Maine has seen an increase in startups and technology-based companies, especially around the Portland area. Many — if not most — went through a process that included designs, models and patents that helped bring their respective idea to market. For a long time, those self-created intangible assets qualified as capital assets, and, thusly, qualified for preferential long-term capital gains tax rates if they were sold.
But that is no longer the case under the Tax Cuts and Jobs Act (TCJA). As of 2018, gains from selling affected intangible assets are taxed at higher ordinary income rates.
Affected Taxpayers and Assets
This unfavorable TCJA change can obviously affect innovators who create intangible assets and sell them at profit down the road (a common occurrence in the startup world). But it can also affect corporations, partnerships and limited liability companies (LLCs) that receive contributions of intangibles assets from the individuals who created them.
The change potentially applies to the following types of self-created intangible assets:
- Models and designs (patented or not)
- Secret formulas and processes
“Self-created” means created by the personal efforts of the taxpayer. Presumably, that means created by an actual human being rather than by a taxable “person” such as a corporation, partnership or LLC.
Contributions to Another Taxable Entity
What happens when an affected intangible asset is contributed to another taxable entity? The unfavorable non-capital-asset treatment rule applies if the tax basis of the intangible in the hands of the new owner is determined in whole or part by reference to the basis of the person who created it.
Take a scenario where an affected intangible asset is contributed to a corporation, partnership or LLC tax-free in exchange for stock, a partnership interest or an LLC membership interest. A later sale of the intangible asset by the entity will produce ordinary income or loss, rather than capital gain or loss.
Special Rule for Patents
In general, self-created patents aren’t defined as a capital asset. However, individual patent holders can make certain transfers and still enjoy capital gain treatment under the current tax law.
Under Internal Revenue Code Section 1235, individual patent holders who transferred patents to an LLC classified as a partnership in exchange for a membership interest retained their status as patent holders. Therefore, the contributing individual’s share of any gain upon the LLC’s subsequent sale of the patent could qualify as long-term capital gain.
Other Intangible Assets
There are several types of intangible assets that weren’t defined as a capital asset in the pre-TCJA law. These include:
- Literary, musical and artistic compositions
- Letters and memoranda held by the taxpayer for whom they were prepared or produced
Most of these assets continue to be excluded from the definition of capital assets under the TCJA, with one important exception: Taxpayers can elect to treat musical compositions or copyrights in musical works as capital assets.
We Can Help
There isn’t much one can do to avoid the unfavorable tax treatment of affected self-created intangible assets under the TCJA. But when affected intangibles are sold with other capital gain assets, making a supportable allocation of more of the sale price to the other assets will help ease the tax pain. Contact Filler & Associates if you have questions or want more information about the treatment of self-created intangible assets.