Snow v. Commissioner U.S. Supreme
Court ruling, a partnership investor may
be able to deduct the expenses related to
developing a product even though the
product has not been offered for sale or
sold. And if you wind up meeting all the
various criteria for both the R&D deduction and the R&D tax credit, the formula
can become complicated as you need
to subtract one from the other in determining the final deduction. Keep good
records, and hope your tax advisor’s
computer is up to the task.
If you write a check and buy (e.g.,
lump sum payment, installment fees,
renewal fees) intellectual property for
your business, you also may be able to
amortize over 15 years the cost of the
purchase per 26 U.S. Code § 197. The
qualifying intangible property under
§ 197(d)(1)(C)(iii) includes “any patent,
copyright, formula, process, design, pattern, know-how, format or other similar
item,” So “trade secret” is not named,
but “know-how” and “other similar
items” are named. Another topic for discussion at the sit-down. Intangible property that the taxpayer creates rather than
purchases may also be eligible under §
197(c)(2) if it was created “in connection
with a transaction (or series of related
transactions) involving the acquisition
of assets constituting a trade or business
or substantial portion thereof.” Should §
197 not be applicable, then have your advisor mull over the potential for counting
the cost under R&D expenses (§ 174),
Now suppose you sell a trade secret or other intellectual property. The
way you “sell” it can have a big impact
on your tax bill, specifically whether
it qualifies as ordinary income vs. a
capital gain. The considerations are
whether you only partly transfer (i.e.,
license) the property vs. exchange all
substantial rights of the property; and
whether the property qualifies as the
provision of services or a non-capital
asset vs. a capital asset (e.g., one held
for more than one year). As you can
guess, meeting the two later categories
will get you into the capital gain bracket, if that is desirable to you. In Pickren
v. United States 378 F.2d 595 (5th Cir.
1967) the transfer of rights and interest of secret formula to liquid wax
products and trade names were viewed
by the Fifth Circuit Court of Appeals
as warranting the application of the
transfer of patent rights, which under
current 26 U.S. Code § 1235 would
constitute a sale of a capital asset if
all substantial rights were transferred.
However, royalty payments under a li-
censing agreement for the formula and
trade names was viewed as ordinary in-
come. The IRS has generally categorized
this “secret formula” type of information
as “know-how.”
Finally, how about the situation where
your trade secret was misappropriated,
and you win damages and/or settle the
case? Well, in Freda v. Commissioner
of Internal Revenue, 2011 WL 3802707
(August 26, 2011, 7th Cir. 2011) (Freda),
the way the tax rate on $15.3 million
in damage payments was decided really
gives notice to all litigators. The circum-
stances involved were C&F Packing Co.,
Inc. (C&F) freezing cooked sausages for
Pizza Hut, Inc. (Pizza Hut), and provid-
ing confidential disclosure of the trade se-
cret for the freezing process to Pizza Hut
due to quality control concerns. Pizza
Hut then allegedly disclosed C&F’s trade
secret to other sausage producers that
partly took over production, at lower
cost of course. After many legal battles
over a decade, C&F won $10.9 million
in damages for claims of “lost profits,
lost opportunities, operating costs, and
expenditures.” That award was reported
as about $8 million in long-term gain
and the rest as ordinary income. The IRS
was OK with that filing. A related court
case claiming trade secret misappropria-
tion was settled for $15.3 million, which
after expenses, legal fees, and a payment
to a former shareholder, C&F reported
about $6 million in cash as a long term
capital gain. However, the IRS took the
view that the settlement was ordinary in-
come, the result being that $700,000+ in
taxes were owed by C&F’s shareholders.
The problem for C&F in the trade secret
misappropriation case was the type of
claim made. The Court indicated that if
C&F sought remedy for replacement of
capital destroyed or injured, then the pay-
ment would have been a return of capital
“and not taxable,” rather than ordinary
income for payment of lost royalties and
profits. Ouch. Goes to show that get-
ting the whole team together to play war
games is really key to long-term success.
So, repeating the disclaimer here that
your authors have any tax expertise
whatsoever, do yourself a favor. Know
enough to know how little you know
(the mark of the truly educated). And,
beware of tax advice regarding taxable
consequences of trade secret development, ownership, protection, licensing
and sale. Such advisers will need to be
of a special sort, and have demonstrable
expertise in the area. There are certainties
in life – death, taxes. Don’t smoke, our
best advice (as non-doctors), for the former. Pay what you owe, but don’t forget
to consider the tax consequences of your
trade secrets, our best advice (as non-tax
specialists), for the latter. CW
