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Royalty income or capital gains? Tax Court provides guidance

The categorization of earnings affects the amount of taxes owed. The capital gains tax rate had been capped at 15 percent for many years. In 2013, it increased to 20 percent rate for some high-earners. However, the capital gains rate is still generally lower than that of ordinary income, which has a top tax bracket of 39.6 percent.

In a recent Tax Court case, the issue in dispute was whether the patent holders had given up control of a patent they transferred. This was important, because it meant the difference between treating earnings as royalties (ordinary income) or capital gains. This post will discuss the holding.

 

A couple transferred patents to a corporation that they jointly owned with a relative and close friend. They retained a 24 percent ownership interest in the corporation through a trust. The couple then reported the money they received for transferring the patents as capital gains from 2006 to 2008. The IRS disagreed and found that the royalty payments were not entitled to capital gains treatment.

In its opinion, the Tax Court agreed with the IRS. It held that an owner needs to transfer “all substantial rights” before a transfer of a patent with qualify as a sale or exchange. The retention of even indirect control leaves the holder in “the same position as if the patent had not been transferred.” This meant that capital gains treatment did not apply.

The general rule for royalties is that they are taxed as ordinary income. This includes royalties from patents, copyrights, oil, natural gas or mineral interests. When the IRS sends a Notice of Deficiency related to the classification of income, seek the advice and assistance of a tax lawyer prior to sending a response.

Source: Accounting Today, "Tax Court Rules Against Patent Holder Over Royalty Income," Roger Russell, Sept. 26, 2014

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