§1235 of the Internal Revenue Code has been one of the most favorable provisions in the tax code for inventors. This provision eliminated the one year waiting period in order to have capital gains treatment afforded to inventors under the old tax law.
Prior to summer 1997, there was one long term capital gains holding period - one year, and one long term capital gains rate - 28%. As a compromise to pressure to lower the capital gains rates, congress created an intermediate term of from 12 to 18 months for capital gains to be taxed at the old rate of 28% and also created new long term period of greater than 18 months for taxation at the newer, lower rate of 15%.
However, the language of §1235 was not framed in terms of a "long term rate", but rather in terms of a forcing function which automatically afforded the inventor a 12 month holding period for the sale of a patent - whether the patent had been held for 12 months or not.
The language of IRC §1235, from which a change is proposed, stated that a transfer of property consisting of all substantial rights to a patent (or application), or an undivided interest by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year. A "Holder" is either (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, if such individual is neither- (A) the employer of such creator, nor (B) related to such creator. In effect, early investors in the project, before the invention was proven, receive the same tax advantages as inventors.
On its face, §1235, when combined with the new tax code would have only allowed a patent to have automatically what is now referred to as mid-term capital gain treatment. Although inventors and holders would be automatically eligible for the 12 month forcing function and thus an intermediate 28%, they would otherwise have an unenviable wait of 18 months in order to get the more preferable 20% (at that time) long term capital gains rate. This would have wreaked havoc in new licensing agreements where a long term rate of licensing income (up to 20 years where the licensing occurs in a utility patent shortly after application) would be taxed at an 8% higher rate if the license constituting a sale occurred before 18 months from creation of the patent application. Alternatives under this scenario would include a short term non sale license to be followed by an option for the full term of the patent to insure that the sale occurs later. Since licensees tax position would be unaffected by the new law, licensees anxious to hurry to complete a full license constituting a sale to lock up the invention as soon as possible (for public offering representations and competitive reasons) might pressure an inventor unaware of the new provision to forever surrender an additional 8% of royalty income to the federal tax collector for not having waited the 18 months.
H.R. 2645, a bill entitled "To make technical corrections related to the Taxpayer Relief Act of 1997 and certain other tax legislation," having already been approved by the House Ways and Means Committee, provides for the amendment of IRC §1235(a), of the 1986 Code by striking `1 year' in each place where it appears and inserting `18 months' in lieu thereof. The bill is to be effective retroactive to May 6, 1997.
During 1997 Internal Revenue Bulletin 1997-45, notice 97-59, stated that the IRS will take the legislation into account by treating a patent disposed of within 18 months to be deemed to have been held for more than 18 months. The inventor and holders getting the benefit of the new long term rate. An extremely cautious licensor/seller might also include language in any license that the IRB notice is being relied upon and that the license include a provision which converts the license/sale to a license/non-sale and option for sale at 18 months if the statute provision is not adopted, or if the IRS later adopts an inconsistent position.
The current long term capital gains rate is 15%, and the technical correction made in 1997 smooths the "instant capital gain" royalty sale regime in the U.S., despite the complicating factors from a prior split capital gains rate.
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