xi

Detailed Table of Contents

Preface .................................................................................................. v

Summary Table of Contents ............................................................... ix

Part I: Introduction and Overview of Intellectual Property

Chapter 1: Introduction ................................................................. 1-1 I. The New Role of Intellectual Property and Tax

Practitioners ............................................................................ 1-1 II. Intellectual Property Transactions and Tax Planning ......... 1-3

A. Choices in Structuring Intellectual Property Transactions ...................................................................... 1-3

B. Choices in Tax Treatment of Certain Transactions ........ 1-4C. Impact of Decisionmaking on Later Intellectual

Property Transactions....................................................... 1-5D. General and Special Tax Provisions Applicable to

Intellectual Property ......................................................... 1-6E. Challenges Facing the Intellectual Property and

Tax Practitioner ................................................................ 1-6F. Case Example .................................................................... 1-8

III. Chapter Summaries ................................................................ 1-9A. Chapters 1–2: Introduction and Overview of

Intellectual Property ......................................................... 1-9B. Chapters 3–9: U.S. Federal Income Taxation of

Intellectual Property ....................................................... 1-10C. Chapters 10–11: Structuring Ownership of

Intellectual Property: U.S. and International Tax Planning Strategies ................................................. 1-12

D. Chapter 12: Estate Planning for Intellectual Property ........................................................................... 1-13

E. Chapter 13: Internet and E-Commerce Taxation ........................................................................... 1-13

Chapter 2: Overview of Intellectual Property .............................. 2-1 I. Patents ..................................................................................... 2-2

A. From Inventions to Patents .............................................. 2-2B. Scope of Protection ............................................................ 2-9C. Types of Patents .............................................................. 2-15D. Sample Tax Issues Involving Patents ............................ 2-16

II. Trade Secrets ......................................................................... 2-17A. Definition ......................................................................... 2-17B. Scope of Protection .......................................................... 2-19C. Examples of Trade Secrets ............................................. 2-21D. Sample Tax Issues Involving Trade Secrets/

Know-How ....................................................................... 2-22 III. Copyrights ............................................................................. 2-23

A. Definition ......................................................................... 2-23B. Scope of Protection .......................................................... 2-25C. Examples of Copyrights .................................................. 2-29D. Sample Tax Issues Involving Copyrights....................... 2-30

IV. Trademarks, Trade Names, and Trade Dress ..................... 2-31A. Definition ......................................................................... 2-31

1. Trademarks ............................................................... 2-312. Trade Names ............................................................. 2-343. Trade Dress ............................................................... 2-34

B. Scope of Protection .......................................................... 2-35C. Categories of Trademarks and Trade Dress .................. 2-40

1. Trademarks ............................................................... 2-402. Trade Dress ............................................................... 2-43

D. Sample Tax Issues Involving Trademarks and Trade Names ................................................................... 2-44

V. Domain Names ...................................................................... 2-45A. Domain Name Registration System ............................... 2-45B. Domain Names and E-Commerce .................................. 2-47C. Scope of Protection .......................................................... 2-48

1. Protection for Domain Names That Are Valid Trademarks ..................................................... 2-48

2. Protection for Generic Domain Names .................... 2-513. Domain Names as Intangible Property .................... 2-58

D. Sample Tax Issues Involving Domain Names ............... 2-59 VI. Computer Software ............................................................... 2-59

A. The Nature of Computer Software ................................. 2-59B. Legal Protection for Computer Software ....................... 2-60C. Computer Software and Licenses ................................... 2-64D. Sample Tax Issues Involving Computer Software ........ 2-65

VII. Web Content .......................................................................... 2-66A. The Nature of Web Content ............................................ 2-66B. Legal Protection for Noncopyrightable Web Content .... 2-67

1. Anatomy of a Web Site .............................................. 2-672. Legal Protection for Noncopyrightable Content ...... 2-68

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C. Legal Protection for Copyrightable Web Content: Copyright Law and DMCA ............................................. 2-69

D. Sample Tax Issues Involving Web Sites and Online Transactions ........................................................ 2-69

Part II: U.S. Federal Income Taxation of Intellectual Property

Chapter 3: Overview of Traditional Principles of Taxation ......... 3-1 I. Introduction ............................................................................. 3-2 II. Structure of the Federal Income Tax System ........................ 3-2

A. Gross Income ..................................................................... 3-2B. Deductions ......................................................................... 3-3C. Tax Rates ........................................................................... 3-6D. Tax Credits ........................................................................ 3-8E. Summary of Income Tax Formula .................................... 3-8

III. Major Intellectual Property Transactions Having Tax Consequences ................................................................... 3-9A. Intellectual Property Development .................................. 3-9

1. In General .................................................................... 3-92. Currently Deductible Expenses ................................ 3-103. Nondeductible Capital Expenditures ....................... 3-104. Depreciation and Amortization Allowances ............. 3-115. Tax Credit for Research and Development .............. 3-13

B. Intellectual Property Acquisitions ................................. 3-131. In General .................................................................. 3-132. Intellectual Property Acquired by Purchase ............ 3-143. Intellectual Property Acquired by License .............. 3-15

C. Intellectual Property Transfers: Sales and Licenses .... 3-151. In General .................................................................. 3-152. Sales of Intellectual Property ................................... 3-163. Licenses of Intellectual Property .............................. 3-18

D. Intellectual Property Litigation ..................................... 3-19E. Structuring Ownership of Intellectual Property:

Transferring Intellectual Property to Domestic and Foreign Holding Subsidiaries ......................................... 3-191. Domestic Holding Subsidiaries................................. 3-192. International Holding Subsidiaries .......................... 3-20

