The headlines for the 2017 tax reform focused on the reduction in the corporate tax rate and the new passthrough tax deduction. But the tax reform wasn’t only about decreasing taxes: it increased some tax rates. For example, certain self-generated intangible assets are now treated as ordinary assets taxed at higher ordinary tax rates. It’s creating unexpected results that our firm has seen in several businesses sales. Entrepreneurs in industries such as software, pharmaceuticals and Fintech will want to pay special attention.
What’s at stake is whether gain from the sale of intangible assets qualifies as long-term capital gain (taxed at a maximum rate of 20%) versus ordinary income (taxed at a maximum rate of 37%). The change in tax law treats many intangible assets that used to qualify for the low 20% rate as ordinary assets taxed at the higher rate. To understand the change, it’s helpful to understand the old rules.
Old Rules: Apps and Software Code as Ordinary Assets
Before the change took effect on January 1, 2018, nearly all intangible business assets qualified as capital assets. Only a relatively small category of intangible assets were treated as ordinary. Software was among the most important: even under the old rules, software was sometimes treated as ordinary.
Under old §1221(a)(3), self-created copyrights were excluded from capital assets because, so the theory went, a self-created copyright represents the product of an individual’s labor much like inventory or services. Gain from the sale of a copyright by the creator of the copyright was treated as ordinary income, just like selling inventory or services. Besides copyrights, items such as literary, musical and artistic compositions were also ordinary.
The IRS applied the rule not only to copyrights themselves, but also to property eligible for copyright protection, even if there was no copyright. Therefore, software coders seeking capital gain treatment were sometimes out of luck, even when they never applied for a copyright. For example, in one case the IRS successfully taxed a programmer’s gain on the sale of software as ordinary income. The programmer disclaimed copyright protection and deliberately did not register a copyright because he desired to keep the source code a secret. Nevertheless, the Tax Court held that, because the program was eligible for copyright protection, the source code fell under the rule governing copyrights. Since it was also sold by the creator of the source code, the gain on the sale of the program was taxed as ordinary income.
App Example: George creates a new App that does not include any open source code. A year later, in December 2017, George sells the App to Google. Because the App is eligible for copyright protection and was created by George’s personal efforts, gain from the sale is taxed at ordinary income tax rates.
This rule potentially treated the sale of software businesses as generating ordinary income. After the tax reform, the rule has expanded in breadth and now covers many other types of intangible property.
Inventors, Designers and Process Creators, Beware
As of January 1, under new §1221(a)(3), patents, inventions, models or designs (whether or not patented), and secret formulas and processes that are created by a taxpayer’s “personal efforts” are all treated as ordinary. This means that essentially all self-created software will be caught by this new rule. It also applies to self-created “models” and “secret processes” that includes many start-up business assets.
Invention Example: Alice creates a secret formula for a revolutionary new sports drink in January 2017. She sells the secret formula to Coca Cola in February 2018. Because the secret formula was created by Alice’s personal efforts, following the tax reform, gain from the sale of the formula is taxed as ordinary income.
But in spite of the wider reach, the new rule has limits, each of which are discussed in greater detail below:
- First, the rule only applies to inventions created by personal efforts. Although unclear, apparently this means that assets created by a corporation qualify as capital assets. As discussed below, this important exception seems to provide yet another tax advantage for S-Corporations.
- Second, patents fall under a special rule.
- Third, it does not extend to all intangible assets or intellectual property. Goodwill, even if self-created, is not an ordinary asset.
Personal Efforts: Corporations and Businesses
What does it mean to be created by “personal efforts”? If the invention, copyright, model, or secret formula was created by a corporation or a business enterprise, involving the efforts of multiple individuals, it is not considered created by the “personal efforts” of everyone involved. The IRS has stated that when a corporation’s asset is created by multiple individuals, each of whom is paid wages at the current market rate, the asset is not considered created by “personal efforts” and therefore qualifies as a capital asset.
The scope of the rule is unclear because it’s based on old cases and rulings. For example, in this case the court mentions in passing that the producer of a motion picture does not create a film through “personal efforts” because of the group of people and capital commitment involved. Consistent with this discussion in the case, the IRS has ruled that an asset created by a group of individuals working for a corporation won’t be considered created by the “personal efforts” of any particular individual because it is created by a business enterprise. However, there is very little guidance on how big a group is necessary.
