In this summary, we cover…
- Major changes in the US Tax Code brought about by the Tax Cuts and Jobs Act
- Specific changes governing sales of patent and self-created property as well as their effects to the technology industry
- Suggestions on how to cope with the changes regarding sales of patent and self-created property
- The Tax Cuts and Jobs Act (TCJA) took effect on January 1, 2018 and provided major changes to the US tax code after several decades, particularly on sales of patent and self-created property.
- Under the new law, self-created copyrights, literary, musical or artistic compositions are no longer considered capital assets.
- Generally, the changes may result in less favorable tax treatment self-created property. In particular, the changes may also:
- Make individuals who have self-created property not benefit from the 20% capital gains.
- Transform the way of sales and deals of property in the technology industry.
- Make LCC-type corporations not entitled to preferential capital gain rates.
- Change how technology companies allocate budget towards research and development.
- To cope with the changes, inventors or their investors may opt to transfer all substantial rights to their patents if it is viable from a business perspective. Another strategy is to sell parts of the company instead of its assets.
- Overall, companies are advised to evaluate their current assets to ensure gains in a sales transaction
With a final vote of 51-48 in the Senate, major reforms to the United States (US) tax code, entitled Tax Cuts and Jobs Act (TCJA), were passed and eventually signed into law last December 22, 2017. These reforms serve as major changes to the US tax code after several decades and have taken effect at the start of the year 2018.
Major changes[i] to the tax system, which may bring significant impacts to the technology industry, are summarized as follows: One major change involved individual and corporate income taxes. Individuals will still be classified into one of seven brackets with new rates as follows: 10%, 12%, 22%, 24%, 32%, 35% and 37%. Meanwhile, corporate tax incomes was reduced from 35% to 21%[ii]. Another change involved capping state and local tax deduction with $10,000 as the cap amount. In terms of mortgage interest, the rate has been lowered from $1 million to $750,000. A slower measure will now be used to gauge inflation and finally, multinational corporations will enjoy low tax rate of 15.5% on cash assets and 8% on non-cash assets for profits they receive from overseas.
Of particular interest to the technology industry with regards to the TCJA are the changes it brings to the sales of patents and other self-created property. But to appreciate and understand these changes, it would be better to have an understanding of the previous law governing patents and self-created property.
Under the previous law, beginning with IRC Section 1221(a), “capital assets” refer to a taxpayer’s property except for those explicitly stated otherwise. Furthermore, the following were explicitly excluded from the definition of capital assets: self-created copyrights, literary, musical or artistic compositions. Meanwhile, self-created intellectual property where characterized under capital assets because the previous law was not able to discuss it clearly[iii].
Another provision – IRC Section 1235 – permits an individual (creator or investor) to transfer all substantial rights to a patent and recognize it as a sale or exchange of a long-term capital asset; therefore, ensuring capital gain to the individual[iii]. Also, IRC Section 1231 contains the definition of “property used in a trade or business” and explicitly states that the following are excluded: copyrights, literary, musical or artistic compositions and similar property defined in IRC Section 1221(a)-(3)3.
With the implementation of TCJA, Section 3311 of the said law now includes the following items which are not considered capital in nature: “a patent, invention, model or design (whether or not patented), a secret formula or process”. This also pertains to copyrights, literary, musical or artistic compositions and other self-created property. The definition of capital assets is therefore narrowed down. Furthermore, Code Section 1231(b)-(1) is also effectively changed to follow the previous revision mentioned. To put simply, “patents, inventions, models or designs and secret formulas or processes no longer qualify as capital assets, nor do they qualify as property used in a trade or business”[iii].
Meanwhile, the provisions under IRC Section 1235 still hold but applies only to patents; in other words, it cannot be implemented for self-created non-patent property such as inventions, models or designs, or secret formulas or processes.
These changes will definitely affect stakeholders in the technology industry and the industry as a whole. Generally, this can result in tax treatment with less favorability to the nature of self-created property.
In particular, inventors may be discouraged to create self-created property or may have to find more creative ways to makes sales from their self-created property because they may not benefit from the 20% capital gains rate they were previously entitled to. For example, with the TCJA enacted, entrepreneurs and innovators who have designs made after 2017 will not be able to enjoy a low rate if they wish to start a new company or sell the technology to someone who will create their own company. However, those who wish to buy these assets may not automatically be considered for full expensing under TCJA – the buyer is required to amortize over a period of time instead of expensing immediately[v].
