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Determining the tax treatment of profits from domain name sales.

The astounding growth of the Internet has led to a dramatic increase in the demand for domain names, giving rise to a vibrant market for the purchase and sale of such names, often at hefty prices. For example, "" was acquired by eCompanies, LLC, in 1999 for $7.5 million, and in July 2007, R.H. Donnelley Corp. purchased the domain name for $345 million. For $3 million, Bank of America acquired the highly pursued "" at an electronic auction held in January 2000. Finally, "" sold for $12.5 million (Steven Levey, "Sticking to the Business: Jake Winebaum Rode the Boom and Weathered the Bust. Now He's Focusing on Work--Dot-com Style," Newsweek, October 16, 2006, and Brian Deagon, "Domain Name Game Still Going Strong; Tad Less Secretive," Investor's Business Daily, February 11, 2008).

The circumstances surrounding the acquisition, registration, and resale of domain names can vary widely. Some owners register domain names for use in their business (e.g., to establish an Internet presence, facilitate web sales of products or services, and marketing), and sell their domain names when disposing of the business, or perhaps in a separate transaction. Other domain name registrants buy large quantities of domain names and sell them at healthy markups, just as a retail business might buy and resell goods. For this group, domain names represent inventory held for future resale. American Distribution Systems, the defendant in Pinehurst, Inc. v. American Distribution Systems, Inc. [256 F. Supp.2d 424 (2003)], is representative of this latter group. American Distribution Systems, Inc. registered thousands of domain names, many of which were confusingly similar to federally registered trademarks. Ninety-five percent of its income was attributable to a combination of domain name sales and monetary settlements received from parties who had threatened trademark infringement lawsuits against the corporation but, instead, opted to resolve these disputes out of court.


Although the domain name transactions described above have been occurring for more than a decade, new legislation needed to directly address the taxation of these transactions is nonexistent. In particular, the IRS has not provided specific guidance on the taxing of income derived from the sale of domain names. As might be expected, the opinions of tax and legal professionals vary regarding the tax treatment of domain name profits.

There are numerous issues to be considered with respect to the taxation of gains from the sale of domain names. The following is an analysis of these issues within the context of relevant cases, along with the framework of existing IRS provisions.

Analyzing Income

In analyzing the taxation of income derived from the sale of a domain name, some pivotal questions need to be considered, including: Is a domain name considered "property" under the Internal Revenue Code (IRC)? If so, what type of property is it? Is it a capital asset within the meaning of IRC sections 1221 or 1231? Was the domain name sold by an entity that is in the trade or business of selling domain names, or was it sold independent of the ordinary course of trade or business? Should the sale of the domain name be treated as the sale of a capital asset, subject to the favorable capital gains rates, or as a noncapital asset subject to ordinary income tax rates?

Is a Domain Name Property?

The parts of the tax code that would apply to the sale of domain names all refer to the term "property." IRC section 1001(a), for instance, provides that the gain from the sale or other disposition of property shall be the excess of the amount realized over the adjusted basis provided in IRC section 1011, and the loss shall be the excess of the adjusted basis over the amount realized. Furthermore, Private Letter Ruling 9443005 states: "in order for either IRC section 1221 or IRC section 1231 to apply, an asset must constitute property." Court decisions express a similar position: 'The meaning of property for purposes of IRC section 1231 is the same as the meaning of property for IRC section 1221" [Hollywood Baseball Association v. Commissioner, 423 F.2d 494 (9th Cir.), cert denied, 400 U.S. 848 (1970)].

Accordingly, close scrutiny should be given to the question of whether a domain name should be considered property. The definition of property is broad, and the IRS has not provided a definition that is specific to the aforementioned IRC sections. Nevertheless, guidance can be found in federal and state court decisions, as well as in IRS guidelines.

