The portion of a termination payment attributable to a transfer of all substantial rights in a patent may be treated as long-term capital gain and taxed at more favorable rates than ordinary income. Such favorable tax treatment can be enjoyed by members of a partnership that has received payment for transferring those patent rights.

A patent holder may treat payments from the sale or exchange of a patent as long-term capital gain under IRC 1235, which taxes such gains at a lower rate than ordinary income.

In January 2017 the IRS considered whether the individual partners in a partnership could count a portion of a termination payment under an agreement between a partnership and a company as transferring all substantial rights in a patent as long-term capital gain under § 1235.

Background

A partnership of four individuals transferred certain "Rights in Product" to a company that agreed to pay the partnership based on sales of the Product. The partnership represented that this agreement transferred all substantial rights to a patent within the meaning of § 1235. For two years, the partners reported payments received under the agreement as long-term capital gains under § 1235.

The partnership and the company later entered into a second agreement that terminated the first agreement and required the company to make a termination payment to the partnership. This second agreement allocated a portion of the termination payment as a final payment satisfying the company’s payment obligations under the first agreement.

The partners asked the IRS for a Private Letter Ruling whether they could treat this portion of the termination payment as long-term capital gain.

The Private Letter Ruling

Section 1235 of the Internal Review Code applies only to a "holder"—that is, an individual whose efforts created the property consisting of all substantial rights in a patent.

The IRS Ruling explained that although a partnership cannot be a holder, each member of a partnership who is an individual may qualify as a holder as to their share of a patent owned by the partnership.

For the termination payment to the partnership, the IRS assumed that 1) the first agreement constituted a transfer of all substantial rights in a patent; and 2) each individual partner qualified as a "holder." Accordingly, the IRS concluded that the portion of the termination payment that was allocated as a final payment for the termination of the company’s payment obligations under the first agreement qualifies as long-term capital gain under § 1235 as to each individual partner’s distributive share of income attributable to the transfer.

Strategy and Conclusion

Although IRS Private Letter Rulings do not bind the IRS and parties may not cite them as precedent, this decision illustrates the importance of properly identifying certain portions of a payment to qualify for preferential capital gain treatment under § 1235.

Further Information The Private Letter Ruling can be found here.

Originally printed in LES Insights on April 4, 2017.