IRC 1235: Capital Gain on Sale of Patents
Understand how the tax treatment for a patent sale is determined by the seller's eligibility, the specific rights transferred, and the buyer's identity.
Internal Revenue Code Section 1235 provides a tax benefit for individuals who sell patent rights. This provision allows gains from qualifying transfers of patents to be treated as long-term capital gains, which are often taxed at lower rates than ordinary income. The rule automatically treats the transaction as a sale of a long-term capital asset, regardless of how long the patent was actually held. This can result in significant tax savings for inventors and other individuals who meet the code’s specific requirements.
Qualifying as a Holder
To benefit from Section 1235, an individual must meet the definition of a “holder.” The tax code is specific about who qualifies for this status. The first category of holder is the individual whose personal efforts created the patentable invention.
The second category includes any other individual who has acquired an interest in the patent property in exchange for money or something of monetary value. This acquisition must occur before the invention is put into practical use. This allows early-stage financial backers who invest in an invention before it is commercialized to also receive favorable tax treatment.
Certain individuals are explicitly excluded from being a holder. The employer of the inventor cannot be a holder, which prevents corporations from receiving this tax benefit for patents developed by their employees. Additionally, individuals who receive their interest in the patent through gift, bequest, or inheritance are not eligible.
Transferring All Substantial Rights
The tax treatment under Section 1235 is contingent upon the “transfer of all substantial rights” to a patent. This phrase means the holder must transfer the exclusive rights to make, use, and sell the invention for the entire life of the patent within a specific country. The transaction must be equivalent to a complete sale, leaving the holder with no significant remaining interest or control.
A transfer can still qualify even if it is limited to a specific geographic area. For instance, selling the exclusive rights to a patent within the United States would be considered a transfer of all substantial rights for that territory. The Internal Revenue Service looks at the substance of the transaction, not just its form. Rights not considered substantial include the retention of legal title for security purposes or the right to terminate the agreement at will.
The favorable capital gains treatment applies even if the payments are made periodically over the transferee’s use of the patent or are contingent on its productivity, use, or disposition. This means that royalty-style payments, which are typically taxed as ordinary income, can qualify as long-term capital gains. Regardless of the payment method, as long as all substantial rights have been transferred, the income is treated as a long-term capital gain.
Limitations on Transfers to Related Persons
The benefits of Section 1235 are not available if the transfer of patent rights is made to a “related person.” The tax code provides a precise definition of who qualifies as a related person to prevent taxpayers from taking advantage of the provision through transactions with close family members or controlled entities. The rules are based on the relationship definitions found in Internal Revenue Code Section 267.
Specifically, a transfer to the holder’s spouse, ancestors (such as parents and grandparents), and lineal descendants (such as children and grandchildren) will not qualify for capital gains treatment. For example, if an inventor sells a patent to their child, the proceeds would be taxed as ordinary income. Siblings are not included in this definition, so a sale to a brother or sister could still qualify.
The related person rules also extend to certain entities in which the holder has a significant ownership stake. A transfer to a corporation in which the holder owns 25% or more of the outstanding stock is considered a transfer to a related person. This prevents an inventor from selling a patent to their own controlled company to convert business income into a capital gain.
These limitations ensure that the tax benefit is applied to arm’s-length transactions with unrelated parties. The rules are strictly enforced, and any holder considering the sale of a patent should carefully review the relationship with the potential buyer. Failure to adhere to these restrictions can result in the disqualification of the transaction from the favorable tax treatment.