The United States Court of Appeals for the Ninth Circuit concluded in Kremen v. Cohen (337 F.3d 1024, 2003 U.S. App. LEXIS 14830) that a domain name is property. The appellant, Gary Kremen, sought a review of the lower court's decision, which had granted summary judgment in favor of the appellee, Network Solutions, Inc. Kremen's suit was based on breach of contract, breach of third-party contract, conversion, and conversion by a bailee. Kremen had registered the domain name through Network Solutions. Subsequently, Network Solutions, due to fraudulent representation by the defendant Cohen, caused the registration of to be transferred ultimately to Cohen. A plaintiff suing under the tort of conversion must prove, among other things, "ownership or right to possession of property" [G.S. Rasmussen & Associates, Inc. v. Kalitta Flying Service, Inc. [958 F.2d 896 (9th Cir. 1992)]. The Ninth Circuit, in deciding the issue of whether conversion of the domain name had occurred, was compelled to first examine and rule on the question of whether a domain name is property. The court ruled that was intangible property of which Kremen was the rightful owner, but concluded that the conversion claim failed, given that this tort does not apply to intangible personal property.

Recognizing that the concept of property is very broad, the Ninth Circuit applied a three-part test to determine the existence of a property right. "First, there must be an interest capable of precise definition; second, it must be capable of exclusive possession or control; and third, the putative owner must have established a legitimate claim to exclusivity." According to the court:

Domain names satisfy each criterion. Like a share of corporate stock or a plot of land, a domain name is a well-defined interest. Someone who registers a domain name decides where on the Internet those who invoke that particular name--whether by typing it into their web browser, by following a hyperlink, or by other means--are sent. Ownership is exclusive in that the registrant also makes that decision. Moreover, like other forms of property, domain names are valued, bought and sold, often for millions of dollars.

The court concluded that Kremen had an intangible property right in his domain name and that Network Solutions, to the detriment of Kremen, had wrongfully transferred the domain name to Cohen.

Contrary to the decision in Kremen, the Supreme Court of Virginia in Network Solutions, Inc. v. Umbro International, Inc. [259 Va. 759, 529 S.E.2d 80 (2000)] concluded, in essence, that the domain name "" was a contractual right, rather than intellectual property. In this case, the Virginia court examined, for the very first time, the question of whether a domain name can be garnished. The court, having determined that a domain name is a contractual right, ruled that it was not subject to garnishment.

Despite Umbro, further support of the position that a domain name is intellectual property can be found in federal legislation and court decisions. Congress, in enacting the Anticybersquatting Consumer Protection Act (ACPA) in 1999, recognized as property a domain name eligible for trademark protection. In particular, the ACPA permits plaintiffs to commence an in rem civil action against the defendant-registrant of a domain name when in personam jurisdiction over a foreign defendant-registrant cannot be obtained [see 15 USC section 1125(d)(2)(A)]. In hearing domain name-related disputes, courts have, in several decisions, held that domain names are property subject to in rem jurisdiction [see Caesars World, Inc. v., 112 F. Supp. 2d 502 (E.D. Va. 2000) and Lucent Technologies, Inc. v., 95 F. Supp. 2d 528 (E.D. Va. 2000)]. The courts ruled that Congress had the authority to treat domain names as property for purposes of an in rem action, and the exercise of such action was not considered a violation of the defendants' constitutional rights.

Character of Domain Name: Capital Asset or Noncapital Asset?

Assuming a domain name is intellectual property, it must be either a capital asset or noncapital asset before determining the appropriate classification of the gain (or loss) derived upon disposition. In the absence of specific provisions in the tax code, the alternative is to rely on the applicable tax provisions for assets that are similar in material respects to a domain name. Arguably, a domain name is substantially analogous to a trademark. Using the three-part test to determine the existence of a property right in Kremen, the Ninth Circuit, which ruled a domain name is intellectual property, discussed clear parallels between the two assets. Therefore, applying the IRC provisions applicable to trademarks should be deemed reasonable.

