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SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III

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SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III B

Intellectual Property, Intangible Assets and Artwork Owned by the Creator

Generally

(1)  In the hands of the creator, intellectual property, intangible assets and artwork represent the type of asset that, from a tax standpoint, benefits greatly from the “step-up” in basis.  For the most part, during the lifetime of the creator, these assets have little or no basis in the hands of the creator, and the sale, exchange, disposition, licensing or other exploitation of these types of assets are considered ordinary income to the creator.  If the asset is transferred in a “carry-over” basis transaction like a gift, the tax attributes carry to the donee.  On the other hand, if the creator of the asset dies with the asset, the asset is entitled to a “step-up” in basis and the asset becomes a long-term capital gain asset in the hands of the beneficiaries.

(2)  Patents, copyrights, and trademarks are common assets, but intangible rights might also include the right of publicity, defined loosely as the right of an individual to have a monopoly on his or her own name, likeness, attributes, etc.  In the case of well-known artists, actors, and celebrities, this right of publicity can be quite valuable.  Some states, like New York, do not recognize a postmortem right to publicity, while approximately 19 states have specifically codified the postmortem right to publicity [1].  Notably, California[2] has codified the postmortem right to publicity, which lasts for a term of 70 years after the death of the personality.  Further, the California statute specifically provides that such rights are freely transferable during lifetime or at death.

(3)  As one can see, each of these intangible assets has its own peculiarities (for example, the duration of the intangible rights) that may affect its value at the date of transfer (whether during lifetime or at death) and that may affect whether the asset or particular rights can be transferred at all.

Copyrights

(1)  Under U.S. law, copyright protection extends to “original words of authorship fixed in any tangible medium of expression,” which includes: “(1) literary works; (2) musical works, including any accompanying words; (3) dramatic works, including any accompanying music; (4) pantomimes and choreographic works; (5) pictorial, graphic, and sculptural works; (6) motion pictures and other audiovisual works; (7) sound recordings; and (8) architectural works.”[3]  The courts have ruled that computer software constitutes protected literary works.[4]

(2)  Knowing the duration of an existing copyright is critical to understanding what value a copyright may have today and what value a copyright may have in the future.

(a)  For works copyrighted on or after January 1, 1978, a copyright’s duration is based upon the life of the author plus 70 years.[5]

(b)  For works copyrighted prior to January 1, 1978, a copyright’s duration was 28 years, with the author (and his or her estate) having the right to renew and extend the term for another 67 years (for a total of 95 years).[6]

(3)  For works copyrighted on or after January 1, 1978, the author (or the author’s surviving spouse or descendants if the author is deceased) has a right to terminate any transfer or assignment of copyright by the author 35 years after the transfer or assignment.[7]  These termination rights apply “in the case of any work other than a work made for hire, the exclusive or nonexclusive grant of a transfer or license of copyright or of any right under a copyright, executed by the author on or after January 1, 1978, otherwise than by will.”[8]  Because only the author has the right of termination during his or her lifetime, even if a gift is made of the copyright, the author’s continued right of termination calls into question how the copyright will be valued.

(4)  Payments to the creator of a copyright on a non-exclusive license give rise to royalty income, taxable as ordinary income.[9]  An exclusive license (use of substantially all of the seller’s rights in a given medium) is treated as a sale or exchange.  When the creator is the seller, it is deemed to be a sale of an asset that is not a capital asset,[10] so it is taxed at ordinary rates.  By contrast, if the seller is not the creator, capital asset treatment under section 1221 of the Code is available if such seller is not a dealer.[11]  Notwithstanding the foregoing, if the creator/author of the copyright, gifts the asset (carryover basis transaction), a sale or exchange by the donee is not afforded capital treatment either.[12]  A gift for estate planning purposes, therefore, may have the unintended effect of prolonging ordinary income treatment after the death of the author/creator of the copyright.