IV. Researching Federal Tax Law .............................................. 3-21A. The Internal Revenue Code ............................................ 3-21B. Treasury Regulations ...................................................... 3-22C. IRS Rulings and Procedures ........................................... 3-24

1. Revenue Rulings ........................................................ 3-242. Private Letter Rulings .............................................. 3-243. Revenue Procedures .................................................. 3-25

D. Case Law .......................................................................... 3-25E. Legislative History .......................................................... 3-26

Chapter 4: Taxation of Intellectual Property Development ........ 4-1 I. Introduction ............................................................................. 4-8 II. Deductibility Under Section 162—Ordinary and

Necessary Business Expenses ................................................ 4-9A. The “Expense” Requirement ............................................. 4-9

1. Section 263: Capital Expenditures ........................... 4-10a. The Impact of INDOPCO ...................................... 4-11b. Post-INDOPCO Rulings and Cases ...................... 4-12c. Treasury Regulations Under Section 263 ............ 4-14

i. General Principle of Capitalization ................. 4-15ii. AmountsPaidtoCreateCertainIdentified

Intangibles ........................................................ 4-15iii. Amounts Paid to Create a “Separate and

Distinct Intangible Asset” ................................ 4-16iv.AmountsPaidforSignificantFuture

BenefitsIdentifiedinFutureGuidance .......... 4-17v. Amounts Paid to Facilitate the Creation of

Intangible Assets .............................................. 4-18vi. Exception for Amounts Paid to Create

Short-Lived Intangible Assets (The “12-Month Rule”) ............................................. 4-20

vii. Exception for Research and Development Expenditures..................................................... 4-22

2. Section 263A: Capitalization and Inclusion in Inventory Costs of Certain Expenses ....................... 4-22a. General Rule .......................................................... 4-22b.ExceptionforQualifiedCreativeExpenses ......... 4-26c. Exception for Film and Television Production .... 4-27d. Exception for Research and Experimental

Expenditures ......................................................... 4-28B. The “Ordinary and Necessary” Requirement ................ 4-28C. The “In Carrying on a Trade or Business”

Requirement .................................................................... 4-301. Trade or Business ...................................................... 4-30

a. Requisite Continuity ............................................. 4-30b.RequisiteProfitMotive ......................................... 4-31c. Determining Whether an Activity Is a

Business or Hobby ................................................. 4-32d. Research and Writing Activities ........................... 4-34e. Photography Activities .......................................... 4-39f. Musician Activities ................................................ 4-40g. Inventive Activities ............................................... 4-40

2. In Carrying On .......................................................... 4-42D. PersonalExpensesandtheHomeOfficeDeduction ..... 4-44E. Substantiation of Business Expenses ............................ 4-47

III. Deductibility Under Section 174—Research and Experimental Expenditures ................................................ 4-47A. Research and Experimental Expenditures .................... 4-48

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1. Definition ................................................................... 4-482. Application to Intellectual Property ......................... 4-49

a. Patents, Trade Secrets, and Know-How .............. 4-49b. Copyrights .............................................................. 4-49c. Trademarks and Trade Names ............................. 4-50d. Computer Software ............................................... 4-50

3. AdditionalQualifiedActivities ................................. 4-51a. Costs Relating to Nonfunctional Aspects of a

Product ................................................................... 4-51b. Costs Relating to Implementation of

Commercial Production ......................................... 4-52B. DisqualifiedExpenditures .............................................. 4-52

1. Quality Control Testing ............................................ 4-532. EfficiencySurveys,ManagementStudies,and

Consumer Surveys .................................................... 4-533. Advertising or Promotion .......................................... 4-534. Acquisition of Another’s Patent, Model,

Production, or Process ............................................... 4-545. Research in Connection With Literary,

Historical, or Similar Projects .................................. 4-546. Costs to Acquire Land or Depreciable Property

Used in Connection With Research and Experimentation ........................................................ 4-55a. General Rule .......................................................... 4-55b. Depreciation Allowances Treated as Section

174 Expenditures .................................................. 4-55c. Amounts Paid to Third Parties That Represent

Expenditures for Land or Depreciable Property ... 4-567. Research Expenditures That Result, as an

End Product, in Depreciable Property ..................... 4-568. Research Expenditures Incurred in Connection

With the Construction or Manufacture of Depreciable Property by Another ............................. 4-57

9. Exploration Expenditures ......................................... 4-5810. Exercised Statutory Stock Options for R&D

Employees .................................................................. 4-58C. “In Connection With a Trade or Business”

Requirement .................................................................... 4-591. Contracting Out Research and Development .......... 4-622. Conducting Research “In House” and

Exploiting Resulting Inventions Through Sale or Licensing ....................................................... 4-66

3. Engaging in Hobby Activities ................................... 4-68D. Reasonableness of Expenditures .................................... 4-70E. The Election to Expense or Amortize ............................. 4-70

1. Current Expense Method .......................................... 4-702. Deferred Expenses (Amortization) Method ............. 4-733. Optional 10-Year Write-Off ...................................... 4-74

IV. Alternative Minimum Tax Considerations .......................... 4-77 V. Amortization or Depreciation of Capitalized Intellectual

Property Development Costs ............................................... 4-78A. Amortization Under Section 197 .................................... 4-78B. Depreciation Under Section 167 ..................................... 4-80

1. Eligible Intellectual Property ................................... 4-80a. Determinable Useful Life ...................................... 4-81b. Trade or Business or Activity Conducted for Profit....................................................................... 4-82

