of the intellectual property because a royalty is a payment to the owner of a property interest in return for permission to use the property. However, as discussed previously, despite the terminology in the contract, the payments may not be royalties. In any case, where an individual is hired to perform or create and the product of these efforts is not owned or controlled at any time by that individual, then the payments received are compensation for services.52
In General Counsel Memorandum 3783853 a musician entered into a contract with a recording company and agreed to record a certain number of musical arrangements for the company to reproduce and sell. According to the contract, the recording company possessed all the rights to the master recordings free from any claims by the musician. In return for making each recording, the musician received a fixed fee plus a percentage based upon sales of the records by the company. The musicianโs will bequeathed an heir a life estate in the continuing payments after death. Although the contract referred to these payments as royalties, the IRS concluded they were compensation for the musicianโs services because the musician never owned the property created by his efforts. Both royalties and compensation are ordinary income to the heirs. However, in this case, if the payments were determined to be compensation, they would be for personal services performed by the musician and thus would be income in respect of a decedent (IRD). If they were determined to be royalties and attributable to the period after the musicianโs death, they would not be IRD.
Whenever an heir receives payments as a result of the decedentโs personal efforts, the original contract determines whether the payments are compensation to the artist or payments for the use of the artistโs property. In either case, the income (royalties or compensation) received by the decedentโs estate or heirs is IRD if the income was owed to the decedent at the date of death. The character of the income to the person receiving IRD is the same as in the hands of the decedent had he or she lived to receive the payment.54 IRD refers to amounts to which the decedent was entitled as gross income but that were not properly includible in computing the decedentโs final income tax return because they were not received as of the date of death. Because individuals are typically cash-basis taxpayers, IRD includes accrued income at the time of death. Regs. Sec. 1.691(a)-2 provides that IRD is included in gross income for the tax year when received by either the decedentโs estate or the person who by the decedentโs death acquires the right to receive the amount.
In summary, royalty payments received by a decedentโs heirs have the same tax treatment that the decedent would have reported had the payments been received prior to death and, in most cases, are ordinary income to the heirs. In general, if the intellectual property owned by the decedent passes to his or her heirs, the property is subject to the step-up-in-basis rules,55 but these rules do not apply to the right to receive IRD. However, the property right is included in the estate for estate tax purposes at its FMV.56 This incidence of double taxation is lessened by an income tax deduction of the estate tax attributable to the right to receive the IRD.57
Charitable Donations of Intellectual Property
If a taxpayer makes a charitable contribution of intellectual property, the taxpayerโs initial deduction is limited to the lesser of the taxpayerโs basis in the contributed property or its FMV.58 Because creatorsโ basis in the property they create is generally low, their deduction is typically relatively small. Under Sec. 170(m), the taxpayer may be entitled to additional deductions in the year of the contribution or later years, based upon a percentage of the income the donee organization receives from the property during a defined period. To take advantage of this additional deduction, the donor must inform the charity of this treatment at the time of the contribution, and additional reporting requirements are imposed on the charity.59 Furthermore, if during the creatorโs lifetime the intellectual property is given to a relative, the transferee will also receive a relatively low charitable deduction upon a later donation of the property because of the carryover basis for gifted property.60
As with all charitable donations, it is necessary to determine whether the donor of intellectual property receives a return benefit, which would affect the allowable charitable deduction. If the taxpayer receives a benefit in return for the donation, the charitable deduction must be reduced by the FMV of the benefit received.61 For example, a charitable organizationโs promise to not sell or license a patent for a period may be consideration to the taxpayer if the taxpayer benefits while others are prevented from purchasing or licensing the patent.
In the case of a sale of intellectual property, determining whether all substantial property rights have been transferred is also important for charitable donations of such property.62 Retention of substantial rights in intellectual property precludes a donor from claiming a charitable deduction. Similarly, transfers of a partial interest in property are not deductible.63 For example, if a donation agreement states that the donor of a patent retains the right to manufacture or use any product covered by the patent, the donor has transferred a nondeductible partial interest in the property.64
The creator of intellectual property who wishes to donate royalties to a charitable organization and avoid income tax after the transfer must assign both the royalties and the source of the royalties (i.e., copyright or patent) to the donee. If the individual assigns to a charity the right to receive royalties but not the underlying property itself, the donor must include the royalty income in gross income and then deduct any royalties paid to the charity. However, a creator who no longer owns the underlying property but, rather, retains a royalty contract may assign the contract rather than the intellectual property itself to a charitable organization, as discussed below.