(5)  In contrast, upon the death of the author/creator who still owns the asset at death, the copyright is entitled to a “step-up” in basis to full fair market value under section 1014 of the Code and the asset is transformed into a long-term capital gain asset. Because the basis of the copyright included in the creator’s estate is no longer tied to that of the creator, the asset no longer falls within the exclusion from capital asset treatment under section 1221(a)(3) and, thus, are capital assets in the hands of the creator’s beneficiaries.  The copyright is deemed to immediately have a long-term holding period even if it is sold within 1 year after the decedent’s death.[13]

Patents

(1)  Individuals who patent qualifying inventions are granted the “right to exclude others from making, using, offering for sale, or selling”[14] such invention for a specified term.  The term for a utility or plant patent is 20 years, beginning on the earlier of the date on which the application for the patent was filed.[15]  The term for a design patent is 14 years from the date of grant.[16]

(2)  Similar to the taxation of copyrights, payments received for a transaction that is not considered a sale or exchange or payments received for a license will be considered royalty income, taxable as ordinary income.[17]

(3)  A sale or exchange of a  patent that does not qualify under section 1235 of the Code (discussed below), may qualify for capital gain treatment because the Treasury regulations specifically provide that a patent or invention are not considered “similar property”[18] to a copyright, which is excluded from capital gain treatment.  However, for the sale of a patent to qualify for capital gain treatment under section 1221 of the Code, the individual generally must be considered a non-professional inventor (otherwise the patent would be considered stock in trade or inventory in the hands of a professional inventor).  Capital gain treatment under section 1231 of the Code is possible but only if the patent is considered to have been “used in a trade or business.”[19]  Often, however, patents held by individuals will not qualify as such.  By consequence, generally, for individuals selling or exchanging a patent, the avenue for capital gain treatment is under section 1235 of the Code.

(4)  Like the tax treatment of the creator of a copyright, if the creator dies with a patent, the asset is entitled to a “step-up” in basis to full fair market value under section 1014 of the Code and the asset is transformed into a long-term capital gain asset.

(5)  Section 1235 Transactions

(a)  Section 1235 of the Code provides that a “transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year.”[20]

(b)  Only an individual may qualify as a holder, regardless of whether he or she is in the business of making inventions or in the business of buying and selling patents.[21]  Specifically, a qualified “holder” includes (i) the creator of the patent,[22] or (ii) “any other individual who has acquired his interest in such property in exchange for consideration in money or money’s worth paid to such creator prior to actual reduction to practice of the invention covered by the patent,”[23] provided that in such instance, the individual is not an employer of the creator or related to the creator.[24]  As such, a trust, estate, or corporation will not qualify as a holder under section 1235 of the Code, although a transfer to a grantor trust would not likely disqualify a subsequent sale or exchange to capital gain treatment.[25]  An entity taxable as a partnership does not qualify as a holder, but each individual in the partnership may qualify separately as such.[26]

(c)  A sale or exchange by a qualified holder to a “related person” will not qualify for capital-gain treatment under section 1235.[27]  A “related person” is generally defined by reference to section 267(b) of the Code and includes (i) the holder’s spouse, ancestors, and lineal descendants (but not siblings);[28] (ii) a fiduciary of any trust of which the holder is the grantor; (iii) any corporation, partnership, or other entity in which the holder (and other related persons) own 25% or more of the ownership interests.[29]

(d)  Because of the foregoing limitations of who can qualify as a holder and the related person limitations on who can be the transferee, many estate planning techniques involving patents are limited if capital gain treatment is to be retained.

(e)  If a qualified holder sells his or her interest in a patent under section 1235 of the Code and later dies before all payments are received, the estate and/or beneficiary of the deceased reports the payments as long-term capital gain as income in respect of a decedent.[30]

Artwork

(1)  The taxation of artwork in the hands of the artist is the same as it would be for the creator of a copyright, as discussed above.  Generally, all payments pursuant to a license and a taxable sale or exchange of the artwork give rise to ordinary income.[31]  A third-party collector or investor in the artwork might qualify for capital gain treatment or section 1231 treatment, as long as the property is not held out for sale in the ordinary course of a trade or business (inventory).[32]  Similarly, capital gain treatment is not available  to a donee of the artist because the donee’s basis is determined by reference to the artist’s basis.[33]

