Section 1235 of the Internal Revenue Code (IRC) permits holders (Creators) “whose efforts created” the patent or holders (Investors) “who  acquired [their] interest in such property in exchange for consideration in money or money’s paid to the creator prior to actual reduction to practice of the invention” to treat the transfer of “property consisting of all substantial rights to a patent, or an undivided interest therein” as a gain on a “capital asset held for more than 1 year” regardless of how short of a time they hold the rights to the patent (collectively “Holders”).
Section 1235 grants the Creators and Investors the lower long-term capital gains (LTCG) tax rate rather than the graduated income tax rates for short-term capital gains on the sale of the patent to a third party.
However, as with many other sections of the IRC, only certain transactions and entities may qualify for the preferential tax treatment. Understanding who qualifies as a Holder is crucial to understanding section 1235. A Holder cannot be a corporation, it must be an individual. However, if the patent is developed and owned by a pass-through entity such as a partnership each owner may qualify separately as a Holder for their share of the partnership profits from the sale of the patent, regardless of the status of other partners. For example, if a corporation owns a share of the partnership, the corporation cannot qualify as a Holder, but if another partner is an individual the individual may still qualify as a Holder on his/her share of the partnership.
The preferential tax treatment is available to the Creator whether or not they are a professional inventor. Unfortunately, the preferential tax treatment is not available to employees or individuals that are related to the Creator.
For Investors, they must invest before the product is reduced to practice to qualify for the LTCG treatment. Generally, this requires that the investment occur before the invention has “been tested and operated successfully under operating conditions” whether the testing occurs before or after the application for the patent. As a good basic rule of thumb is if there is no working prototype the investment will qualify but if there is a working prototype, the development is too far for the investment to qualify.
Finally, only the transfer of certain types of rights in the patent qualifies for the preferential tax treatment. Section 1235 provides that only transfers of “property consisting of all substantial rights to the invention, or an undivided interest” qualify for the preferential treatment. The regulations clarify that transfers limited “geographically within the country of issuance”, by duration, to exploitation of the invention in certain fields (e.g. medical), and grants of “less than all the claims or inventions covered by the patent and have value at the time of the grant” do not qualify for the preferential treatment. While these rules are restrictive, they do not exclude all partial transfers. For example, interests may still be sold on a regional or country basis. In addition, certain rights are specifically excluded from the definition of “substantial” and may be retained by the Holder. Specifically, the regulations provide that the retention of a right to ensure specific performance or the retention of a security interest will not affect the preferential treatment of the transfer.
Section 1235 is a unique and interesting section of the IRC. It reminds everyone the unique role individual inventors have made on the development of the US and the entire world. It seems only appropriate that these inventors are given special tax treatment.