Post-Tax Reform: Obtaining Capital Gain Treatment on Sale of Patents

TCJA changes treatment on patent sales…well sort of

Dec 10, 2019
Federal tax Business tax Life sciences

Companies in the life science and biotechnology industries often own patents or patentable material with tremendous value, sometimes valued at hundreds of millions of dollars. When such a company is sold in an asset or deemed asset sale, or when the company sells these patents, the question often arises: Does the sale of the patents generate ordinary income or capital gains?

Although the answer to this question was relatively straightforward prior to the passage of the Tax Cuts and Jobs Act (TCJA) in 2017, it is no longer straightforward. The complexity arises both from the intersection of two Code provisions, one of which was amended by the TJCA, as well as from a dearth of IRS guidance on the matter.


Before the passage of the TCJA, patents generally qualified as capital assets under section 1221 and had an advantageous position relative to some other forms of intellectual property (IP), such as copyrights. Under section 1221(a)(3), copyrights were, in some cases, denied capital gain status when sold. The principle behind section 1221(a) is that someone whose occupation is the creation of intellectual property should pay ordinary income tax on its sale, similar to the way an attorney or doctor pays ordinary income tax on fee income.

Under the TCJA, section 1221(a)(3) was revised to include a "patent, invention, model or design (whether or not patented), a secret formula or process," thereby excluding that IP from capital gain treatment on sale. However, there are scenarios under which capital gain treatment is still available for these types of IP. This article explores some of those scenarios.

The TJCA and the current statutory scheme

The treatment of the sale of section 197 assets revolves around recent changes to the Code as well as statutory history extending back more than half a century.  

Section 1221 is the principal code provision that determines what property is treated as a capital asset for income tax purposes. It defines capital assets to include all property held by a taxpayer, regardless of the property’s relationship to a trade or business, and then provides a list of exclusions.[1] Prior to the passage of the Tax Cuts and Jobs Act (TCJA), section 1221(a)(3) provided that the following are excluded from capital gains treatment:

A copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by:

(A) a taxpayer whose personal efforts created such property,

(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom the property was prepared or produced, or

(C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B).[2]

Thus, a “copyright or a literary, musical, or artistic composition” is not a capital asset in the hands of a taxpayer “whose personal efforts created such property.” In contrast, a “letter, memorandum, or similar property” is not a capital asset in the hands of the taxpayer who created it, and is also not a capital asset in the hands of a taxpayer for whom it was prepared or produced.

The TCJA amended section 1221(a)(3) and added “a patent, invention, model or design (whether or not patented), a secret formula or process” to the list of assets excluded from capital asset treatment in the introductory sentence. The conference report explains the reason for the change: “The intent of Congress is that profits and losses arising from everyday business operations be characterized as ordinary income and loss.”[3]

Historical background to section 1221(a)(3)

Some background on the origins of these provisions can provide helpful context. Until 1950, whether a copyright and similar property was considered to be a capital assets depended on whether its creator was a professional or an amateur. When created by a professional—a professional writer, composer, or artist, etc.—the created property was considered to be "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”[4] Under section 1221(a)(1), such property was excluded from the definition of capital asset, and its disposition generated ordinary income. When created by an amateur, however, such self-created property was a capital asset under the introductory language of section 1221(a) and its disposition therefore generated capital gain.[5]

In 1948, General Dwight D. Eisenhower claimed amateur status regarding the sale of the rights to his World War II memoir.[6] Because the capital gain rate at the time was 25 percent while the ordinary income tax rate was 77 percent, such a tax position significantly impacted the amount of tax Eisenhower would pay on the sale of his book rights.

In response, in 1950 Congress amended the definition of capital asset to include the section 1221(a)(3) exception for self-created copyrights and similar property.[7] According to the House report to the Revenue Act of 1950, “When any person sells an invention or a book or other artistic work which is the product of his personal effort his income from the sale is taxed as ordinary income, . . . (even if it was) the first time he may have engaged in such a trade or business.”[8] The logic behind this is that the creator of a copyright is being compensated for labor, which should be taxed at ordinary rates.

At that time, however, Congress did not extend the same treatment to self-created patents and inventions. According to the Senate report, “The desirability of fostering the work of such inventors outweighs the small amount of additional revenue which might be obtained under the House bill, and therefore the words ‘invention,’ ‘patent,’ and ‘design’ have intentionally been eliminated from this section of the bill.”[9] Therefore, the question of capital gain or ordinary income treatment for patents continued to turn on whether they constituted property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. That question generally turned on whether the taxpayer was a professional or amateur inventor.[10]

Instead, in 1954, Congress adopted section 1235, explicitly granting long-term capital gain treatment to the transfer of all substantial rights of self-created patents and inventions regardless of how long the asset is held, whether the consideration is received in a lump-sum or periodically over the period of the patent’s use, and whether the consideration is contingent on the productivity, use, or disposition of the property.[11] However, the benefits of section 1235 are limited, as discussed below.[12] Section 1235 survived the TCJA overhaul, yet questions remain as to how sections 1221(a)(3) and 1235 coexist.

Section 1235

Section 1235 provides:

(a) General

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, regardless of whether or not 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.

(b) “Holder” defined

For purposes of this section, the term “holder” means:

(1) any individual whose efforts created such property, or

(2) 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, if such individual is neither:

(A) the employer of such creator, nor

(B) related to such creator (within the meaning of subsection (c)).

Thus, section 1235 (i) confirmed that the sale of patents by amateurs generated capital gains, and (ii) extended capital gains treatment to the sale by professionals, when the specified conditions were met.

