Deborah A. Geier
Professor of Law, Cleveland-Marshall College of Law, Cleveland State University
Does the sale of a patent by its creator create capital or ordinary gain? Prior to the legislation commonly referred to as the Tax Cuts and Jobs Act (TCJA) enacted in late December, we had a clear answer: long-term capital gain (with some statutory limits). The TCJA has muddied the water significantly.
Prior to the TCJA, patents were not listed in § 1221(a)(3), which has long excepted self-created copyrights and self-created literary, musical, and artistic works from the definition of “capital asset” (with an elective “exception to the exception” for musical compositions in § 1221(b)(3), thanks to the Country Music Association). In addition, transferees of such assets also hold them as ordinary assets if their basis is determined by reference to the creator’s basis. The § 1221(a)(3) exception is premised on the analogy to labor income; although property is transferred, the property was created through the personal effort of the creator. While the same can be said of self-created patents, Congress provided them favorable treatment not only by failing to include them in the § 1221(a)(3) list but also by providing additional favorable rules in § 1235.
Section 1235 provides that the transfer of all substantial rights to a patent or an undivided interest in all substantial rights (other than by gift or bequest) to an unrelated party by certain “holders” generates long-term capital gain, even if the patent was held for less than one year and even if the consideration may look like (ordinary) royalty payments because contingent on (or measured by) use of the patent. The “holders” that can benefit from these favorable rules include patent creators (whether amateurs or professional inventors), as well as buyers of a patent from the inventor before the invention covered by the patent is reduced to practice, even if the buyer is in the business of buying and selling patents and even if he holds patents for sale to customers in the ordinary course of business, so long as the buyer is not the inventor’s employer. In Pickren v. U.S., 378 F.2d 595 (5th Cir. 1967), the Fifth Circuit extended application of § 1235 to unpatented secret formulas and trade names, though the taxpayers failed to transfer all substantial rights to the property and thus were denied capital gains treatment under § 1235.
Section 3311 of the House version of the TCJA would have repealed the § 1221(b)(3) election to treat self-created musical compositions as capital assets and—more important to the current discussion—would have added the words “a patent, invention, model or design (whether or not patented), a secret formula or process” before “a copyright” in the § 1221(a)(3) exception to the definition of a capital asset. Thus, a patent held by its creator or by a taxpayer whose basis is determined by reference to the creator’s basis would be an ordinary asset. Consistent with this change, § 3312 of the House bill would have repealed § 1235.
The Senate version of the TCJA contained neither provision.
Section 13314 of the Conference Report failed to repeal the favorable § 1221(b)(3) election for composers, added the quoted language above to § 1221(a)(3) for patents and similar property, but failed to repeal § 1235. Thus, § 1221(a)(3) effectively provides that gain realized on the sale of a patent by its creator (or by a taxpayer whose basis is determined by reference to the creator’s basis) is ordinary gain. At the same time, retained § 1235 provides that such gain is long-term capital gain, so long as the seller sells all substantial rights to the patent. Both cannot be true.
As described above, § 1235 provides favorable long-term capital gain treatment even to sellers other than the inventor. Did Congress retain § 1235 to ensure capital gain treatment to sellers other than the inventor, so long as they complied with the § 1235 rules described above? If that was the intent, Congress needed to amend the definition of “holder” in § 1235(b)(1) to exclude the inventor, which it failed to do.
And why in heaven retain the § 1221(b)(3) rule permitting composers to sell their music at capital gains rates while burdening inventors with ordinary gain? Enacted in 2005 as a temporary measure but made in permanent in 2006, § 1221(b)(3) is perhaps the best example of the strength of sheer lobbying power. As mentioned above, the Country Music Association lobbied Congress heavily for this provision. The legislative history contains a single sentence: “The Congress believes it is appropriate to allow taxpayers to treat as capital gain the income from a sale or exchange of musical compositions or copyrights in musical works the taxpayer created.” But why is it “appropriate”? The sale of a song’s copyright by the composer represents a return on labor just as much as an artist’s sale of her painting, an author’s sale of her copyright to a book, or now an inventor’s sale of her patent, all of which produce ordinary gain (unless § 1235 continues to apply to the latter). What policy rationale could conceivably justify this distinction? Could it, by chance, have anything to do with the fact that Senate Finance Committee Chair Orrin Hatch is a composer? Just sayin….
In any event, add resolving the disconnect between amended § 1221(a)(3) and unamended § 1235 to the Technical Corrections Act of 2018.