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Professor's receipt of royalties treated as capital gains.

In Letter Ruling (TAM) 200249002, the IRS concluded that a university professor was entitled to long-term capital-gain treatment for royalties received from his employer for rights to a patent on the professor's invention. Because treating the royalties as long-term capital gains and not as ordinary income was a significant advantage to the professor, the ruling has attracted the attention of colleges, universities and faculty members engaged in like transactions. Although other taxpayers may not rely on this ruling as precedent, the TAM suggests how the Service may rule given similar facts.


In TAM 200249002, the professor was a party to a collective-bargaining agreement with his university-employer, which was part of a state university system. Under the agreement, an invention by a university employee in the employee's field or discipline, or created with university support, was the university's property. However, the employee would share in the proceeds from the invention.

In the course of performing research, the professor developed an invention, fried a patent application and assigned the patent to the university. He then executed a royalty agreement with the university that provided for payments to him based on a percentage of the receipts derived from the invention's sale. The university treated the payments as royalties, not as salary or wages.

The IRS concluded that the payments were not compensation for services but, instead, were for the transfer of the professor's patent rights and, thus, were subject to capital-gain treatment. It relied on Sec. 1235 and case law to support its decision.

Sec. 1235

Under Sec. 1235(a), a transfer (other than by gift, inheritance or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein that includes a part of all such rights, by any holder, will be treated as the sale or exchange of a capital asset held for more than one year, regardless of whether payments in consideration of such transfer are (1) payable periodically over a period generally coterminous with the transferee's use of the patent or (2) contingent on the productivity, use or disposition of the property transferred. Sec. 1235(b) defines a "holder" for this purpose to mean (1) any individual whose efforts created such property or (2) any other individual who acquired his or her interest in exchange for consideration in money or money's worth paid to such creator before actual reduction to practice of the invention covered by the patent, if such individual is neither the employer of such creator nor related to such creator.

Regs. Sec. 1.1235-1(c)(2) provides that payments an employee receives as compensation for services rendered as an employee under an employment contract requiring the employee to transfer to the employer the rights to any of his or her inventions are not attributable to a transfer to which Sec. 1235 applies. However, it is a question of fact whether payments an employee receives from the employer (under an employment contract or otherwise) are attributable to the employee's transfer of all substantial rights to a patent (or an undivided interest therein) or are compensation for services rendered. In making this determination, Regs. Sec. 1.1235-1(c)(2) provides that consideration must be given to all the facts and circumstances of the employment relationship and whether the payments depend on the production, sale or use by, or the value of the patent to, the employer. If it is determined that the payments are attributable to the transfer of patent rights (and all other Sec. 1235 requirements are met), such payments will be treated as proceeds derived from the sale of a patent.

IRS Analysis

Because an employment relationship existed in TAM 200249002, the IRS applied the Regs. Sec. 1.1235-1(c)(2) facts-and-circumstances test. It identified several factors to support its conclusion, including (1) the employee was not "hired to invent"; (2) the employee received the royalty payments separate from his salary; (3) the employee and employer executed written agreements to assign the patent rights and to agree on the royalties; (4) royalty payments would continue beyond the employment relationship for the patent's life; (5) the royalty payments were connected to the transfer of the rights to the invention, rather than compensation for services; and (6) the payments received by the employee depended on the use or value of the licensing of the patent, which varied substantially each year. The Service did not address whether the professor qualified as the "holder" of the invention within the meaning of Sec. 1235(b).

To support these factors, the IRS relied primarily on Chilton, 40 TC 552 (1963), and McClain, 40 TC 841 (1963). In Chilton, an employee working as an engineer was required to assign any of his inventions, patent applications and patents involving aircraft engines to his employer. The employer paid Chilton a regular salary, in addition to royalties based on a percentage of the patents' values. The royalty payments would continue for the life of the patents, even beyond Chilton and his employer's employment relationship.

Chilton classified the salary as ordinary income and the royalties as gains from the sale of capital assets. The court concluded Chilton was not "hired to invent" and held that he correctly classified the royalty payments as capital gains.

In McClain, royalty payments were attributable to an employee's transfer of patent rights, and the payments were afforded capital-gain treatment under Sec. 1235. McClain worked as an engineer and, during the course of his employment, invented a new airplane windscreen for which he obtained two patents with his employer's assistance. He assigned the patents to his employer, as required by his employment contract. The employer and McClain shared the royalties received for licensing of the patents. The court ruled that McClain properly classified the royalties as gains from the sale of capital assets under Sec. 1235.


Proper characterization of a royalty payment as ordinary income or as capital gain affects both the employee filing an individual return and the employer responsible for reporting the payment to the employee and the IRS. Although TAM 200249002 may not be relied on as precedent, the ruling should provide helpful information to colleges, universities and faculty members in similar circumstances, in determining whether to classify a royalty paid to an employee for the sale or licensing of a patent on the employee's invention as a gain from the sale of a capital asset under Sec. 1235.


Annette B. Smith, CPA


Washington National Tax Service

PricewaterhouseCoopers LLP

Washington, DC
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Article Details
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Author:Smith, Annette B.
Publication:The Tax Adviser
Date:Jul 1, 2003
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