New Tax Law Adversely Affects Inventors

January 26, 2018

Like you, we are reviewing the new tax legislation (P.L. 115-97), commonly called the Tax Cuts and Jobs Growth Act. The act was signed into law by President Trump on December 22, 2017 and most of its provisions are generally effective after December 31, 2017. The final tax law in its enrolled version is available online here.

A Few Observations

As we are reviewing the new law, two provisions caught our eye relating to patent inventors and certain related parties:

  1. Certain transfers of patents by inventors are still taxed at long-term capital gains rates. Since 1954, under Section 1235 of the Code, the transfer of a patent by the inventor generally has been entitled to long-term capital gains treatment, irrespective of whether the patent had been held for more than one year. The House bill had proposed to repeal Section 1235 but the repeal was not enacted in the final bill that was signed into law. Accordingly, if the patent transfer complies with the provisions of Section 1235, then it can still be eligible for long-term capital gain treatment.
  2. A sale or exchange of a patent or other invention held by its inventor that does not comply with Section 1235, however, does not get long-term capital gain treatment. Under prior law, certain patents and other inventions held by their inventors, even though not qualifying under Section 1235, could be treated as capital assets and could be eligible for long-term capital gain treatment. Prior law has been changed by excluding such patents and inventions from the definition of a capital asset and so-called “quasi-capital assets.” The results can be dramatic. Assume that the patent is sold for $100 and has a zero tax basis. The gain on the sale is the full $100. If it is taxed at long-term capital gain rates (20%) (like under the old law), the tax owed is $20. But, under the new law, if the patent does not fall within Section 1235, it is now taxed at ordinary income rates (37%) so the tax owed is $37 or a whopping 85% more in taxes due.

A Few Questions

  1. Why did the final law provide that non-Section 1235 self-created patents and other inventions are not capital assets and yet retain Section 1235 which provides that some patents (but not other inventions) are afforded long-term capital gain treatment? The answer is not clear from the conference report. Some commentators believe the provisions are in direct conflict. Our preliminary conclusion is that Section 1235 remains a narrow safe harbor granting long-term capital gain treatment for certain self-created patents but not for other self-created patents or other inventions. We will await regulatory or judicial clarification before finalizing our conclusion.
  2. Why did the final law provide that certain self-created patents and other inventions that are not compliant with Section 1235 are not capital assets or “quasi-capital assets”? The conference report does not address this directly but the inference seems to be that self-created patents and other inventions are more like services and less like capital. Of course, a self-created patent that complies with Section 1235 will get long-term capital gain treatment.
  3. Does the new tax act affect the secondary market for patents and other inventions? The short answer is “no.” The new tax act addresses, basically, the tax relationship between the inventor and the first person to whom she transfers her patent or other invention. Generally, once that transferee owns the patent or other invention, separate tax rules apply and that transferee (and subsequent transferees) may be eligible for long-term capital gain treatment.

A Few Prognostications

As a result of these changes, we expect to see several changes when the inventor later seeks to monetize her patent or other invention including:

  1. Inventors who cannot comply with Section 1235 will seek a higher purchase price for their patents to compensate them for the ordinary income tax treatment.
  2. There will be more pressure by sellers to do stock deals rather than asset deals.
  3. Keep in mind, that many buyers will be interested in doing asset deals (rather than stock deals) because, under the new tax act, capital assets, like equipment, can be expensed immediately rather than depreciated over time.
  4. Finally, there will be a greater incentive by inventors (who cannot comply with Section 1235) to keep the patent or other invention and just license it.

If you would like more information regarding the new tax legislation and how it affects inventors and other patent holders, please contact one of the attorneys below.