Sunday, September 19, 2010

Incentive to Innovate

I attended the Mass Innovation Night Wednesday  It is a pretty neat event. Neuron Robotics   is making a central control unit to use in robot applications.  Another neat start up was Isabella Products which has a picture frame with a linked e-mail address.  I really wish my mother was still around.  I would definitely have gotten her one.  I was chatting with an attorney who does a lot of start-ups and I was really surprised to find that he wasn't aware of the special tax treatment available for patents.  It's not the first time that I've run into so I thought it might be worth a blog post even though I haven't noticed any striking developments in that area.

Code Section 1235 applies to inventors and their financial backers.  It allows capital gains treatment on payments in exchange for the transfer of a patent even if the payments are over a period of time or contingent on the use of the property.  An analogy that can be used for distinguishing capital transactions from ordinary income is that of a tree and its fruit.  If you sell the tree that's a capital transaction.  If you sell the fruit that is ordinary income. This distinction and the ways that  people try to confound it are sources of much tax complexity which I will discuss from time to time. There is an assumption that when payments for property are spread over time, some portion of the payments represent compensation for the time value of money (which used to amount to something).  Another principle is that things that you create yourself are not capital assets in  your hand.

Code Section 1235 suspends both these principles when it comes to compensating inventors.  Payments that qualify under 1235 are 100% capital gain even though long deferred and the relief is targeted to the creators.  The requirements for 1235 treatment are that the taxpayer be a "holder", which is either the inventor or someone who acquired all rights from the inventor before the invention is reduced to practice.  The inventor can transfer rights even before patents are issued and still qualify for capital gains treatment.  In one case the courts allowed 1235 treatment for the sale of patentable designs even though no patents were ultimately applied for.

In order to qualify for the treatment the sale must be of all substantial rights in the patent or an undivided interest in all the substantial rights.  This might create a significant business issue, since a sale that is restricted to a particular industry or geographic area will not qualify.  I think it is possible that 1235 is not thought about a lot, because the end game of a lot of start ups is the creation of a public company or being taken over by one.  I think this is what accounts for the strange popularity of C corporations.  Nonetheless, it can be a great benefit in the right circumstances and should not be neglected.


  1. Thanks for the blog... Can shareholders of a S corp that was sold through an asset sale transaction qualify for the section 1235 treatment? I couldn't find any definitive rulings on this. Thanks for comments in advance!!!

  2. I've been troubled by that question also. Here is the best I could find:

    IRC § 1235 by its terms applies to patent dispositions by individuals but not by corporations. See IRC § 1235(b), which defines “holder” to include only certain individuals. Although the rule in IRC § 1363(b) states that an S corporation should compute its taxable income as an individual, IRC § 1235 perhaps does not apply to the S corporation. But see Treas. Reg. § 1.1235-2(d)(2), which allows individual partners to qualify with respect to patents owned by their partnership. Thus, S shareholders may be able to qualify under IRC § 1235 with respect to patents owned by their S corporation.

    .04. Definition of “Capital Gains and Losses”

    Eustice & Kuntz: Federal Income Taxation of S Corporations (WG&L)

  3. What about the case of a patent sale by an S-Corp that is 100%owned
    by the inventor of the patent, would the S-Corp qualify as a patent

  4. I believe that there is no clear guidance on the issue. I think it is reasonable though.