Saturday, August 23, 2008

How patents fall under the IRS sphere of influence

26 U.S. Code 1235 is the part of the U.S. tax code that deals with the sale or exchange of patents, and the key word here is "patents": 26 USC 1235 - Sale or exchange of patents (a) General - A transfer (other than by gift, inheritance or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder ... ... shall be considered the sale or exchange of a capital asset held for more than 1 year, ... ... regardless of whether or not payments in the consideration of such transfer are - (1) payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred. It stipulates patents, but does not include patent applications, especially those that still have the patent pending status. There have been published accounts, and I am sure private transactions, of people selling the rights to their patent applications. Why? Despite nonsense to the contrary, patent applications can be highly useful capital assets, and not that much less a sure thing than an issued patent (i.e., while many patent applications do not become patents, many issued patents are susceptible to becoming non-patents through invalidation). Inventors, or acquirers, in the business world, can effectively use a portfolio of patent applications. They are as much a capital asset as a portfolio of patents. Indeed, the PTO Web guide to "provisional patent applications" (which are even weaker than "patent applications"), states one clear business use of a provisional patent application as a financial asset: "Enables immediate commercial promotion of the invention with greater security against having the invention stolen;" While provisional applications are a bit wishy-washy, a patent application is a serious investment, especially in terms of claims drafting costs. It is not a hobbyist-business attempt at asset creation, especially since an inventor can spend many tens of thousands of dollars to get through a few Office Actions and still not have a patent. Yet the inventor still may be able to find someone to buy the application as an asset. An inventor should be entitled to the same capital gains treatment for his or her patent application. The phrase "patent applications" isn't the same as the phrase "patents", and thus the IRS could or could not argue that 26 USC 1235 does not apply to the sale or exchange of patent applications. Frankly, I doubt they would care either way. But the law is the law, and the law currently says that the capital gains treatment only applies to "patents". Yet another example of Congress not fully thinking when drafting an IP law. I would say that Congress "obviously" did not think this through, but Congress has yet to tell me what they mean by "obvious" in the patent world (I don't care how many pretend academics you hire, 35 USC 103 is unconstitutionally vague). Does the IRS accept "patent applications" as "patents" in interpreting Section 1235, as a case where Congress intended to use a specific term, patent, in a slightly more general way to also include patent applications? A 2002 IRS Technical Advice Memorandum on Section 1235, where the IRS itself is a bit confused about this issue (see TAM-117258-02 (August 2002),, where it writes: Section 1.1235-2(a) states that the term "patent" means a patent granted under the provisions of Title 35 of the United States Code, or any foreign patent granting rights generally similar to those under a United States patent. .... So far the memo, and this paragraph, is still talking about "patents", with a very reasonable modifer that "foreign patents" are "patents" under 1235. But then the IRS writes: .... It is not necessary that the patent or patent application for the invention be in existence if the requirements of 1235 are otherwise met. Where did "patent application" come from? It is the only time the phrase is used in any definitional sense in the memo, and seems to imply that "patents" in 1235 includes "patent applications". Indeed, IRS Regulation 1.197-2(c)(7) [197 deals with amortizing goodwill and the like], at one point in time, if not still today, describes as assets excluded from Section 197 including both patents and patent applications, again implying some sort of asset equivalence for patents and patent applications. Other instances. The IRS Web page for deducting general R&D expenses (,,id=97640,00.html) states: R&D expenditures include the expenditures of obtaining a patent, such as attorney's fees expended in the making and perfecting a patent application. Again, kind of implies equal treatment of patents and applications in the IRS' eyes. Another IRS Web page also seems to suggest that patent applications fall under 1235. The Web page, "Ordinary or Capital Gain or Loss" covers capital gains in general (see As one example of when a capital asset transaction is not treated as a capital gain, the page states: Depreciable property transaction. Gain on the sale or exchange of property, including a leasehold or a patent application, that is depreciable property in the hands of the person who receives it ... is ordinary income if the transaction is either directly or indirectly between any of the following pair of entities: .... [basically, selling to an entity you mostly control]. The implication here is that if you sell the patent application to an entity that is pretty much distinct from you (like a licensing company, or a product developer, etc.), any proceeds or royalties you receive are treated as capital gains under Section 1235. Thus it seems, in light of a fair number of IRS writings, that "patent applications" are included under "patents" in Section 1235. If so, are these scattered IRS commentaries enough assurance for an inventor selling a patent application? This is why Congress needs to add language to Section 1235 along the lines of "By 'patent' in this Section, is also meant patent applications.