In determining whether a trademark is a capital asset, IRC sections 1221 and 1231 can be used as guidelines. These IRC sections can also serve as bases for analyzing the asset type of a domain name. If the domain name asset satisfies the capital asset definition under IRC section 1221 or 1231, then the gain or loss upon the sale can be treated as capital in nature.

IRC section 1221 defines capital asset as "property held by the taxpayer (whether or not connected with his trade or business)" but specifically excludes the following five categories of assets: 1) stock or other property held by the taxpayer as inventory, or property held primarily for sale to customers in the ordinary course of a trade or business; 2) IRC section 167 depreciable property or real property used in the taxpayer's trade or business; 3) a copyright, literary, musical, or artistic composition, a letter or memorandum, or similar property held by a taxpayer who is also the creator; 4) accounts or notes receivable acquired in the ordinary course of trade or business; and 5) certain publications of the U.S. government.

If the sale of a domain name is incident to the ordinary course of a trade or business (i.e., represents the sale of inventory), then the domain name would be considered inventory within category 1 of the exclusions described in IRC section 1221. Consequently, income derived from its sale would be considered the disposition of a noncapital asset and be classified as ordinary income.

By contrast, if a domain name seller is not in the business of selling domain names, then the analysis is very different. Exclusions 1, 3, 4, and 5 would clearly not apply. However, would such a domain name fall within exclusion category 2, depreciable property used in a trade or business? The domain name would be a capital asset under IRC section 1221, unless it is property used in a trade or business of a character subject to allowance for depreciation under IRC section 167. IRC section 167 provides that a depreciation deduction is permitted for "a reasonable allowance for the exhaustion, wear and tear, or obsolescence of property used in a trade or business, or of property held for the production of income." Because intangible assets are amortized, rather than depreciated, does the language "property ... of a character subject to allowance for depreciation under section 167" include amortizable intangibles that may be subject to the amortization rules of IRC section 197?

The IRS has answered this question in the affirmative. Treasury Regulations section 1.197-2(g)(8) states: "An amortizable section 197 intangible is treated as property of a character subject to the allowance for depreciation under section 167. Thus, for example, an amortizable section 197 intangible is not a capital asset for purposes of section 1221." All hope for capital gains treatment is not lost, however, because Treasury Regulations section 1.197-2(g)(8) goes on to state that if the intangible is "used in a trade or business and held for more than one year, gain or loss on its disposition generally qualifies as section 1231 gain or loss."

Under IRC section 1231, "property used in a trade or business" is defined as "of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year" that is not any of the following: 1) property of a kind includable in the inventory of the taxpayer; 2) property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business; 3) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by the taxpayer described in section 1221 (a)(3); or 4) certain publications of the U.S. government. A domain name that is an amortizable intangible would be included within the IRC section 1231 definition of a capital asset, as long as the domain name is not inventory in the hands of the taxpayer.

Whether a domain name is deemed an amortizable intangible or not, it is still considered a capital asset, if not under section 1221 then under section 1231. Under either scenario, the gain or loss inherent in the transfer of the contract will be a capital gain, rather than ordinary income, provided the requisite one-year holding period is satisfied.

For example, consider a "contractual right," as the Virginia Supreme Court stated in Umbro. Would the domain name be a capital asset or a noncapital asset? A key question would be whether contractual rights are amortizable intangibles. According to the revised IRC section 167, in order to be amortizable, an asset must have a limited useful life. The contractual rights between a domain name owner and the registrar would be subject to perpetual and infinite renewal periods, therefore making the useful life indeterminable. Accordingly, the domain name would not be an amortizable intangible, which means that it would fall within the IRC section 1221 definition of capital asset, but fail the IRC section 1231 definition of capital asset. [Note that courts have ruled that contractual rights are capital assets. In Foy v. Comm'r, 84 T.C. 50 (1985), the Tax Court ruled that a contractual right was a capital asset and that its sale resulted in capital gain.]

