Charitable contributions of patents.

Because of strategic redirection, market capital limits and technological advancements, many corporations are reevaluating their intellectual asset investments. Some of these corporations may be holding unexploited intellectual assets, such as patents. If so, they might be able to contribute them to a Sec. 501(c)(3) public charity and take a charitable deduction for the full fair market value (FMV).

Two important factors arise in determining whether a corporation's contribution of a patent will be eligible for a FMV, Sec. 170 deduction:

* Whether the patent being donated is a capital asset for Sec. 170(e)(1) purposes; and

* Whether the corporation is donating its entire interest or an undivided portion of its entire interest in the patent.

Note: The provisions that would limit a donor's charitable contribution deduction to the donor's basis in the patent could be considered in future tax legislation later this year. Such legislation could include a retroactive effective date.

Sec. 170(e)(1) Capital Asset

Generally, if a charitable contribution is made in property other than money, the contribution would be the property's FMV at the time of the contribution. However, special rules apply to contributions of appreciated property. Sec. 170(e)(1)(A) provides that any charitable contribution of property will be reduced by the gain that would not have been long-term capital gain had the property contributed been sold by the taxpayer at its FMV (determined at the time of such contribution).

Is it a capital asset? Sec. 1221(a)(2) excludes property, used in a trade or business, of a character which is subject to depreciation under Sec. 167, from the definition of capital asset. Thus, if a patent is deemed depreciable property used in a trade or business, it would not be within the definition of a capital asset under the general rule of Sec. 1221. Regs. Sec. 1.167(a)-3 states that patents with a limited useful life are intangible assets that may be depreciable.

However, under a special rule in Sec. 170(e)(1), flush language, property used in a trade or business (as defined in Sec. 1231(b)) is a capital asset for Sec. 170(e)(1) purposes. Whether a patent falls within this definition depends on the facts and circumstances. To avoid the Sec. 170(e)(1)(A) reduction rule, the patent must be considered to be used in the taxpayer's trade or business and must have been held by the taxpayer for at least one year (so that it can be deemed a long-term capital asset).

In Smith, TC Memo 1981-219, the Tax Court held that a taxpayer was entitled to a charitable deduction for the FMV of a patent contributed to a university. The patent had been applied for more than a year before the contribution was made, but was not issued until the year of contribution. Thus, if a donor applies for a patent more than a year before the contribution, the one-year holding requirement might be deemed as met, even if the patent letter is issued less than a year before the contribution was made.

R&E expenses. When patents are created by a corporation, the costs associated with their creation are often expensed under the Sec. 174 research and experimentation (R&E) rules. However, even if self-created patent costs are expensed, the characterization of a patent as depreciable property (as part of the Sec. 1231(b) definition of property used in a trade or business) should not be affected by that fact (i.e., the character of the property does not change by the taxpayer's treatment of the expense).

In Rev. Rul. 85-186, the Service ruled that R&E expenditures previously deducted under Sec. 174 were not subject to recapture on a subsequent sale of the resulting patented and unpatented technology. Although Rev. Rul. 85-186 involved an actual property sale, there seems to be no reason to distinguish an actual property sale from a hypothetical one. Accordingly, because Sec. 170(e)(1) looks to a hypothetical sale of the contributed property in determining the gain that would not have been long-term capital gain, a reasonable conclusion is that the donor should not have to recapture Sec. 174 costs in calculating its Sec. 170 deduction.

Donation of Entire Interest?

Sec. 170(f)(3) generally denies a charitable deduction for contributions of less than the donor's entire property interest. However, a deduction would be allowed under Sec. 170(f)(3)(B)(ii) for a contribution of a partial interest if it consists of the donor's entire interest in the property (unless the property in which such partial interest exists was divided to create such interest). Also, a deduction would be allowed if the taxpayer contributes an undivided portion of its entire property interest.

In Rev. Rul. 2003-28, the IRS presented three different scenarios involving contributions of patents. In the first, a taxpayer donated a license to use a patent, but retained the right to license it to others. The Service held that this violated the Sec. 170(f)(3) partial-interest rule, because the taxpayer retained a substantial right--namely, the right to license the patent to others. It further stated that the same conclusion would be reached if any other substantial right were retained; for example, no deduction would be allowed if the taxpayer contributed a patent solely for a particular geographic area, while retaining rights to the patent in others.

In the second scenario, a taxpayer donated a patent to a university, subject to the condition that a certain university employee had to remain employed there for the patent's remaining life; otherwise, the patent would revert to the donor. The ruling stated that the likelihood that the employee would cease to be an employee of the university before the patent expired was not so remote as to be negligible. The Service held that this violated the partial interest rule, because the contribution can be defeated by the occurrence of an event that is not so remote as to be negligible.

In the third scenario, a taxpayer contributed all its interest in a patent to a university, but the university could not sell or license the patent for three years. This restriction did not result in any benefit for the taxpayer, and the patent could not revert to the taxpayer. The IRS held that this contribution qualified for a FMV deduction under Sec. 170. However, the restriction would reduce the patent's FMV at the time of contribution, resulting in a reduction of the Sec. 170 deduction.

Recent IRS Exam Activity

In recent examinations involving charitable contributions of patents, the IRS has appeared to focus primarily on the valuation of a patent as of the contribution date. Its challenges to taxpayer valuations of donated patents have focused on the patent's technical or commercial viability and the uniqueness of its design. As such, the IRS will probably look more favorably on a taxpayer's valuation report used to determine a charitable deduction if an unrelated third party corroborates or validates the patent's FMV, as stated in the report.

FROM CHRISTINE BERNSCHEIN, J.D., CPA, MBA, WASHINGTON, DC

Annette B. Smith, CPA

Partner

Washington National Tax Service

PricewaterhouseCoopers LLP 

Washington, DC