Assigning Income From Intellectual Property
Assigning income from intellectual property is another controversial area. As the following cases explain, the royalty contract itself is property and may be successfully assigned if certain conditions are satisfied. However, compensation for services cannot be assigned, and therefore payments received from the creatorโs personal services are taxable to the creator of the intellectual property.65
Judicial authority provides guidance to determine the circumstances in which a creator or owner of intellectual property may shift the income from the property to another person. In these cases, the income-producing property may be the creative work itself (i.e., copyright or patent) or a contract to receive income from the creative work. Because income from property is taxable to the owner of the property, it is generally necessary to transfer the income-producing property itself to shift the income.66 The crucial question regarding the assignment of royalty income is whether the assignment accomplishes a complete transfer of some interest in the property.
In Lewis, the publisher employed the taxpayer as an editor, but the taxpayer was also the author of books that he sold to the publisher in exchange for royalties.67 Because the taxpayer did not convey any interest in the royalty contract but rather directed the publisher to pay the royalties to his children, the income was taxable to him.
However, in Nelson the taxpayer successfully assigned income from a patent to his wife because he completely divested himself of any ownership interest in the royalty contract.68 Similarly, in Reece, the owner of a patentable invention sold his patent rights to a corporation in exchange for a contractual right to receive future royalty payments.69 The First Circuit viewed the royalty contract as property that the taxpayer conveyed by โabsolute assignmentโ to his wife. Because the taxpayer retained no property rights in the royalty contract after the assignment to his wife, he was not taxed on the income.
Taxpayers must take care when assigning income to related persons. For example, an inventor successfully assigned royalty income to his wife and children because, the Second Circuit concluded, the taxpayer did not have control of the company paying the royalties, despite the fact that the taxpayerโs relatives owned the majority of the companyโs stock.70 Had the taxpayer controlled the company, he would not have severed sufficient ownership of the royalty agreement to shift the income to his relatives. On the other hand, in Eckel the inventor was not able to shift royalty income because he did not part with his entire interest in the royalty contract and he and his wife controlled the assignee corporation.71 In a similar case, despite the fact that the taxpayer assigned all of his rights in license contracts from his patented inventions to his wife, he was taxable on the income because he was the president and majority shareholder of the company paying the royalties.72
The holder of intellectual property should be careful when structuring the assignment of income subsequent to a divorce. Where a divorce agreement requires a taxpayer to pay alimony and the individual transfers property to a trustee who pays income from the property to discharge the taxpayerโs alimony obligation, the income used to pay the alimony is taxable to the taxpayer, who, in turn, is entitled to a deduction for the alimony paid.
In Hopkins, royalty income used to pay alimony to the taxpayerโs former wife was taxable to the taxpayer because the alimony agreement did not address the royalties; the taxpayer could substitute cash or securities for the assignment and was merely shifting his royalty income to satisfy his alimony obligation.73 Generally, if a taxpayer sets aside and irrevocably transfers intellectual property (i.e., patent or copyright) or a royalty contract to a trust in full discharge of his or her marital obligations, then the royalty income is not taxable to the taxpayer. Further discussion of the use of alimony trusts to support a former spouse, however, is beyond the scope of this article.74
In summary, the creator of intellectual property may assign the income produced from that property to another by either transferring the intellectual property or by completely transferring the right to receive future royalty income to another taxpayer. If the assignor retains sufficient power and control over the assigned property or over receipt of the income, the assignment will not be effective. To assure that the income will be taxed to the assignee, the assignor should retain no (or minimal) incidents of ownership in the property, including controlling the payment of the income. Interfamily assignments as well as transfers to controlled corporations may receive more scrutiny, so family members and their advisers should pay particular attention to structuring the assignment according to the guidelines in this article.