2. Depreciation Methods ............................................... 4-83a. Straight-Line Method ............................................ 4-83b. Income-Forecast Method ....................................... 4-84

i. Income-Forecast Property ................................ 4-85ii. Computation of Depreciation Allowances ....... 4-86iii. Income From the Property ............................... 4-88iv. Basis Rules........................................................ 4-91v. Look-Back Method ............................................ 4-93

c. Comparison of Methods......................................... 4-943. Safe Harbor Amortization Under Section 167 ......... 4-95

C. Amortization Under Section 195 .................................... 4-96 VI. Checklists: Application of Deduction Rules to Various

Intellectual Properties .......................................................... 4-97A. Patents ............................................................................. 4-97

1. Section 162 Business Expenses ................................ 4-972. Section 174 Research and Experimental

Expenditures ............................................................. 4-983. Qualifying Research and Experimental

Expenditures ............................................................ 4-984. Disqualifying Expenditures ...................................... 4-985. The Trade or Business Requirement ........................ 4-99

a. A Case Example................................................... 4-100b. Another Case Example........................................ 4-100c. Summary.............................................................. 4-101

6. The Section 174 Elections ....................................... 4-101a. Section 174(a) Current Expense Method ........... 4-101b. Section 174(b) Deferred Expense Method .......... 4-101c. No Election........................................................... 4-101

7. Depreciation or Amortization of Patent Development Costs ................................................. 4-102a. Section 197 15-Year Amortization Not

Applicable ........................................................... 4-102b. Section 167 Depreciation Applicable .................. 4-102

i. Ascertainable Useful Life ............................... 4-102ii. Trade or Business or Activity Conducted

forProfit ......................................................... 4-103c. Different Depreciation Methods Available for

Capitalized Patent Development Costs .............. 4-103i. Straight-Line Method ..................................... 4-103

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ii. Income-Forecast Method ................................ 4-1038. Interaction Between Section 174(b) and the

Depreciation Rules .................................................. 4-104B. Trade Secrets and Know-How ...................................... 4-105

1. Section 162 Business Expenses .............................. 4-1052. Section 174 Research and Experimental

Expenditures ........................................................... 4-105a.DefinitionofResearchandExperimental

Expenditures ....................................................... 4-105b. Disqualifying Expenditures ................................ 4-105c. The Trade or Business Requirement .................. 4-106d. Payments to Third-Party Developers ................. 4-106

3. The Section 174 Elections ....................................... 4-107a. Section 174(a) Current Expense Method ........... 4-107b. Section 174(b) Deferred Expense Method .......... 4-107c. No Election........................................................... 4-107

4. Depreciation or Amortization Rules ....................... 4-107a. Section 197 15-Year Amortization Not

Applicable ............................................................ 4-108b. Section 167 Depreciation .................................... 4-108

i. Indeterminable Life Means No Depreciation .... 4-108ii. Safe Harbor Amortization .............................. 4-108

C. Copyrights ..................................................................... 4-1081. Deductibility Under Section 174 ............................ 4-1092. Deductibility Under Section 162 ............................ 4-109

a. UNICAP Rules ..................................................... 4-110b.Definitionof“TangiblePersonalProperty” ....... 4-110c. Direct and Indirect Costs .................................... 4-111

i. Direct Material Costs ..................................... 4-111ii. Direct Labor Costs .......................................... 4-111iii. Indirect Costs .................................................. 4-111iv. Exception for Selling and Distribution Costs .... 4-112v. Exception for Costs in Rendition of Services .... 4-112vi. Example .......................................................... 4-112

d.Exceptionfor“QualifiedCreativeExpenses” ..... 4-113i. DefinitionofWriter,Photographer,and

Artist ............................................................... 4-113ii. Trade or Business Requirement .................... 4-113iii. Exception for Certain Expenses .................... 4-114iv. Section 162 Elements ..................................... 4-114v. Examples of When Section 263A(h)

Would Not Apply ............................................ 4-114e. Exception for QualifiedFilmandTelevision

Production Costs .................................................. 4-115i. QualifiedProductions ..................................... 4-115ii. Limits on Deduction ....................................... 4-115iii. Calculating Aggregate Costs.......................... 4-116iv. Trade or Business Requirement .................... 4-118

3. Notice 88-62 ............................................................. 4-119a. Three-Year Recovery ........................................... 4-119b. “Creative Properties” .......................................... 4-119c.“QualifiedCreativeCosts” ................................. 4-119

4. Depreciation Rules .................................................. 4-120a. Determinable Life Determination ...................... 4-120b. Trade or Business or Activity Conducted for Profit..................................................................... 4-121

c. Depreciation Methods ......................................... 4-121i. Straight-Line Method ..................................... 4-121ii. Income-Forecast Method ................................ 4-121

5. Section 197 15-Year Amortization Not Applicable ... 4-122D. Trademarks and Trade Names ..................................... 4-122

1. Section 162: Ordinary and Necessary Business Expenses .................................................................. 4-122

2. Section 174: Research and Experimental Expenditures ........................................................... 4-122

3. Depreciation and Amortization Rules for Capitalized Trademark Costs ................................ 4- 122a. Section 167 Depreciation Not Applicable ........... 4-123b. Section 177 Amortization Election Repealed ..... 4-123c. Section 197 15-Year Amortization ..................... 4-123

i. Application to Self-Created Trademarks and Trade Names ........................................... 4-123

ii. When Amortization Begins ............................ 4-1234. Deductibility of Advertising .................................... 4-123

a. Revenue Ruling 92-80 ........................................ 4-124b. Nabisco, Inc. v. Commissioner ............................ 4-124c. Treasury Regulations .......................................... 4-124

5. No Deduction for Obtaining Trademark and Copyright Protection on Elements of Advertising .............................................................. 4-125

