Joint patent owners and LLCs: retaining capital gain treatment for a patent held in an LLC.

Three IRS letter rulings offer joint inventors reassurance they will not lose IRC section 1235's benefits (allowing long-term capital gain treatment on a subsequent transfer, rather than ordinary income treatment) if they transfer their patent rights to a limited liability company (LLC).

BACKGROUND

A patent is the grant of a property right to an inventor, issued by the U.S. Patent and Trademark Office (PTO). According to 35 USC section 154(a)(1), it is "the right to exclude others from making, using, offering for sale, or selling the invention" or "importing it into" the United States.

According to the PTO, generally, only the inventor may apply for a patent. Two or more persons who develop an invention jointly may apply as joint inventors. A patent also may be owned jointly when part of the interest in the patent is assigned.

USING LLCs

It is common to hold a joint patent in an LLC so that the patent is managed by a majority of the managing members or by some other mutually determined means.

Because of the nature of patent rights, patent owners cannot "sell" their patent, but may grant licenses to others (patentees). The patentee can exclude others from making, using, offering for sale, selling or importing the invention without the patentee's permission.

CAPITAL GAIN TREATMENT

For federal income tax purposes, the lack of a true sale or exchange generally would preclude a gain from a patent from being characterized as capital gain, even when the patent is a capital asset in the inventor's hands. However, section 1235(a) allows certain taxpayers to receive long-term capital gain treatment if "all substantial rights" or an "undivided interest" in the patent is transferred.

Section 1235's characterization provisions are limited to individuals and to individual holders whose efforts created the property. Although a partnership is not a qualified holder, Treasury regulations section 1.1235-2(d)(2) allows partners who are individuals to qualify as "holders" as to their pro rata portion of a patent owned by the partnership. Presumably, an LLC treated as a partnership under the "check the box" regulations would receive the same look-through treatment; LLC members who are individual inventors would qualify as "holders" as to their pro rata portion of a patent owned by the LLC.

FRIENDLY RULINGS

Recently, the IRS issued three letter rulings confirming that conclusion. Letter rulings 200506008, 200506009 and 200506019 each addressed situations in which multiple individuals create an invention jointly, apply for a patent as joint inventors and immediately transfer it to a new LLC. The IRS concluded that following the transfer of each individual's interest in the patent to the LLC, he or she will retain status as a "holder" for section 1235 purposes. Provided the other section 1235 requirements are met, such individual's share of any subsequent gain recognized by the LLC on a transfer of an interest in the patent will qualify as a long-term capital gain.

For more information see the Tax Clinic, edited by Annette Smith, in the July 2005 issue of The Tax Adviser.

The Tax Adviser

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