Business Example: Bob and a group of experienced engineers form an LLC and receive seed funding. The LLC hires employees and the business successfully creates new equipment and software to reduce the cost and improve the performance of internet servers. In June 2018, more than a year after the technology is created, the LLC sells all of its assets, substantially all of which consist of inventions, designs, and secret processes (but not patents). Because the assets were not created through the “personal efforts” of any particular individual, gain from the sale qualifies for long-term capital gain.
Personal Efforts: S-Corporations
Of course, if an entrepreneur owns a C-corporation and sells the stock of the C-corporation, the sale of the stock qualifies as capital gain. This new rule only affects the sale of assets, not the sale of stock.
While a C-corporation faces a potential double-tax on the sale of its assets, not so with an S-Corporation. The gain on the sale of the assets of an S-Corporation passes through to the shareholder, who pays tax on the gain at the shareholder level. Because the S-Corporation is a pass-through entity, dividends are generally tax-free and the shareholders aren’t subject to double-tax.
As long as the inventions, models or designs (whether or not patented), and secret formulas and processes owned by the S-Corporation were created by a team employed by the corporation, they shouldn’t be considered created by the “personal efforts” of the S-Corporation. Therefore, the gain from those assets should qualify for capital gain treatment.
What if the business is organized as an LLC? For tax purposes, an LLC is also a pass-through, taxed as a partnership if it has more than one member. In theory, there should not be any difference. As long as the intangible property is created by a team and a business enterprise, and all or most of the contributors are paid wages at the going rate, it shouldn’t matter if the business is organized as an LLC or an S-corporation. In both cases, the property should qualify as a capital asset because it’s not created by “personal efforts” of a particular individual.
However, because the scope of “personal efforts” is unclear, it’s arguably safer to use an S-Corporation. Unfortunately, however, once the intangible property is created by the personal efforts of an individual, the taint can’t be cured by contributing the property to an LLC or S-Corporation. That’s why it’s vital to start off with the correct structure from the beginning.
Not (Quite) All Intangible Property is the Same
Following the tax reform, the allocation of the sale price of a business to the business assets has become more important than ever. When it comes to allocations, sellers desire allocations to assets producing capital gain, while buyers want greater allocation to assets that can be depreciated or deducted over a shorter period of time.
Buyers want bigger allocations to inventory to recover their costs faster, but sellers want lower allocations because inventory does not produce capital gain. Similarly, buyers sometimes want a bigger allocation to a covenant not to compete when other assets are not depreciable or amortizable, whereas sellers want a lower allocation because a covenant generates ordinary income.
Sellers selling a business with self-created inventions or secret formulas may want to allocate greater value to goodwill and other assets producing capital gain. The buyer does not necessarily have an adverse interest because many of these types of intangible assets are amortized over fifteen years. However, particularly because the buyer and seller do not have adverse interests, the IRS can challenge an allocation if, for example, it believes that too much is allocated to goodwill.
Special Rule for Patents
In one of the more convoluted tax rules, even though new §1221(a)(3) applies to patents, the tax code continues to include a special rule for patents. Under §1235, the creator of a patent qualifies for long-term capital gain treatment on the sale of a patent. Indeed, this special rule is even more generous than the general rule for long-term capital gain because it applies regardless of the patent creator’s holding period. Therefore, even through patents no longer qualify as capital assets if created through “personal efforts”, the creator’s gain from the sale of patents still qualifies as long-term capital gain. (This is the kind of logic that only a tax lawyer could think up!)
Of course, there are a few hoops to go through to qualify for §1235, including the requirement to either sell all “substantial rights” or an undivided interest in the patent. But these requirements don’t impose any substantial constraints beyond what would be necessary to qualify for long-term capital gain, while removing the holding period requirement.
The 2017 tax reform created a sea change in the taxation of businesses, not all of which are favorable. Entrepreneurs and inventors must tread carefully when considering how to best organize their new ventures, as well as how to structure sales. Some care taken in the beginning can yield substantial tax savings at the time of sale.