According to recent news, a provision in the recently passed “Tax Cuts and Jobs Act of 2017” affects a previously favorable tax rate for innovators with self-created intellectual property and removes those sales from being treated as capital assets.
The original version of the bill (the “House Bill”) included a provision that significantly impacted the sale of IP. The legislation that was passed by the U.S. Senate (the “Senate Bill”) did not have a similar provision. The reconciled bill, which became law on December 22, 2017, appears to take the position of the original House Bill and lowers corporate and individual tax rates.
It also removes the ability to treat certain self-created property as capital assets, raising the capital gains rate from 20% to 37%. This means that the gain from the sale of a self-created asset will be taxed at an increase of 17%.
Currently, a self-created patent, invention, model or design (patented or not), or a secret formula or process is treated as a capital asset. Any gain or loss recognized as a result of a sale or exchange is taxed at the capital gains rate – a rate far more favorable than ordinary income tax rates. Creators of musical compositions or taxpayers who hold a copyright in musical works created by personal efforts could even elect to treat that property as a capital asset. Passage of the new tax law changes all of that.
“It changes the treatment pretty dramatically for a seller who had self-created a patent or an invention, model or design,” says Jennifer O’Leary, a tax attorney at Pepper Hamilton. “It changes a lot of deal structures where the seller would have been quite willing to sell assets in the past.”
According to an analysis by Lexis Nexis, the change under Section 1221 of the Internal Revenue Code results in the exclusion of certain patents, designs and secret formulas or processes from the definition of “capital asset.”
Interested taxpayers have been advised to take action by the end of the year if they hold rights to a self-created piece of intellectual property or are looking to monetize the asset in the near future, since the sale of self-created assets will no longer receive capital asset treatment. Sale of any self-created IP after January 1, 2018 may be subject to the 37% tax rate, rather than the prior tax rate of 20%.
“To adjust to the new provision, sellers likely will want to ask for a great purchase price to net the same amount of after-tax dollars,” says Brian Newman, certified public accountant and tax partner at CohnReznick LLP.
Also worth noting is the fact that while corporations do not benefit from reduced capital gains rates, trusts do. Therefore, depending on the tax status of their owners, income flowing through transparent entities (which include S corporations, LLCs, LPs and other partnership type vehicles) may also benefit from reduced capital gains rates if they take action now.