This effect is more applicable to individuals within the technology industry rather than on companies themselves. A good illustration is as follows: suppose an asset is bought at $200, expensed under TCJA. If it is sold for $230 the following year, only the first $200 will be considered as ordinary income and only the additional $30 would be capital. In effect, for those who wish to sell their self-created property, sellers may opt for a greater purchase price to match after-tax dollars amount.
Effects on the individual level ultimately channels through to the industry level. Given the scenario mentioned above, this may transform how the technology industry sell and make deals when it comes to patented assets[vi]. As a result of these changes in selling and dealing with patents across the technology industry, companies who previously sourced budgets from savings due to favorable IP tax treatment may now reduce budget for their research and development initiatives[vii].
The effects of TCJA is also influenced by the type of corporation structure. Technology companies under the C corporation structure may not be directly affected by the changes because the tax regime governing this type of corporation does not distinguish between ordinary and capital gain income. On the other hand, in most situations, LCC-type corporations will now be not entitled to preferential capital gain rates. Therefore, maximizing the transfer of income away from self-created property will now be critical in pass-through disposition transactions since self-created property are now governed by ordinary income tax rates instead of capital gain rates[viii].
There may also be reasons to believe that the likelihood of corporate subsidiary structures to hold intellectual property might rise[iv]. This is because the considerations under the changes may be circumvented due to treating corporate stock as a capital asset.
To adjust accordingly with the tax reforms related to self-created property and in to benefit from Section 1235, individual inventors or their investors in start-ups must consider the option of transferring “all substantial rights” to their patents and if it is justifiable from a business perspective. Another option, difficult but not impossible, include selling ownership of the company instead of its assets. Generally, technology firms are also advised to evaluate current capital gain assets across their likelihood to ensure a sales transaction[iii].
[i] Horowitz, J. (2017, December 26). 34 things you need to know about the incoming tax law. Retrieved May 12, 2018, from http://money.cnn.com/2017/12/20/news/economy/republican-tax-reform-everything-you-need-to-know/index.html
[ii] Baram, M. (2017, December 20). How The Tax Bill Will Impact Silicon Valley: Great For Big Tech, Good For Startups. Retrieved May 12, 2018, from https://www.fastcompany.com/40510564/how-the-tax-bill-will-impact-silicon-valley-great-for-big-tech-good-for-startups
[iii] McCarten, J. M. (2018, January 23). Patent Turmoil: Self-Created IP After Tax Reform. Retrieved May 16, 2018, from https://www.lexology.com/library/detail.aspx?g=9801bb76-f8fc-4c78-a4f5-2cbe6fe3b503
[iv] Andolina, J., Karelitz, D. S., & Lemaster, K. (2018, January 17). Key Provisions in the Tax Cuts and Jobs Act (the “Act”) with the potential to impact Technology and Life Science Industries. Retrieved May 16, 2018, from https://www.goodwinlaw.com/publications/2018/01/01_17_18-key-provisions-in-the-tax-cuts
[v] Kauri, V. (2017, December 22). Self-Made IP No Longer Deemed Capital Asset In New Tax Law – Law360. Retrieved May 16, 2018, from https://www.law360.com/articles/997285/self-made-ip-no-longer-deemed-capital-asset-in-new-tax-law
[vi] Balbirer, L., & Merzel, D. (2018, February 16). How the Tax Reform Act Impacts the Technology Industry. Retrieved May 12, 2018, from https://kaufmanrossin.com/blog/tax-reform-act-impacts-technology-industry/
[vii] Nayak, M. (2017, November 3). Tax Bill Would Eliminate Capital Gains Treatment for IP Sales. Retrieved May 16, 2018, from https://www.bna.com/tax-bill-eliminate-n73014471731/
[viii] Eberly, E., & DuVall, T. (2018, January 25). Tax Reform’s Impact on Tech Companies: The Good, the Bad, and the Ugly. Retrieved May 12, 2018, from https://www.ksmcpa.com/blog/tax-reform-s-impact-on-tech-companies-the-good-the-bad-and-the-ugly