Other Issues for Intellectual Property
Foreign Income Exclusion and Retirement Plans
Individuals living abroad also are affected by the proper characterization of the income from intellectual property. Again, the IRS looks to the terms of a contract to determine whether amounts paid to the creator of intellectual property are earnings from providing personal services rather than income from the sale of property.75 In Tobey, the IRS argued that income from the sale of paintings by an artist who was a U.S. citizen living in Switzerland was income from the sale of personal property rather than earned income, thus denying the artistโs foreign earned income exclusion under Sec. 911.76 However, the Tax Court concluded that if the taxpayerโs personal efforts result in the creation of personal property, the gain from the sale of that property should be categorized as earned income. According to the court, โ[T]he legislative history of the definition of โearned incomeโ clearly indicates that the distinction between โearned incomeโ and other types of income is essentially the distinction between income derived from the taxpayerโs personal expenditure of time, energy, and skill, and income derived from the use of his property.โ77 In another case dealing with the sourcing of income for foreign taxation purposes, payments to a singer were held to be for services performed in making records rather than sales of the music because the singer had no property right or interest in the recordings, which were created for the recording company, according to the terms of the contract.78
Sec. 401(c) provides that earned income โincludes gains (other than any gain . . . from the sale or exchange of a capital asset) and net earnings derived from the sale or other disposition of, the transfer of any interest in, or the licensing of the use of property . . . by an individual whose personal efforts created such property.โ79 Thus, both royalties and income from the sale of intellectual property by an individual who is in the business of creating the intellectual property are considered earned income for purposes of tax-favored retirement plans.80
Intellectual Property at Death
An individual creator who owns rights to intellectual property at the time of death may be subject to an estate tax on the property. Two significant federal tax issues faced by these individuals are how much the intellectual property is worth and, if the creator licensed the property before death, how the royalty payments are treated after death. As with other property owned by the decedent at the time of death, intellectual property must be valued at its FMV.81 It is important to note that works of art and their copyrights are treated as separate properties for gift and estate tax purposes.82 Valuation of intellectual property typically is based upon estimated earnings from the property.83 The valuation of patents must take into account whether the patented technology has been made obsolete, any restrictions on the doneeโs use of the property, and the length of the remaining patent.84 Similar issues must be addressed for the valuation of copyrights and other intellectual property.
Intellectual property may make up a significant amount of a decedentโs estate. As a result, individuals are encouraged to seek the advice of an estate tax practitioner, not only to reduce their federal taxes but to make sure gifts and other transfers of the property are properly structured for the heirs. The valuation of intellectual property for transfer tax purposes can be especially difficult, and a detailed discussion of the issue is beyond the scope of this article. Taxpayers are encouraged to consult with their tax adviser and seek the services of a qualified valuation professional.
Planning Opportunities
The value of intellectual property is a function of the legal rights the property conveys. Because most individuals, as well as their tax advisers, are not well-versed in this complex area of the law, they should seek competent legal counsel. The cost of legal mistakes may be much greater than the professionalโs fee. Properly structuring the arrangement initially and understanding its consequences may alleviate later problems. As discussed in this article, the recognition of income and deductions related to intellectual property depends on factors including the terms of the legal agreement, ownership of the property created, whether ownership is transferred properly, and the nature of the taxpayerโs activities when the property was created.
In general, when a creator receives payments pursuant to a contract, the terms of that contract determine whether the income is for services provided or the right to use the property, and that determination generally looks to who owns the intellectual property. Consequently, when creators of intellectual property are structuring contracts, they should take care to address who owns the resultant property. Because intellectual property often takes years to produce income, creators seeking to deduct their early-year losses should be reminded that the characterization of the creative activity as a business or hobby depends on the creatorโs circumstances at the time the property is created. Individuals should be advised to consult the IRS criteria for this determination, carry on their activities in a businesslike manner, and maintain adequate records to establish the nature of an activity as a trade or business, if applicable.
Effective 2013, certain individuals may be subject to a 3.8% tax on unearned income or net investment income.85 The proper characterization of earned versus investment income from intellectual property may thus significantly affect tax liability. For purposes of this new tax on net investment income, royalty income is considered investment income, while payments to the creator of intellectual property for personal services are earned income.86 Gains or other payments from the transfer of the intangible property may or may not be investment income. The material discussed here will be useful to taxpayers and their advisers as they navigate the rules of the net investment income tax.
