This article will review the basic U.S. Federal tax considerations of intellectual property ("I.P.") taxation in the context of corporations and partnerships and examine some typical tax considerations when I.P. is held through a corporation or a partnership.
A corporation may acquire I.P. in several ways, including
receiving a contribution of I.P. from a shareholder, purchasing or licensing the use of I.P. from another person, or creating I.P. in-house. Under Code §351, a shareholder's contribution of property, such as I.P., to a corporation will be tax-free if
the transfer is solely in exchange for stock of the transferee corporation, and the transferor is in control of the transferee corporation immediately after the exchange, which for this purpose means ownership of 80% or more of the total value and 80% or more of the total voting rights with respect to the corporation's stock. In a Code §351 exchange, the transferee corporation's basis in the contributed I.P. will be the same as that of the transferor shareholder.
If the Code §351 requirements are not met, the shareholder will recognize gain, but not loss, to the extent that the value of the stock exceeds his or her adjusted basis in the I.P. Here, value of shares is closely associated with the value of the I.P. at the time of transfer. Any gain recognized by the transferor shareholder will be added to the transferee corporation's adjusted basis in the contributed I.P. Examples of circumstances in which a shareholder will recognize gain in an otherwise tax-free Code §351 exchange include a transfer where the transferor receives cash or other property in addition to the stock of the transferee corporation.
In the past, there was some doubt as to whether intangible assets, such as I.P., constituted "property" for purposes of Code §351. Though the issue has been settled in favor of the taxpayer, an issue that is not clear is whether a transfer of less than all substantial rights in the property, such as a transfer of a license to use the I.P., is a tax-free transfer under Code §351. In Revenue Ruling 69-156,1 the I.R.S. determined that the transfer by a domestic corporation of an exclusive right to import, make, use, sell, and sublicense a patent involving a chemical compound to its foreign subsidiary was not a transfer of "property" within the meaning of Code §351. It stated that tax-free treatment under Code §351 is only available when the rights transferred by the shareholder would constitute a sale, not a license, if the transfer were a taxable transfer.
In contrast, in E.I. Dupont de Nemours v. U.S.,2 the Court of Claims held that a carved-out right to a nonexclusive license would qualify for tax-free treatment under Code §351 and that there was no basis for limiting tax-free treatment under Code §351 to transfers that would constitute sales or exchanges if they were not subject to a nonrecognition provision. The I.R.S has recognized that this case has precedential value and must be strongly considered, although it has not withdrawn the ruling.3
A shareholder's receipt of stock in exchange for services does not meet the requirements of Code §351. However, if I.P. is transferred and the I.P. constitutes property for the purposes of Code §351, the transfer will be tax free under Code §351, even though the shareholder performed services to produce the property. Further, where the transferor shareholder agrees to perform services in connection with a transfer of property, the I.R.S. determined that tax-free treatment under Code §351 will be accorded if the services are "merely ancillary or subsidiary" to the transfer. These ancillary and subsidiary services could include promoting the transaction by demonstrating and explaining the use of the property, assisting in the "starting up" of the property transferred, or performing under a guarantee relating to the effective starting up.4
Under circumstances in which the shareholder must recognize gain on the I.P. transfer, the gain will be subject to the recapture rules of Code §1245 if the I.P. was amortizable. The rules of Code §§1221 and 1231 must be applied to determine whether the gain is ordinary income or capital gain.
A corporation may acquire I.P. as a separate asset or as part of a trade or business. In the case of separately acquired I.P., the corporation's basis in the I.P. generally will be the purchase price. In the case of I.P. acquired as part of a trade or business, the corporation's basis in the I.P. will depend upon whether the acquisition is an asset or stock acquisition. In the case of an asset acquisition, the purchase price must be allocated among the assets of the trade or business, including the I.P., under the rules of Code §1060.
In the case of a stock acquisition, the corporation will not receive a step-up in the basis of the underlying assets of the acquired corporation, unless it makes an election under Code §338 to treat the stock purchase as an asset purchase. The purchase price will be allocated under rules similar to the rules of Code §1060.
In the case of self-created I.P. where the corporation capitalizes the costs of developing the I.P., the corporation will have a basis in the I.P. generally equal to the capitalized costs. As discussed below, this basis may be amortized. Alternatively, if the corporation is permitted to deduct all or some of the costs incurred in developing the I.P., the corporation may have no basis or a very low basis in the I.P.
Corporations are subject to amortization rules for self-created and acquired I.P., as discussed in our article "Tax 101: Taxation of Intellectual Property - The Basics." Thus, for example, under the rules of Code §197, a corporation generally may amortize its basis in a broad list of acquired I.P. (including, patents, trademarks, trade names, trade secrets and know-how, copyrights, and computer software) if the acquired I.P. is used in a trade or business or an activity carried on for the production of income and was not separately acquired. Though corporate taxpayers have several choices in amortization methods, Code §197 requires straight-line depreciation over a 15-year period. The rules of Code §167 must be applied to determine the amortization permitted for a corporation's self-created and separately acquired I.P.
In the case of contributed I.P., one of two situations may arise:
A shareholder may contribute I.P. that was amortizable in the hands of the shareholder. A shareholder may contribute I.P. that was not amortizable in the hands of the shareholder, such as certain self-created I.P. In the former case, the transferee corporation generally steps into the place of the transferor shareholder and, thus, receives a carryover basis, which must be amortized over the remainder of the original amortization period. If gain is recognized on the transfer, the transferee corporation's basis in the I.P. will equal the transferor shareholder's basis plus the recognized gain. The amortization of the I.P. will be bifurcated: The portion of the basis corresponding to the carryover basis will continue to be amortized over the remaining original amortization period, and the portion of the basis that corresponds to the recognized gain will be amortized under a new 15-year amortization period.
In the latter case, the corporation generally will not be permitted to amortize the contributed I.P., unless the transferor recognizes of gain. In that case, the recognized gain will be treated as a purchase price, and become the transferee corporation's basis in the I.P., which may be amortized.
A corporation's disposition of I.P. may take several forms, including
a sale of I.P. to an unrelated third party, a sale of I.P. to a shareholder, or a distribution of I.P. to a shareholder. If a corporation sells amortizable I.P. to an unrelated third-party, any recognized gain attributable to the pre-sale amortization...