Creative Clients Require Creative Planning

June 22, 1998 Advisory

[Reprinted with permission from The Connecticut Law Tribune Magazine Trusts & Estates

June 22, 1998.]

Special tax, valuation and transfer problems make estate planning for intellectual property owners a challenge.

The creators of intellectual property have estate planning needs that distinguish them from other clients. The intellectual property may create significant income potential and yet is often illiquid and difficult to value. One cannot use traditional approaches for intrafamily transfers without considering the special tax problems that may arise. Testamentary planning requires recognition of the tax features of these assets, and the importance of providing a mechanism for the continued management and exploitation of the assets.

Our case study involves Professor Leonardo DaVinci. Professor DaVinci is a widower in his 60s with three children. He recently invented a flying machine, for which he has obtained a patent, and has authored a valuable manuscript, which is a copyrightable work. Because of prior successes, he has accumulated a substantial investment portfolio in addition to the intellectual property. He has been advised that unless he commences an aggressive gift program, there will be a substantial estate tax at his death. The professor would like to be able to transfer the economic benefits of the intellectual property to his children, but, if possible, retain control of the management and exploitation of the properties.

A detailed discussion of the nature of intellectual property rights is beyond the scope of this article, but a basic description of patents and copyrights is helpful. A patent is a right granted by federal law to exclude others from exploiting an invention for a limited period of time extending from the day the patent issues to 20 years from the date the patent application was filed. Under current law, a copyright subsists from the moment of creation, and it protects the tangible expression of original works of authorship for the life of the creator plus 50 years.

Intellectual property rights may be sold or licensed to others to permit the use or exploitation of the property on agreed-upon terms. Property rights in a patent generally may be transferred without restriction. Ownership of a copyright may also be transferred in whole or in part, but copyright law generally provides that the creator may terminate a grant within five years following the 35th year after the grant, even if the grant is termed "irrevocable".

Gifts of the Property

Based upon the substantial value of DaVinci's estate, the conventional strategy of shifting wealth to family members during his lifetime would seem to be appropriate. Annual exclusion gifts may be made that generally are forever outside the scope of the federal transfer tax system. In addition, each individual has an "applicable exclusion amount," which may be used to shelter additional gifts made either during life or at death. The applicable exclusion amount currently is $625,000, and will gradually increase each year until the year 2006, when it reaches $1 million.

Because Professor DaVinci anticipates that the value of the property is going to increase and generate a significant income stream, making a gift of the property now will remove the future growth and income from the professor's estate.

Instead of transferring his patent and copyright outright to his children, the professor could name an inter vivos trust as the owner of the interests, creating the potential to reduce the overall income tax on the payments received by allocating income to low-tax-bracket beneficiaries. This planning can be particularly helpful with respect to the patent, because owners of a fractional interest in a patent are entitled to exploit the patent in full, without the consent of the other owners. The use of a trust will consolidate these rights in the trustee.

Income Tax Issues

Before engaging in any gift giving, it is important to anticipate the special income tax rules that apply to intellectual property. Under §1235 of the Internal Revenue Code, an inventor is entitled to treat payments received for the transfer of all of the substantial rights to a patent as capital gain. If the inventor gives away rights in the patent, however, the recipients will not be entitled to capital-gain treatment under IRC § 1235, because they are not considered "holders" under IRC §1235(b). But that section is intended to be a safe harbor for inventors, and it is not intended to exclude the application of other sections of the tax law. Accordingly, DaVinci's children, as gift recipients, would be entitled to capital-gain treatment for the payments received for the exploitation of the patent as long as they meet the requirements under general tax law.

In analyzing whether payments received in connection with the sale of a patent are eligible for capital gain treatment in the hands of the children, the holding period of the patent is of particular importance. Payments received by Professor DaVinci when he licenses his patent to AirItalia automatically are classified as long-term capital gains pursuant to IRC § 1235, regardless of how long he has owned the patent or invention. The children's holding period begins when the invention is "actually reduced to practice," i.e., when it has been demonstrated that the flying machine works. In order for the children to receive long-term capital-gain treatment, the professor's invention would have had to have been reduced to practice 18 months before it was transferred.

Consequently, if the professor transferred his invention to his children before the invention was reduced to practice, payments received by the children to exploit the invention would never qualify for long-term capital-gain treatment, because the holding period would never commence. When planning for inventors who intend to transfer their inventions to their children, it is important to time the transfers so that they occur 18 months after the inventions are reduced to practice. Failure to do this may forever taint the payments received with respect to the inventions as ordinary income.

In contrast, payments received for copyrights are characterized as ordinary income, and transferees who receive a copyright by gift are also required to report payments received for the exploitation of the copyright as ordinary income. The concerns with a gift of a copyright are whether the transferor's statutory right to terminate an "irrevocable" assignment will prevent a gift from being considered complete for tax purposes and whether it will cause inclusion of all or part of the copyright in the transferor's estate. The law in this area is unclear, because there have been no published rulings from the IRS, but presumably the same principles that allow a taxpayer to treat a sale of a copyright as complete despite a fight of termination would apply to a gift of a copyright.

Other Methods of Transfer

As an alternative to gifts, the professor could sell the property to his children, particularly where the value of an unexploited property may be relatively low. Although IRC § 1235 does not apply to sales between related parties the professor could report his gain, if any, on the sale of the patent as capital, as long as it would otherwise qualify under the general capital-gain rules. The sale of the copyright would yeild ordinary income to the professor. This approach will act, in essence, as an "estate freeze" in which the professor would receive a (presumably low) fair-market value for his property. The children would then exploit the property to its full potential, thereby receiving the benefits of its increase in value over time.