Ordinary Income versus Capital Gains: Lottery Winnings Cases

It should be noted that the issue of ordinary income versus capital gains classification has been a long-standing source of contention between the IRS and taxpayers, and the courts have examined the issue on numerous occasions [see Hort v. Comm'r, 313 U.S. 28 (1941); Comm'r v. P.G. Lake, Inc., 356 U.S. 260 (1958); and Arkansas Best Corp. v. Comm'r, 485 U.S. 212 (1988)]. In more recent years, the courts have ruled on whether proceeds received in exchange for the sale of the rights to future installments of lottery winnings should be treated as ordinary income or capital gains [see Lattera v. Comm'r, 437 F.3d 399 (3d Cir. 2006) and United States v. Maginnis, 356 F.3d 1179 (9th Cir. 2004)].

A typical fact pattern in these cases involved taxpayers claiming and reporting as ordinary income on their personal income tax return the installments of lottery winnings they had received, yet, after lattery winnings they had received, yet, after later selling the rights to this same stream of future income for a lump sum amount, taking the position that the lump sum proceeds should be treated as capital gains. The courts have consistently viewed this position as a faulty attempt to characterize as capital gains that which, in substance, is ordinary income. According to the courts, the substance of the income remains unchanged. There should be no difference in the classification of the income, whether it is received in annual installments or in a lump sum. This rationale is the essence of the "substitute-for-ordinary-income doctrine," which the courts rely upon in concluding that lottery winnings and the sale of rights to future installments of the same constitute ordinary income. The doctrine states that "lump sum consideration [that] seems essentially a substitute for what would otherwise be received at a future time as ordinary income may not be taxed as a capital gain" (see P.G. Lake, Inc., cited by Maginnis).

The courts' analyses in these lottery winnings cases shed light on the task of classifying assets as capital or noncapital and, consequently, determining the appropriate tax treatment of the resulting gain or loss resulting from their sale. In Maginnis, the court considered the following two factors critical to the determination, although it added the caveat that those factors "are not dispositive in all cases":1) whether the taxpayer made "any underlying investment of capital in return for the receipt of his lottery right"; and 2) whether the sale of the taxpayer's lottery right reflected an increase or growth "in value over [an] underlying asset the taxpayer held." The court ruled that "capital gains treatment is not appropriate [with respect to the lump sum lottery proceeds] ... because no asset appreciated." Noting that the taxpayer "made no underlying investment in exchange for a right to future payment," the court stated there had been no investment of capital which could be said to have generated or created the lottery right. The court concluded "because [the taxpayer] made no capital investment before winning the lottery, the assignment of the lottery right is better understood as the pure assignment of a gambling winning, rather than as the assignment of a capital asset, the sale of which could create a capital gain." The Ninth Circuit Court of Appeals affirmed the district court's decision.

The two-factor test of Maginnis, when applied to domain name cases, strengthens the position that domain names are capital assets, to which capital gains or loss treatment should apply. Domain names would generally meet the "invested capital" prong of the test. Typically, domain name owners invest capital to acquire their domain names, sometimes significant amounts to acquire well-known or commercially promising names. Thus, the $7.5 million paid by eCompanies LLC to acquire represents capital invested. As mentioned ear the difference represents appreciation in value, as determined by competing buyers in the marketplace. This latter point leads to the second prong of the Maginms two-factor test: value appreciation. Relying on an earlier decision in Gillette [Comm r v. Gillette Motor Transport, Inc., 364 U.S. 130,134,4 L.Ed.2d 1617, 80 S.Ct. 1497 (I960)], the Maginnis court theorized that "realization of appreciation in value accrued over a substantial period of time . is typically necessary for capital gains treatment." The market for domain name purchases and sales offers indisputable evidence that domain names appreciate in value. Because they satisfy the two-factor test, the increase in their value should be deemed capital in nature, and the tax treatment applicable to capital gains and losses should apply to domain name sales.