Individuals seeking to sell or donate intellectual property must ensure that they have transferred all substantial property rights. This will assure that they have transferred ownership of the property and will affect the tax treatment of income recognized by the transferor. In general, all substantial property rights are considered transferred if the creator no longer has control over how the property is used for generating income. Tax advisers should be aware that the royalty contract is property (separate from the intellectual property itself) that the individual must transfer to successfully assign the royalty income.
With respect to assignment of income from intellectual property, arrangements should be structured such that the assignor retains no (or minimal) incidents of ownership over the property, including controlling the payment of the income. As discussed previously, a charitable contribution deduction for a donation of intellectual property is generally limited to the lesser of the holderโs basis or FMV of the property. As a result, tax advisers should plan for a transfer of the property that may yield a more favorable tax benefit.
In the case of a transfer of a patent, the buyer/licensee may receive more favorable treatment if the transaction is treated as a license rather than a sale because the royalty payments are generally deductible. However, for a sale, the buyer must capitalize the payments. The seller/licensor may receive more favorable tax treatment if the transfer is treated as a sale rather than a license. Sale proceeds will result in capital gain (or loss), while royalty payments are reported as ordinary income.
A legal advice memorandum recently issued by IRS field attorneys cautions taxpayers that the treatment of a sale or license must be consistent between the parties to the agreement.87 Taxpayers negotiating transfers should ensure that each party agrees that it intends to treat the transaction as a sale or license and that the tax effects are considered in determining the proper price. Taxpayers and their advisers should review existing agreements to determine whether the tax treatment is proper and consistent with that of the other parties to the agreement.
If the creator licensed a work prior to death, the royalties due at death are IRD, but royalties earned after death are not IRD. There is no basis step-up for IRD, and the person receiving the income will have the same type of income the decedent would have recognized had he or she received the income.88 On the other hand, inherited intellectual property has a stepped-up basis under Sec. 1014(a). Therefore, holders of intellectual property should structure their agreements to take advantage of the basis step-up rules where possible.
For wealth transfer tax purposes, it is usually better to make a lifetime gift than a transfer at death. A gift freezes the value of the property for transfer tax purposes. However, the creator of a copyrighted or patented work normally has a nominal basis in the property. Additionally, the person receiving a gift of a copyright from the creator will generally have the creatorโs lower basis in the property, and the gain on a subsequent sale will generate ordinary income rather than capital gain.89 The gain on sale will be reduced or eliminated if the estate or the beneficiaries sell the property rather than the creator. The beneficiaries will also have a higher basis for later sale.90
Thus, the relative tax advantages of dying with the intellectual property, as opposed to making a lifetime gift, should be addressed. With respect to property bequeathed, tax advisers should closely examine the contract to understand the substance of the transaction and determine the character of the income to the heirs. The labels used in the contract (e.g., royalty, compensation, or sale) are not determinative. Finally, because of the potentially significant value and complexity of intellectual property, creators are encouraged to seek the advice of an estate tax practitioner to ensure that gifts and bequests are structured properly for transfer tax purposes.
Conclusion
The tax law for intellectual property involves a maze of general principles and specific provisions. Understanding and applying these rules can be a daunting task for individuals and their tax advisers. As intellectual property replaces tangible property as the driver of economic wealth, it is crucial that tax practitioners become more familiar with intellectual property laws. The federal income tax rules for intellectual property discussed here are intended to provide a useful reference for practitioners dealing with this type of property, as well as a foundation for further research.
Footnotes
1 Jones, T.C. Memo. 1998-354; cf. Chief Counsel Advice 200305007 (1/10/12).
2 IRS Letter Ruling 8137103 (6/18/81).
3 Groetzinger, 480 U.S. 23 (1987); Higgins, 312 U.S. 212 (1941).
4 Regs. Sec. 1.1402(a)-1(c).
5 Rev. Rul. 55-385, 1955-1 C.B. 100; Rev. Rul. 68-498, 1968-2 C.B. 377.
6 Langford, T.C. Memo. 1988-300.
7 Rev. Rul. 68-498,1968-2 C.B. 377; Dacey, T.C. Memo. 1992-187.
8 Holbrook, 194 F. Supp. 252 (D. Or. 1961).
9 IRS Letter Ruling 9725037 (6/20/97).
10 Boulez, 83 T.C 584 (1984).
11 Individuals may receive royalty income from the extraction of natural resources. This income may be subject to self-employment tax if the individual was engaged in the related business. Because this article focuses on intellectual property, the income from mineral rights and natural resources is not discussed.
