Buying, selling and licensing intellectual property has become more common, and banks are beginning to appreciate the fact that IP, such as a patent, trade name or logo, is an asset of real value.
“If Coke needs money, it could traditionally get a loan based on its tangible assets or cash flow, but Coke can now also get a loan based on the value of its intangible assets, such as its trademarks — the look of the bottle and the Coca-Cola name,” says David C. Blum, partner with Levenfeld Pearlstein, LLC.
However, when buying, selling or licensing IP, businesses should be aware that there are federal and state tax considerations involved, which, depending on how it is structured, can either cost or save you money on taxes.
Smart Business spoke with Blum about how to structure an IP transaction to maximize tax benefits.
What constitutes intellectual property?
Intellectual property is a very broad category of intangible assets. These assets include some of the more commonly known intangible assets, such as patents, copyrights and trademarks.
But IP also includes other types of intangible assets, such as trade names, trade dress, trade secrets, know-how, patent applications, source code and franchise rights. These assets, however, are not all taxed the same.
What are the factors in the differences in taxation?
There are several factors. It varies depending on the type of IP (patent, know-how, trademark, copyright, etc.), whether the transaction is treated as a sale or a license, and whether the IP is sold as part of a business or individually.
Understanding the tax consequences is critical to determining if you can get favorable tax rates if you’re disposing of it or favorable deductions if you’re acquiring it. To get favorable tax treatments on an IP transaction, it’s important to understand what you have. To that end, it’s important to work with tax advisers because, depending on how you structure the transaction, you could have vastly different tax consequences.
What are the differences between selling IP and licensing it?
In a sales transaction, the seller generally sells all, or substantially all, of its rights to an asset or undivided interest therein. The seller may be able to get favorable capital gain rates.
The buyer, on the other hand, will likely be required to capitalize the acquisition cost and depreciate or amortize over a specific number of years.
In a license transaction, the licensor does not part with ‘substantially all’ rights to the asset. The licensor continues to receive income from the asset in the form of royalties, and the licensee will generally have a deduction in the amount paid.
There are parallels to real estate: Think, for example, of a building instead of a patent. The question is, did you sell a building (patent) or did you lease (license) it? You could call it a lease; you could call it a sale.
But at the end of the day, who has the right to the income? Who has the right to possess it? Who’s paying the insurance and maintenance? Who has the right to sell it in the future? Who could be sued as the owner?
How do authorities determine whether a sale or license has occurred?
You need to consider the type of IP, the facts and circumstances of the transaction, and who has the benefits and burdens of ownership. The IRS can and will recast a transaction to reflect its actual substance.
If I’m renting a shopping center, I can pay the insurance, maintenance and taxes, but ultimately, if a landlord can kick me out, then I don’t own it. I don’t have the benefits and burdens of ownership.
The U.S. Supreme Court used an analogy to a ‘bundle of sticks.’ If you hold a bundle of sticks in your hand, how many sticks have you given away and how many have you kept? Those sticks equate to your rights of ownership.
If you’ve given away sufficient ownership, you have effectively sold the IP, even though you may have documented it as a license. Thus, although the agreement is labeled a license, for federal tax purposes, it may be a sale.
But, if the parties report it as a license and the IRS takes the position that the IP was sold, the parties could have entirely different (and unexpected) tax consequences.
What tax considerations should businesses be aware of?
We’ve talked generally about federal tax issues, but there are also state and local tax issues to consider. If you are licensing IP in a jurisdiction different than your home jurisdiction, you may have income and sales tax liabilities — and filing obligations in such other jurisdiction.
On top of the federal tax issues, there are multistate and local considerations, as well, depending upon where the IP is being used, how it’s being used and who is using it. These are important considerations beyond the consequences of the federal income tax rate and deductibility of payments.
David C. Blum is a partner with Levenfeld Pearlstein, LLC. Reach him at (312) 476-7557 or firstname.lastname@example.org.