E. Computer Software ....................................................... 4-1261. Deductibility Under Section 162 ............................ 4-1262. Deductibility Under Section 174 ............................ 4-1263. Revenue Procedure 2000-50 ................................... 4-126

a.Definitionof“ComputerSoftware” .................... 4-127b. Routine Accounting, Management Information

Systems, Billing, and Payroll Systems.............. 4-127c. Documentation for Maintaining and

Describing Software ............................................ 4-128d. Project-by-Project Basis ...................................... 4-128e. Changing Methods of Accounting ....................... 4-128f. Payments Made to Third-Party Software

Developers............................................................ 4-1284. Three-Year Amortization ........................................ 4-1295. Section 197 15-Year Amortization Not

Applicable ............................................................... 4-129

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6. Summary of Cost Recovery Options ...................... 4-1297. Distinction Between Development Costs and

Acquisition Costs ..................................................... 4-130a. Private Letter Ruling 200236028 ....................... 4-130b. Treasury Regulations .......................................... 4-130

F. Domain Names .............................................................. 4-1311. Initial Costs to Register a Domain Name .............. 4-131

a. Capitalization ...................................................... 4-131b. 12-Month Rule ..................................................... 4-131

i. Renewal Periods ............................................. 4-131ii. Non-Applicability to Section 197

Intangibles ..................................................... 4-1322. Later Costs in Developing Goodwill in

Domain Name .......................................................... 4-132a. Domain Names Functioning as Trademarks ..... 4-132

i. Capitalization and Amortization ................... 4-132ii. Deductible “Advertising” ............................... 4-132iii. Revenue Ruling 92-80 .................................... 4-132iv. Nabisco, Inc. v. Commissioner ....................... 4-133v. Treasury Regulations ..................................... 4-134vi. Application to Domain Names ....................... 4-134

b. Generic Domain Names Not Protected Under Trademark Law ................................................... 4-134i. Capitalization and Amortization .................. 4-134ii. Deductible Advertising ................................... 4-135

G. Web Site Structures and Web Content ........................ 4-1351. Anatomy of a Web Site ............................................ 4-1352. Determining Applicable Tax Rules ........................ 4-135

a. Treatment as Software Development Costs....... 4-135b. Treatment as Copyright Development Costs ..... 4-135c. Treatment as Advertising Costs ......................... 4-136

3. Taxation of Costs for Developing Web Site Structure .................................................................. 4-136a. Treatment as Software: Revenue

Procedure 2000-50 ............................................... 4-136i. Payments to Third-Party Software

Developers ....................................................... 4-137ii. Amortization/Depreciation Options .............. 4-137

b. Treatment as Advertising ................................... 4-1384. Taxation Related to Copyrightable Web

Content Development Costs ................................... 4-138a. Capitalization ...................................................... 4-138b. Exceptions to Capitalization ............................... 4-139

i. Section 263A(h) .............................................. 4-139ii. Notice 88-62 .................................................... 4-139iii. Treatment as Advertising ............................. 4-140

c. Depreciation and Amortization of Copyright Development Costs .............................................. 4-140

5. Taxation Related to Noncopyrightable Web Content Development Costs ................................... 4-141a. Treated as Advertising ........................................ 4-141b. Not Treated as Advertising ................................ 4-141

i. Content That Lasts Less than One Year ...... 4-141ii. Content That Extends Beyond a Year ........... 4-141

VII. The Section 41 Research Credit ......................................... 4-142A. “QualifiedResearch”Defined ........................................ 4-144

1. The Discovery Requirement ................................... 4-1442. The “Process of Experimentation” Requirement ... 4-146

B. ActivitiesExcludedFrom“QualifiedResearch” .......... 4-1491. Research After Commercial Production ................. 4-1502. Internal-Use Computer Software ........................... 4-150

a.Internal-UseSoftwareDefined ........................... 4-152b. High Threshold of Innovation Test .................... 4-154c. Software Not Required to Satisfy the High

Threshold of Innovation Test .............................. 4-156d. Effective Date of Internal-Use Software

Rules..................................................................... 4-156C. QualifiedResearchExpenses........................................ 4-156

1. In-House Research Expenses .................................. 4-157a. In General ............................................................ 4-157b.WagesPaidforQualifiedServices ...................... 4-158c. Supplies and Personal Property Used in the ConductofQualifiedResearch .......................... 4-159

2. Contract Research Expenses .................................. 4-1613. Trade or Business Requirement ............................. 4-161

a. In General ............................................................ 4-161b. Research Performed for Others .......................... 4-162

D. Computation of the Credit ............................................ 4-1621. Basic Method ........................................................... 4-162

a. In General ............................................................ 4-162b. Charts Illustrating Computation Steps ............. 4-164c. Example ............................................................... 4-165d. Business Disposition and Acquisition ................ 4-166e. Controlled Corporations ...................................... 4-166f. “Gross Receipts” .................................................. 4-169

2. AlternativeSimplifiedCredit ................................. 4-172E. Documentation Required for the Credit....................... 4-173F. Limitation on Section 174 Deductions ......................... 4-174

Chapter 5: Taxation of Intellectual Property Acquisitions .......... 5-1 I. Introduction ............................................................................. 5-5 II. Amortization Under Section 197 ............................................ 5-9

A. In General .......................................................................... 5-9B. Exception for Separately Acquired Patents,

Copyrights, and Computer Software .............................. 5-121. Trade or Business Acquisition .................................. 5-12

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2. Stock Acquisitions Considered Trade or Business Acquisitions ............................................... 5-14

3. Single Asset Acquisitions Considered Trade or Business Acquisitions ............................................... 5-15