12 Field Service Advice 1302 (6/13/94); Schwartz, T.C. Memo. 1987-381.
13 Further discussion of the treatment of the capital asset by the publishing company is beyond the scope of this article. However, see Regs. Sec. 1.263(a)-4(c)(3) for intangibles acquired from employees where the payments may be deducted in the amount that was included in the employeeโs compensation. See also Sec. 174 regarding research and experimentation expenses for rules allowing deduction or amortization of intellectual property in certain cases.
14 Rev. Rul. 2004-46, 2004-20 I.R.B. 915. If the agent is a corporation, no Form 1099-MISC is required; however, the agent must file Form 1099-MISC for the payments to the author.
15 Id.
16 Sec. 263A(h). This exemption from the capitalization rules does not apply to corporate taxpayers.
17 Sec. 263(a); Regs. Sec. 1.263(a)-4; and Sec. 174(a).
18 Sec. 183(d). For more on determining whether an activity is a hobby, see Gard, โNine Factors That Determine Whether an Activity Is a Hobby,โ 44 The Tax Adviser 480 (July 2013).
19 Churchman, 68 T.C. 696 (1977); cf. Vitale, T.C. Memo. 1999-131, affโd 217 F.3d 843 (4th Cir. 2000).
20 Even if the taxpayer proves the requisite profit motive, expenses related to maintaining a home office or studio may be limited by Sec. 280A.
21 See, e.g. (in addition to cases in note 19), Calarco, T.C. Summ. 2004-94; cf. Grommers, T.C. Memo. 1992-343, and Wesley, T.C. Memo. 2007-78.
22 Flint v. Stone Tracy Co., 220 U.S. 107 (1911).
23 Groetzinger, 480 U.S. 23 (1987); Rev. Rul. 58-112, 1958-1 C.B. 323.
24 Rev. Rul. 91-19, 1991-1 C.B. 186.
25 IRS Publication 533, Self-Employment Tax, p. 5 (2004).
26 Regs. Sec. 1.1402(a)-1(c); Walker, 202 F.3d 1290 (10th Cir. 2000).
27 Rev. Rul. 57-127, 1957-1 C.B. 275.
28 Rev. Rul. 58-353, 1958-2 C.B. 408; Rev. Rul. 60-226, 1960-1 C.B. 26.
29 Cory, 230 F.2d 941 (2d Cir. 1956).
30 Hopkinson, 126 F.2d 406 (2d Cir. 1942); TeLinde, 18 T.C. 91 (1952).
31 Waterman v. Mackenzie, 138 U.S. 252 (1891).
32 E.g., Myers, 6 T.C. 258 (1946); Federal Laboratories, Inc., 8 T.C. 1150 (1947); Kimble Glass Co., 9 T.C. 183 (1947); and Cleveland Graphite Bronze Co., 10 T.C. 974 (1948).
33 Mitchell v. Hawley, 83 U.S. 544 (1873).
34 Rev. Rul. 60-226, 1960-1 C.B. 26.
35 Secs. 1221(a)(3)(A) and (b)(3).
36 Sec. 1221(a)(3)(C); Regs. Sec. 1.1221-1(c).
37 Regs. Sec. 1.1221-3(b).
38 FAA 20131201F (3/22/13). The transfer of a patent in this advice was between related parties; thus, pursuant to Sec. 1235(d), the seller recognized a short-term capital gain rather than long-term capital gain.
39 Regs. Sec. 1.263(a)-4(c)(1)(vii) and Sec. 167(f)(2).
40 Myers, 6 T.C. 258 (1946).
41 Du Pont & Co., 288 F.2d 904 (Ct. Cl. 1961); see also Waterman v. Mackenzie, 138 U.S. 252 (1891).
42 Sec. 1235(a).
43 General Counsel Memo. 32920 (10/8/64).
44 Sec. 1235(b)(2). This section applies only to individual taxpayers.
45 Regs. Sec. 1.1235-2(e).
46 Regs. Secs. 1.1235-2(b)(1)(i)โ(iii).
47 Regs. Sec. 1.1235-2(b)(1)(iv). The regulations provide other examples of rights that may or may not be substantial, depending upon the particular circumstances of the transfer.