The Impact of Amortization Rules on Tax Basis of Domain Name Asset

In computing the gain or loss from the sale of a capital asset, one variable is the tax basis of the domain name. Should the acquisition cost be capitalized and then amortized, or should the cost be expensed? If the former, which amortization rules should apply? How should certain costs related to marketing and website development be treated?

If domain names used in a trade or business are considered intellectual property, then the costs should be capitalized, and the amortization rules currently in place for trademarks should apply. IRC section 197 allows the straight-line method of amortization to be used for almost all intangible assets over a 15-year period. Included in the extensive list of IRC section 197 intangibles are "any franchise, trademark, or trade name" [section 197(d)(1)(F)]. The amortization rule applies to IRC section 197 intangibles that were acquired in connection with a trade or business, or in a separate transaction, but it does not apply to self-created intangibles, such as the cost of creating a customer relationship through advertising.

Both IRC sections 167 and 197 provide guidance on the amortization of intangibles. Prior to the enactment of section 197, section 167 was the source of reference for determining which intangibles were amortizable and the allowable method. IRC section 197 was added on August 10, 1993, and governs amortization of intangible property acquired after that date and, if a valid election for retroactive section 197 treatment had been filed by the taxpayer, intangible property acquired after July 25, 1991.

If the IRS, on the other hand, were to side with the Umbro court and hold that domain names are to be classified as "contractual rights," then amortization deductions will likely not be allowed. This is because contractual rights can be viewed as having indefinite renewal periods, and on that basis, IRC section 197 provides that contractual rights are not amortizable. It should be noted that although the initial domain name registration period can range from one to 10 years, the registrant has the option of renewing the registration for an infinite number of future periods.

Development, Advertising, and Marketing Costs

An ancillary issue is the costs associated with website development. These costs should not be added to the cost basis of acquiring the domain name, but should be separately addressed. Currently, there are no IRC provisions addressing website development costs; however, Revenue Procedure 2000-50 permits the application of IRC section 174--which covers research and development expenditures--to website development costs. The rationale is that website development is generally a software-driven process, and therefore analogous to software development. Revenue Procedure 2000-50 allows for the current expensing of such costs under IRC section 174 (a) or the amortization of the same over 60 or more months under IRC section 174(b). Alternatively, IRC section 167(f) provides that the costs could be amortized over 36 months. In applying these rules, a distinction must be made between in-house-developed websites and third-party-developed websites. Costs incurred for the development of a website by a third party are amortizable under IRC section 174 rules, provided the taxpayer bears the risk associated with the contractual arrangement.

Consistent with IRC section 197 expenditures for trademarks, advertising and marketing costs incurred to enhance the value of a domain name should be expensed, rather than capitalized [IRC section 197 (k), example 1].

Domain Name Legislation Is Past Due

While tax professionals await specific IRS guidance that directly addresses tax issues concerning domain names, they should rely on the framework of the IRC as it currently exists. This leaves tax experts with the task of extrapolating from code provisions governing those assets that are analogous to domain names. Significantly, more than a decade has passed since the emergence of domain names and the tax issues that accompany them. The time for Congress to introduce legislation that specifically addresses the tax treatment of domain names is long overdue.

Several courts, as well as Congress, have had to decide on legal issues concerning domain names and, in so doing, have begun to set patterns of interpretation of their legal aspects (e.g., the Kremen court deciding that a domain name is intellectual property, and Congress recognizing that a domain name is property for purposes of an in rem lawsuit). It is likely that Congress, when developing legislation tailored for domain names, will build on these judicial decisions and expand, as appropriate, the tax laws in place for intangible assets.

Maxine D. Morgan, JD, CPA, is an assistant professor of business law at the school of business at Long Island University, Brooklyn, N.Y.
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Title Annotation:e-commerce
Author:Morgan, Maxine D.
Publication:The CPA Journal
Date:Nov 1, 2008
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