C. Exception for Readily Available Software and Bundled Software ............................................................ 5-171. Readily Available Software ....................................... 5-172. Bundled Software ...................................................... 5-193. DefinitionofComputerSoftware .............................. 5-20

D. Exception for Rights of Fixed Duration or Amount ............................................................................ 5-21

E. Computing the Section 197 Deduction ........................... 5-211. In General .................................................................. 5-212. Determining Adjusted Basis in Acquired

Intellectual Property ................................................. 5-22a. “Applicable Asset Acquisitions” ............................ 5-23b.“QualifiedStockPurchases” ................................. 5-25

3. Treatment of Contingent Payments ......................... 5-25F. Worthlessness of Section 197 Intangibles ...................... 5-26

III. Depreciation Under Section 167 ........................................... 5-27A. Eligible Intellectual Property ......................................... 5-27B. Computing the Section 167 Deduction ........................... 5-30

1. Straight-Line Method................................................ 5-312. Income-Forecast Method ........................................... 5-32

a. Income-Forecast Property ..................................... 5-34b. Computation of Depreciation Allowances ............ 5-35c. Current and Forecasted Income from

the Property ........................................................... 5-37d. Look-Back Method ................................................. 5-39

3. Variable Contingent Payment Method .................... 5-41 IV. Licensing of Intellectual Property ........................................ 5-41

A. Licenses Acquired as Part of a Trade or Business ........ 5-421. General Rule .............................................................. 5-422. Exception for Nonexclusive Licenses of

Intellectual Property ................................................. 5-423. Exception for Contingent Payments for

Trademarks and Trade Names ................................. 5-43B. Licenses Not Acquired as Part of the Acquisition of

a Trade or Business ......................................................... 5-441. General Rule .............................................................. 5-442. Rights of Fixed Duration or Amount ........................ 5-45

V. Distinguishing Between a Purchase and License ............... 5-45 VI. Checklist Outlines: Application to Various Types of

Intellectual Property ............................................................. 5-46A. Patents ............................................................................. 5-46

1. Patent Acquired as Part of a Business ..................... 5-46a. Fifteen-Year Amortization .................................... 5-46b. Adjusted Basis of Patent ....................................... 5-46

i. Accounting and Legal Fees .............................. 5-47ii. Fixed Installment Payments ........................... 5-47iii. Contingent Payments ....................................... 5-47iv. Allocating Basis Among Multiple Assets ........ 5-47

2. Patent Acquired Separately ...................................... 5-47a. Determining Whether Patent Is Acquired

Separately .............................................................. 5-48b. Eligibility for Tax Depreciation Under

Section 167 ............................................................. 5-48i. Determinable Useful Life ................................. 5-48ii. TradeorBusinessorActivityforProfit .......... 5-49

c. Straight-Line Method of Depreciation ................. 5-49i. Determining Useful Life .................................. 5-50ii. Taxpayer’s Own Experience............................. 5-50iii. General Industry Standards ............................ 5-50iv. Reasonable Accuracy Enough .......................... 5-50

d. Income-Forecast Method of Depreciation ............ 5-51i. Computation ..................................................... 5-51ii. Advantages of Income-Forecast Method ......... 5-51iii. Disadvantages of Income-Forecast Method .... 5-52

3. Patents Purchased for Contingent Payments .......... 5-52a. Acquired as Part of a Business ............................. 5-52b. Acquired Separately .............................................. 5-52c. Tax Planning ......................................................... 5-53

4. Patents Acquired Under a License ........................... 5-53a. Licenses Acquired as Part of a Trade or

Business ................................................................. 5-53b. Licenses Not Acquired as Part of a Trade or

Business ................................................................. 5-53B. Trade Secrets and Know-How ........................................ 5-53

1. Purchase Costs .......................................................... 5-53a. Section 197 Intangibles ......................................... 5-53b. Fifteen-Year Amortization for Purchase

Costs ....................................................................... 5-54c. No Other Depreciation Allowances Allowed ........ 5-54d. Adjusted Basis ....................................................... 5-54

i. Accounting and Legal Fees .............................. 5-54ii. Fixed Installment Payments ........................... 5-54iii. Contingency Payments ..................................... 5-54iv. Determining Basis in a Business Purchase .... 5-55

2. License Costs ............................................................. 5-56C. Copyrights ....................................................................... 5-56

1. Copyrights Acquired as Part of a Business .............. 5-56a. Fifteen-Year Amortization .................................... 5-56b. Adjusted Basis ....................................................... 5-57

i. Accounting and Legal Fees .............................. 5-57ii. Contingent Payments ....................................... 5-57iii. Determining Basis in a Business Purchase ..... 5-57

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2. Copyrights Acquired Separately............................... 5-57a. Determining Whether a Copyright Is

Acquired Separately .............................................. 5-58b. Eligibility for Tax Depreciation Under

Section 167 ............................................................. 5-58i. Determining Useful Life .................................. 5-58ii. TradeorBusinessorActivityforProfit .......... 5-58iii. Separating Underlying Tangible Property ..... 5-59

c. Straight-Line Method of Depreciation ................. 5-59i. Determining Useful Life .................................. 5-60ii. Taxpayer’s Own Experience............................. 5-60iii. Industry Standard ............................................ 5-60iv. Reasonable Accuracy Standard ....................... 5-60

d. Income-Forecast Method of Depreciation ............ 5-60i. Computation ..................................................... 5-60ii. Advantages of Income-Forecast Method ......... 5-61iii. Disadvantages of Income-Forecast Method .... 5-61

3. Tax Treatment of Tangible Property Embodying the Copyright ............................................................. 5-62a. Purchase of Book Manuscript and Copyright

Thereon .................................................................. 5-62b. Purchase of Original Painting and Copyright