48 Sec. 2033; Regs. Sec. 20.2031-1; and Regs. Sec. 20.2031-9.
49 Secs. 102(a) and 1014(a).
50 Secs. 1221(a)(3) and 1014(a).
51 Sec. 1221(a)(3)(C).
52 Blum, 11 T.C. 101 (1948), affโd 183 F.2d 281 (3d Cir. 1950).
53 GCM 37838 (2/1/79).
54 Sec. 691(a); Regs. Sec. 1.691(a)-3(a); and GCM 37838.
55 Sec. 1014(a)(1).
56 Sec. 1014(c).
57 Sec. 691(c).
58 Sec. 170(e)(1)(B)(iii). This is true regardless of the type of intangible property, including copyrights, patents, and trademarks.
59 Sec. 170(m)(8)(B); Sec. 6050L(b); and Regs. Sec. 1.6050L-2.
60 Secs. 170(e)(1)(B)(iii) and 1015(a).
61 Regs. Sec. 1.170A-1(h).
62 See also โSale or Exchange of Intellectual Propertyโ on p. 817.
63 Sec. 170(f)(3); Notice 2004-7, 2004-3 I.R.B. 310; and Rev. Rul. 2003-28, 2003-1 C.B. 594.
64 Rev. Rul. 2003-28, 2003-1 C.B. 594.
65 Lucas v. Earl, 281 U.S. 111 (1930).
66 Id.; Helvering v. Horst, 311 U.S. 112 (1940).
67 Lewis v. Rothensies, 61 F. Supp. 862 (E.D. Pa. 1944).
68 Nelson v. Ferguson, 56 F.2d 121 (3d Cir. 1932).
69 Reece, 233 F.2d 30 (1st Cir. 1956).
70 Heim v. Fitzpatrick, 262 F.2d 887 (2d Cir. 1959).
71 Eckel, T.C. Memo. 1974-33.
72 Sunnen, 333 U.S. 591 (1948).
73 Hopkins, 15 T.C. 160 (1950).
74 For further discussion of alimony trusts, see Helvering v. Fuller, 310 U.S. 69 (1940); Douglas v. Willcuts, 296 U.S. 1 (1935); Helvering v. Leonard, 310 U.S. 80 (1940); Tuttle, 89 F.2d 112 (6th Cir. 1937); and Nicolai, 126 F.2d 927 (9th Cir. 1942).
75 See Rev. Rul. 71-182, 1971-1 C.B. 214, later revoked by Rev. Rul. 79-85, 1979-1 C.B. 246.
76 Tobey, 60 T.C. 227 (1973).
77 The IRS later acquiesced to the Tobey decision in Rev. Rul. 79-85, 1979-1 C.B. 246.
78 Ingram v. Bowers, 57 F.2d 65 (2d Cir. 1932).
79 Sec. 401(c)(2)(C).
80 Because this article focuses on individual taxpayers rather than business entities, some topics that are more likely to be relevant to corporations, such as armโs-length pricing of intellectual property for cross-border use and other multijurisdictional issues, are beyond its scope.
81 Sec. 2031(a).
82 Sec. 2055(e)(4); Regs. Sec. 25.2522(c)-3(c)(1)(ii). The copyright is a separate interest from the work itself and unless transferred is generally owned by the creator of the work, even if the work is sold or given away. See Secs. 2055(e)(4) and 2522(c)(3) for treatment of the separate assets for estate and gift tax deductions.
83 See St. Louis Screw Co., 2 B.T.A. 649 (1925); Estate of Andrews, 850 F. Supp. 1279 (E.D. Va. 1994); and Regs. Sec. 20.2031-1.
84 Notice 2004-7, 2004-3 I.R.B. 210.
85 Sec. 1411.
86 Sec. 1411(c)(1)(i).
87 FAA 20131201F (3/22/13).
88 Secs. 1014(c) and 691(a)(3).
89 Secs. 1221(a)(3)(C) and 1015(a).
90 Sec. 1014(a).
| EditorNotes | |
| Claudia Kelley is a professor and Tamara Kowalczyk is an associate professor in the Walker College of Business at Appalachian State University in Boone, N.C. For more information on this article, contact Prof. Kelley at kelleycl@appstate.edu. |