(2)  Artwork in the hands of a collector or investor (third-party other than the creator or a donee of the creator) is considered a collectible under the Code and would be subject to the 28% long-term capital gain tax, rather than 20%.[34]  Under the Code, a “collectible” is any work of art, rug, antique, metal, gem, stamp, coin, alcoholic beverage, or any other tangible personal property designated by the IRS as such.[35]

(3)  As with copyrights and patents, the basis of property in the hands of a person acquiring property from a deceased artist is the fair market value of the property at the date of the artist’s death or on the alternate valuation date, if so elected.[36]  The artwork in the hands of the estate or the artist’s beneficiaries becomes a capital asset, qualifying for long-term capital gain treatment.[37]

Turney P. Berry

Louisville, Kentucky


[1] See, Milton H. Greene Archives Inc. v. Marilyn Monroe LLC, No. 08-056471 (9th Cir. 8/30/12), aff’g 568 F. Supp. 2d 1152 (C.D. Cal. 2008).  A good discussion of statues, cases, and current controversies see  http:rightofpublicity.com maintained by Jonathan Faber of the Indiana University McKinney School of Law.

[2] Ca. Civ. Code § 3344.

[3] 17 U.S.C. § 102(a)(1)-(8).

[4] See, e.g., Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1243 (3rd Cir. 1983).

[5] 17 U.S.C. § 302(a).

[6] 17 U.S.C. § 304.

[7] 17 U.S.C. § 203(a).

[8] Id.

[9] § 61(a)(6).  See also Treas. Reg. § 1.61-8.  Rev. Proc. 2004-34, 2004-22 I.R.B. 964, allows certain taxpayers to defer to the next taxable year, certain payments advance royalty payments.

[10] § 1221(a)(3).  § 1221(b)(3) provides a limited exception for copyrights in musical works, pursuant to which the taxpayer may elect to have § 1221(a)(3) not apply to a sale or exchange.

[11] It could also be afforded § 1231 treatment (asset primarily held for sale to customers in the ordinary course of a trade or business).

[12] § 1221(a)(3)(C).

[13] § 1223(9).

[14] 35 U.S.C. § 154(a)(1).

[15] 35 U.S.C. § 154(a)(2).

[16] 35 U.S.C. § 173.

[17] § 61(a)(6). See also Treas. Reg. § 1.61-8.

[18] “For purposes of this subparagraph, the phrase “similar property” includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law), but does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law.”  Treas. Reg. § 1.1221-1(c)(1).

[19] § 1231(a)(3)(A)(i).  The holding period is deemed to start when the patent is reduced to practice.  Kuzmick v. Commissioner, 11 T.C. 288 (1948).

[20] § 1235(a).

[21] § 1235(a)(2) and Treas. Reg. § 1.1235-2(d)(3).

[22] § 1235(b)(1).

[23] § 1235(b)(2).

[24] § 1235(b)(2)(A)-(B).

[25] See Treas. Reg. § 1.671-2(c).  If a holder sells his or her interest in a transfer qualifying under section 1235 of the Code and later dies before all payments are received, the estate and/or beneficiary of the deceased reports the payments as long-term capital gain as income in respect of a decedent.

[26] Treas. Reg. § 1.1235-2(d)(2).  See also, Priv. Ltr. Ruls. 200135015, 200219017, 200219019, 200219020, 200219021, 200219026, 200506008, 200506009, and 200506019.

[27] § 1235(d).

[28] § 1235(d)(2)

[29] § 1235(d)(1).

[30] § 691 and Treas. Reg. § 1.691(a)(3).

[31] §§ 1221(a)(3) and 61(a)(6). § 1221(b)(3) provides a limited exception for copyrights in musical works, pursuant to which the taxpayer may elect to have § 1221(a)(3) not apply to a sale or exchange.

[32] § 1221(a)(1).

[33] §§ 1221(a)(5)(B) and 1015.

[34] § 1(h)(4).

[35] §§ 1(h)(5)(A) and 408(m)(2).

[36] § 1014(a).

[37] See §§ 1221(a)(3) and 1223(9).

Leave a reply. Please note that although this blog may be helpful in informing clients and others who have an interest in information privacy and security, it is not intended to be legal advice. The information on this blog also should not be relied upon to form an attorney-client relationship.

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