Thereon .................................................................. 5-624. Copyrights Purchased for Contingent Payments .... 5-62

a. Acquired as Part of a Business ............................. 5-62b. Acquired Separately .............................................. 5-63c. Tax Planning ......................................................... 5-63

5. Copyrights Acquired Under a License ..................... 5-63a. Licenses Acquired as Part of a Trade or

Business ................................................................. 5-63b. Licenses Not Acquired as Part of a Trade or

Business ................................................................. 5-63D. Trademarks and Trade Names ....................................... 5-64

1. Trademark and Trade Name Purchase Costs ......... 5-64a. Fifteen-Year Amortization .................................... 5-64i. DefinitionofTrademarkforTaxPurposes ..... 5-64ii. DefinitionofTradeNameforTaxPurposes ... 5-64iii. Similar Rights Granted by Contract ............... 5-64

b. Single Acquisitions Subject to Fifteen-Year Amortization .......................................................... 5-64i. Exception for Trademark or Trade Name

Included as Ancillary Right ............................. 5-64ii. Exception for Nominal Valued Trademark

or Trade Name .................................................. 5-65c. Depreciation Under Section 167 Not

Applicable .............................................................. 5-65d. Computation of Fifteen-Year Amortization ......... 5-65e. Adjusted Basis ....................................................... 5-65

i. Accounting and Legal Fees .............................. 5-65ii. Fixed Installment Payments ........................... 5-65iii. Contingent Payments ....................................... 5-66iv. Determining Basis in Business Acquisitions ... 5-66

2. Contingent Serial Payments for Trademarks and Trade Names ...................................................... 5-66a. Requirements for Current Deduction ................... 5-67b. Further Requirements for Current Deduction .... 5-67c. Application to Licenses ......................................... 5-67d. Capitalization and Fifteen-Year Amortization

in Some Circumstances ......................................... 5-673. Trademarks and Trade Names Acquired by

License ....................................................................... 5-68a. Treatment of Contingent Serial Payments .......... 5-68b. Treatment of Payments that Fail to Qualify as

Contingent Serial Payments ................................. 5-68E. Computer Software ......................................................... 5-68

1. Computer Software Acquired as Part of a Trade or Business ...................................................... 5-68a.DefinitionofComputerSoftwarefor

Tax Purposes ......................................................... 5-69b. Incidental and Ancillary Rights ........................... 5-69

2. Separately Acquired and Readily Available Computer Software ................................................... 5-69a. Separately Acquired Software .............................. 5-69

i. For Internal Use ............................................... 5-70ii. Example ............................................................ 5-70

b. Readily Available Software ................................... 5-70i. Election to Expense Purchase Costs ............... 5-70ii. Dollar Limitation .............................................. 5-70iii. Investment Limitation ..................................... 5-70iv. Taxable Income Limitation .............................. 5-70v. Tax Planning .................................................... 5-70vi. Three-Year Amortization if Section 179

Election Not Made ............................................ 5-71vii. Example ............................................................ 5-71

3. Bundled Software ...................................................... 5-72a. Depreciation Rules for Hardware ......................... 5-72b. Election to Expense ............................................... 5-72

4. Computer Software Acquired by License ................. 5-735. Installation and Customization Work Related

to Acquisition of Software ......................................... 5-73a. The IRS’s View ...................................................... 5-73b. Treasury Regulations ............................................ 5-74

F. Domain Names ................................................................ 5-741. Domain Names Functioning as Trademarks ........... 5-74

a. Fifteen-Year Amortization .................................... 5-74b. Determining Basis in a Business Acquisition...... 5-75

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Detailed Table of Contents xxv

2. Generic Domain Names Not Protected Under Trademark Law ......................................................... 5-75a. Does Section 197 Amortization Apply? ................ 5-75

i. Trademark? ....................................................... 5-76ii. “Similar Item”? ................................................. 5-76

b. Does Section 167 Depreciation Apply? ................. 5-76i. Safe Harbor Amortization Not Applicable ...... 5-76ii. More Guidance Needed .................................... 5-77

G. Web Content .................................................................... 5-771. Purchase Costs .......................................................... 5-772. License Fees ............................................................... 5-77

Chapter 6: Taxation of Intellectual Property Sales and Licenses ....................................................... 6-1

I. Introduction .............................................................................6-7 II. The “Sale” Versus “License” Determination .......................... 6-8

A. Patents ............................................................................... 6-91. Restrictions or Limitations That Preclude a

Finding of Sale ............................................................. 6-92. Restrictions or Limitations That Do Not

Preclude a Finding of Sale ........................................ 6-11B. Trade Secrets and Know-How ........................................ 6-14C. Copyrights ....................................................................... 6-14D. Trademarks and Trade Names ....................................... 6-15

III. Taxation of Intellectual Property Sales and Exchanges .............................................................................. 6-16A. Calculating the Amount of Gain or Loss “Realized”

in a Sale or Exchange ...................................................... 6-161. Amount Realized ....................................................... 6-162. Adjusted Basis ........................................................... 6-163. Allocating Consideration Received in a

Business Acquisition ................................................. 6-17B. Determining Whether Gain or Loss Is “Recognized” .... 6-18

1. General Rule .............................................................. 6-182. Nonrecognition Provisions ........................................ 6-19

a. Exchanges of “Like-Kind” Intellectual Property ... 6-19b. Sales of Intellectual Property to Spouses and

Incident to Divorce ................................................ 6-213. Special Loss Disallowance Rules .............................. 6-22

a. Section 197(f)(1): Sales of Section 197 Intangibles ............................................................. 6-22

b. Section 267: Sales or Exchanges to Related Parties .................................................................... 6-24

c. Section 707(b): Sales or Exchanges to Controlled Partnerships ........................................ 6-25