Before engaging in any gift giving, it is important to anticipate the special income tax rules that apply to intellectual property.

A variation of this technique would be for DaVinci to form a "defective grantor trust," to which he would sell the intellectual property. The beneficiaries of the trust would be the children. The trust is "defective" because it is intentionally designed so that the professor would not recognize gain on the sale, and all items of income, gain and loss would be taxed to the professor, instead of the trust. The trust would be drafted so that when the professor dies, the trust assets (i.e., the presumably appreciated intellectual property) would not be included in his estate for tax purposes. As the trust receives income from the exploitation of the asset, the income will be taxable to the professor, and his payments of this tax will not be considered additional gifts for tax purposes. In addition to freezing the value of the property for gift tax purposes, this effectively allows the children the benefit of the income from the exploitation of the property, without their having to pay income taxes.

Professor DaVinci informs you, however, that he wants to retain control over the way the properties are exploited, and therefore he is not comfortable with an outright gift or sale. He also thinks he might want to keep some of the income from the properties after all.

One way DaVinci can accomplish his goals is through the use of a limited partnership (LP) or limited liability company (LLC). The professor could transfer his interests to the entity, and yet retain the right in the capacity of general partner or manager of the entity to control the property. The professor would then convey interests in the entity to his children, who would be passive investors. Income from the property would be reported by the owners of the entity in accordance with their respective interests.

Estate tax savings result from the opportunity that the LP or LLC provides to make gifts of noncontrolling interests to younger generation family members. Recipients can take discounts from the fair-market value of the property before it was contributed to the entity because the interests being transferred constitute a minority interest in the entity, they are not marketable, and they are subject to restrictions contained in the partnership or operating agreement. This feature can be very significant for the professor, whose estate is in the top estate tax bracket; therefore, 55 percent of every dollar of future growth in the value of the assets would otherwise be subject to estate taxes.

Although family limited partnerships and limited liability companies have recently come under increased scrutiny from the IRS, the significant nontax business reasons for establishing this structure for an owner of intellectual property should help a taxpayer to defend any challenges.

Two factors should be addressed before conveying a patent to a business entity. First, if the inventor retains an interest in the entity, he may still be able to take advantage of IRC §1235 as to his interest, but the remaining partners or members would receive capital-gain treatment from the exploitation of the asset only if it is considered a capital asset in the hands of the entity. Capital-gain treatment will likely be available, as long as the entity is not in the trade or business of inventing or exploiting inventions. If the entity is managing and exploiting multiple inventions, it may lose capital-gain treatment. Second, if the inventor sells the patent to a business entity in which he owns more than a 50 percent interest, the inventor recognizes ordinary income on the sale.

Disposition of Contract Rights

If Professor DaVinci has already sold or licensed his intellectual property, and now wishes to give the contract rights under that sale or license to his children, there are other issues that should be considered. In order to avoid assignment-of-income principles that might cause taxation on the income from the contract to the professor instead of the children, he should transfer all of his rights under the contract, as well as any reversionary rights under the contract to the intellectual property itself.

If DaVinci is reporting gain on the sale of the property as an installment sale, it is possible that the transfer of his rights under the contract will be considered a disposition of an installment note, resulting in income to the professor, based on the difference between his cost basis in the property and the value of the contract when he transfers the rights to his children.

Sales of patents that qualify for IRC §1235 treatment are specifically exempt from the minimum interest rules, but sales outside the scope of IRC §1235 may be subject to the minimum interest rules, which require a sale of property to include a minimum amount of interest. Although the amount of the contract payments will not be increased, these rules may recharacterize a portion of the payments received by the children as interest.

Estate Administration

Our estate plan for the professor also involves an analysis of what will happen if he dies while owning his patent and copyright. Much of the value of intellectual property is likely to be tied to its potential revenue stream, and therefore the estate may lack the liquidity to pay the estate taxes. The income the estate or ultimate recipient receives from the sale or license of a copyright or patent may constitute "income in respective of a decedent" (IRD). The professor should consider purchasing insurance to provide some or all of the funds necessary to pay estate or income taxes.

The tax payment mitigation provisions may be applicable to provide some relief, but new IRC §2033A, which excludes certain family businesses from a taxpayer's estate, is not available for a family business where the primary assets of the business are patents and copyrights.

If he has not already established a business entity to hold the assets, DaVinci should leave his intellectual property in trust for his children. It is important to centralize the management of the professor's patents and copyrights, as well as the licenses with respect to the properties, because fractionalizing interests in the properties can seriously compromise the ability to exploit them.

One way an inventor who wants to retain control over his properties and keep some income can accomplish his goals is through the use of a limited partnership or limited liability company.

Finally, for the creative client, the advisor should give some though to naming a specialized fiduciary (for example, a literary executor) who can guide the exploitation of the client's work after the client's death. The person selected to administer an estate and trust may not have the expertise or aptitude to manage, market and oversee the exploitation of an invention or artistic work properly. Accordingly, the fiduciary rights with respect to the intellectual property can be carved out and delegated to someone who is best able to fulfill the client's wishes competently and profitably.

This article has only touched on the many issues that can arise when advising an inventor, artist, composer or writer. Estate planning for a creative client requires creative planning to accomplish your client's goals with the most favorable income, gift and estate tax results.