Section 1235 survived the TCJA,[13] even though the reasons given for the addition of patents to section 1221(a)(3) appear inconsistent with section 1235.[14] Several commentators have commented on and questioned this policy decision and the resulting statutory scheme,[15] but section 1235 would appear available notwithstanding its contradistinction to section 1221(a)(3).[16] Accordingly, after the TCJA, a sale of a patent whose treatment under section 1221(a)(3) would be ordinary income may still generate capital gains treatment if it can satisfy the requirements of section 1235.

It should be noted that section 1235 contains several restrictions not found in section 1221. Accordingly, an analysis of the sale of IP under section 1235 must be performed independent of an analysis performed under section 1221(a)(3).

Section 1221(a)(3) property developed by company employees

As noted above, section 1221(a)(3) is limited to situations in which a taxpayer’s “personal efforts” created the property. In regards to “a letter, memorandum, or similar property,” however, the rule covers not only the personal efforts of a taxpayer, but also “a taxpayer for whom the property was prepared or produced.”

What constitutes "personal efforts" of a taxpayer? The regulations provide that a taxpayer expends personal efforts if the taxpayer "performs ... creative or productive work which affirmatively contributes to the creation of the property, or if such taxpayer directs and guides others in the performance of such work."[17] Consequently, if the work product is the subject of either individual or collaborative effort, the individuals involved will be treated as having created the product with their personal efforts. If, on the other hand, the taxpayer "merely has administrative control over writers, actors, artists, or personnel and … does not substantially engage in the direction and guidance of such persons in the performance of their work," the property is not deemed to have been created as a result of the taxpayer's personal efforts.[18]

In line with the statute and regulation, authorities have indicated that the “personal efforts” of the taxpayer did not create the intangibles where the taxpayer is a business entity and the property is created by its employees. In Revenue Ruling 55-706, the IRS concluded that films produced by a publicly owned motion picture company were not covered by Code Sec. 1221(a)(3) and stated: “The property created by these corporations is not considered to be created by the personal efforts of a taxpayer where all of the costs and expenses are paid for by the corporation at the current going rate for the services rendered.”[19]

The precise scope of this ruling is not entirely clear. Does it cover property created by employee-owners of a closely-held corporation or partnership? If an original patentable item was created by a taxpayer’s personal efforts but then developed further by reasonably compensated employees, would the original patent taint these new intangibles? Although there is some authority following the footsteps of Revenue Ruling 55-706 that sheds limited light on these questions, a facts-and-circumstances analysis must generally be performed in these situations.

Additionally, the IRS could issue new guidance on the issue as a result of the change in the statute. However, an IRS departure from the substance of Revenue Ruling 55-706 would require explanation and elaboration.


Section 1235 has fairly limited applicability. Many business transactions involving patents and similar intangibles will thus require a deep dive into section 1221(a)(3) and the definition of “personal efforts” to determine whether the gain on sale is capital gain or ordinary.

Section 1221(a)(3) does not apply to trademarks, trade names, goodwill, or customer based intangibles such as customer lists; the sale of these assets thus generally generates capital gain. Because of this disparity of treatment between various intangibles, taxpayers should take a close look at where the true breakdown of intangible value sits for purchase price allocation purposes. Due to the complexities surrounding the treatment of gain upon the sale of IP, taxpayers are advised to consult with their tax advisors when selling IP with built-in gain.

[1] Section 1221(a) (“For purposes of this subtitle, the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include...”)
[2] Section 1221(a)(3)
[3] Conf. Rep. at 414
[4] Section 1221(a)(1)
[5] Seee.g.Kueneman v. Comm’r, 68 T.C. 609 (1977), aff'd, 628 F2d 1196 (9th Cir. 1980)
[6] The Associated Press, “Eisenhower to Pay Tax as an ‘Amateur’ Writer,” The New York Times, June 2, 1948
[7] P.L. 81-814, section 210
[8] H.R. Rep. No. 81-2319, at 54 (1950), reprinted in 1950-2 C.B. 380
[9] S. Rep. No. 81-2375, at 34 (1950)
[10] Seee.g.Hofferbert v. Briggs, 178 F.2d 743, 745 (4th Cir. 1949); Dreymann v. Comm’r, 11 T.C. 153, 162 (1948)
[11] See S. Rept. 1622, 83d Cong., 2d Sess., 439 (1954)
[12] H.R. Rep. No. 83-1337 (benefit not intended to encompass one who was “hired to invent” the property)
[13] The House bill would have repealed section 1235 entirely, but the conference committee omitted that provision from the final legislation. Conf. Rep. at 414-415
[14] HR Rep. No. 409, 115th Cong., 1st Sess. 271 (2017)
[15] Seee.g., Anthony P. Polito, Did Congress Goof? Legislating Taxation of Self-Created Patents, in Tax Notes (Oct. 18, 2018); Kyle Richard, Does the Tax Cuts and Jobs Act Affect University Tech Transfer?, in Tax Notes (June 25, 2018)
[16] See Boris I. Bittker & Lawrence Lokken, Federal Taxation Of Income, Estates & Gifts  50.4.1 (rev. 3d ed. 2005) (stating unequivocally that section 1235 is still valid law post the TCJA, in contrast to some observers who appear unsure of the matter). See also Staff of Joint Comm. on Taxation, General Explanation of Public Law 115–97, at fn. 1027 (J. Comm. Print 2018) (The “JCT Bluebook”) (stating that, although section 1221(a)(3) has been amended, “[h]owever, consistent with prior law... the transfer of a patent by an individual that created the treated as a sale or exchange of a capital asset...” under “section 1235”)
[17] Reg. §1.1221-1(c)(3)
[18] Id.
[19] Rev. Rul. 55-706, 1955-2 C.B. 300, overruled in part by Rev. Rul. 62-141, 1962-2 CB 182.

RSM contributors

  • Matthew Scaliti
    Life Sciences Tax Leader
  • Nick Gruidl
  • Joseph Wiener
    Senior Manager

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