C. Determining “Character” of Gains and Losses .............. 6-261. Preferential Treatment for Long-Term

Capital Gains ............................................................. 6-26

2. Limitation on the Deduction of Capital Losses ....... 6-26D. General Characterization Provisions ............................. 6-27

1. The Sale or Exchange Requirement ......................... 6-272. TheDefinitionofCapitalAsset ................................ 6-28

a. Exception for Inventory and Inventory-Like Property ................................................................. 6-28

b. Exception for Trade or Business Property ........... 6-29c. Exception for Self-Created Copyrights and

Similar Property .................................................... 6-31i. Application of the Exclusion to

Abstract Ideas ................................................... 6-31ii. Application of the Exclusion to Work-for-

Hire Creations .................................................. 6-33iii. Application of the Exclusion to Property

That Is Both Patentable and Copyrightable ................................................... 6-33

iv. Application of the Exclusion to Musical Compositions or Copyrights in Musical Works .................................................. 6-34

3. Holding Period ........................................................... 6-34E. Special Characterization Provisions .............................. 6-35

1. Section 1231: Quasi-Capital Assets.......................... 6-36a. Section 1231 Transactions .................................... 6-36b. The Operation of Section 1231.............................. 6-37

2. Section 1235: Transfers of All Substantial Rights to Patents ....................................................... 6-37a. Transfer ................................................................. 6-39

i. Transfers Between Employers and Employees ......................................................... 6-39

ii. Transfers of Undivided Interests and Successive Transfers ........................................ 6-41

iii. Payments for Infringement .............................. 6-42b. Holder..................................................................... 6-42c. All Substantial Rights ........................................... 6-44

i. Right to Sue for Infringement .......................... 6-47ii. Transfers of Undivided Interests ..................... 6-48

d.DefinitionofUndividedInterest ........................... 6-48e. Patents ................................................................... 6-49

i. Provision of Services ......................................... 6-50f. Related Person ....................................................... 6-50

3. Sections 1239 and 707(b) Ordinary Income ............. 6-534. Section 1245 Recapture ............................................. 6-54

a. In General .............................................................. 6-54b. Property Subject to Section 1245 Recapture........ 6-56

i. Treatment of Self-Created Intangibles Expensed Under Section 174 ........................... 6-56

ii. Treatment of Self-Created Intangibles Not Expensed Under Section 174 .................... 6-57

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Detailed Table of Contents xxvii

5. Section 1253 Transfers.............................................. 6-58a. Treatment of Contingent Payments ..................... 6-58b. Treatment of Noncontingent Payments ............... 6-58c. Consideration That Is Part Fixed and Part

Contingent ............................................................. 6-60d. Basis Recovery ....................................................... 6-60

F. Deferred Payment Sales and Contingent Payments ..... 6-611. Installment Sale Reporting....................................... 6-622. OID and Unstated Interest ....................................... 6-63

IV. Licenses of Intellectual Property .......................................... 6-65 V. Assignments of Income from Intellectual Property ............. 6-65 VI. Abandonment of Intellectual Property ................................ 6-66 VII. Checklist Outlines for Different Types of

Intellectual Property ............................................................. 6-67A. Patents ............................................................................. 6-67

1. Nonexclusive Licenses of Patents ............................. 6-672. Exclusive Licenses and Sales of Patents .................. 6-673. Patent Transfers Qualifying Under Section 1235 ... 6-68

a. Status as Professional Inventor Irrelevant .......... 6-68b. Holding Period Irrelevant ..................................... 6-69c. Nature of Consideration Irrelevant ...................... 6-69

4. Requirement Under Section 1235 ............................ 6-69a. Transfer ................................................................. 6-69

i. Transfers Between Employers and Employees ......................................................... 6-69

(a) A Question of Fact ................................... 6-70(b) Employees Who Receive Percentage of

Royalties .................................................. 6-70(c) Employee Receives Fixed Salary ............ 6-70(d) Determining Whether Employee was

“Hired to Invent” ..................................... 6-71(e) Example ................................................... 6-71

ii. Transfers of Undivided Interests and Successive Transfers. ....................................... 6-72

b. Holder..................................................................... 6-72i. Only Individuals Qualify.................................. 6-73ii. Treatment of Partnerships .............................. 6-73iii. Treatment of Grantor Trusts ........................... 6-74

c. All Substantial Rights ........................................... 6-74i. Disqualifying Transfers ................................... 6-75ii. Rights That May be Retained .......................... 6-76iii. Other Rights That May or May Not be

Retained ............................................................ 6-76iv. Right to Terminate or Revoke the Transfer ..... 6-77v. Retention of Right to Sue for Infringement. ..... 6-78vi. Transfers of Undivided Interests ..................... 6-78vii. Transfers Not Qualifying for Section 1235

Treatment ......................................................... 6-78

viii. Transfers Subject to Nonexclusive Licenses ............................................................. 6-78

(a) Macdonald v. Commissioner .................. 6-78(b) Revised Ruling 78-328 ............................ 6-79(c) Blake v. Commissioner ............................ 6-79(d) First National Trust & Savings

Bank of San Diego v. United States ....... 6-79d. Patents ................................................................... 6-79

i. Patentable Inventions ...................................... 6-79ii. Options .............................................................. 6-80

e. Related Person ....................................................... 6-815. Patent Transfers Not Qualifying Under

Section 1235 ............................................................... 6-82a. Sale Versus License ............................................... 6-84

i. Transfers Characterized as Licenses .............. 6-84(a) Transfers With Duration Limitations .... 6-84(b) Transfers of Nonexclusive Rights .......... 6-85(c) Transfers That Divide Manufacturing ... 6-85(d) Transfers That Do Not Include

“Use” Rights ............................................ 6-85(e) Particular Terminology in Agreement

Irrelevant ................................................. 6-86ii. Transfers Characterized as Sales:

Permissible Restrictions .................................. 6-87(a) Restrictions That Protect the

Transferor ................................................ 6-87(b) Retention of Right to Approve

Sublicense ................................................ 6-88(c) Retention of Right to Sue for

Infringement ........................................... 6-89(d) Transfer of Undivided Interests ............. 6-90(e) Transfers Invoke Contingent

Payments ................................................. 6-90(f) Transfers With Geographical and

Field-of-Use Limitations ......................... 6-90(g) Transfers Subject to Nonexclusive

Licenses ................................................... 6-91b. Capital Asset ......................................................... 6-92

i. Patents Held by Professional Inventors .......... 6-92ii. Patents Used in a Trade or Business .............. 6-92

(a) PatentsExcludedFromDefinitionofCapital Asset ........................................... 6-92

(b) Patents That Are Considered Capital Assets ......................................... 6-93

(c) Patents That Are Considered Quasi-Capital Assets .............................. 6-93

c. Holding Period ....................................................... 6-93i. Beginning of Holding Period ............................ 6-93

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ii. Tacking on of Holding Period........................... 6-946. Overriding Characterization Provisions .................. 6-94

a. Section 1239 ........................................................... 6-94b. Section 707(b) ........................................................ 6-95c. Section 1245 Depreciation Recapture .................. 6-95i. DefinitionofSection1245Property................. 6-96ii. Patent Applications .......................................... 6-96iii. Self-Created Patents Expensed Under

Section 174 ........................................................ 6-96B. Trade Secrets and Know-How ........................................ 6-97

1. In General .................................................................. 6-97a. Services Versus Property ...................................... 6-97b. License Versus Sale ............................................... 6-97c. Know-How Transfers Treated as Licenses .......... 6-97d. Know-How Transfers Treated as Sales ................ 6-97e. Trade Secret Misappropriation Claims ................ 6-97

2. QualificationasProperty .......................................... 6-983. License Versus Sale................................................... 6-984. Know-How Transfers Qualifying Under

Section 1235 ............................................................. 6-100a. Trade Secrets and Know-How That Are

Patentable ............................................................ 6-100b. Trade Secrets and Know-How Transferred in

Connection With Patents .................................... 6-100c. Other Elements of Section 1235 ......................... 6-100

5. Know-How Transfers Not Qualifying Under Section 1235 ............................................................. 6-101a. Sale or Exchange ................................................. 6-101b. Capital Asset ....................................................... 6-101

i. Self-Created Trade Secrets and Know-How ...... 6-102ii. Purchased Trade Secrets and Know-How ..... 6-102iii. Treatment as Quasi-Capital Assets Under

Section 1231 .................................................... 6-102iv. Trade Secrets and Know-How in Hands of

Professional Developer ................................... 6-102c. Holding Period ..................................................... 6-103

6. Overriding Characterization Provisions ................ 6-103a. Section 1239 ......................................................... 6-103b. Section 1245 Depreciation Recapture ................ 6-103i. Definitionof“Section1245Property” ............ 6-104ii. Purchased Trade Secrets and Know-How ..... 6-104iii. Self-Created Trade Secrets and Know-How ...... 6-105

C. Copyrights ..................................................................... 6-1051. In General ................................................................ 6-1052. License Versus Sale................................................. 6-106

a. Fragmentation of Medium of Expression ........... 6-106b. Permissible Restrictions or Limitations............. 6-106c. Impermissible Limitations .................................. 6-107

d. Nature of Consideration ...................................... 6-1073. Copyright Transfers Considered Sales .................. 6-1084. Character of Gain or Loss on Copyright Sales ...... 6-110

a. Section 1235 Not Applicable ............................... 6-110b. General Characterization Principles Apply ....... 6-110

i. Treatment of Self-Created Copyrights .......... 6-110ii. Special Rule for Musical Compositions

and Copyrights Therein ................................. 6-111iii. Rules for Design Patents and Computer

Software .......................................................... 6-112iv. Treatment of Copyright Dealers and

Inventory ......................................................... 6-112v. Treatment of Work-for-Hire Creations ......... 6-113

5. Overriding Characterization Provisions ................ 6-113a. Section 1245 Depreciation Recapture ................ 6-113b. Application to Copyrights ................................... 6-114

D. Trademarks and Trade Names ..................................... 6-1141. In General ................................................................ 6-114

a. Historical Background Leading to Section 1253 .......................................................... 6-114

b. Current Tax Framework ..................................... 6-1152. Section 1253 Transfers: Ordinary Income ............. 6-115

a. Contingent Payments .......................................... 6-115b. Noncontingent Payments .................................... 6-116

i. Six Retained Powers That May Cause Ordinary Income Treatment .......................... 6-116

ii. Duration of Restrictions Relevant ................. 6-117iii.OtherPotentiallySignificantRetained

Powers ............................................................. 6-118iv. Basis Recovery ................................................ 6-119

3. Non-Section 1253 Transfers ................................... 6-120a. Not a Capital Asset Under Section 1221............ 6-120b. A Quasi-Capital Asset Under Section 1231 ....... 6-120

4. Overriding Characterization Provisions ................ 6-121a. Section 1239 ......................................................... 6-121b. Section 1245 Depreciation Recapture ................ 6-121

E. Computer Software ....................................................... 6-1221. In General ................................................................ 6-122

a. Tax Consequences of a License ........................... 6-122b. Tax Consequences of a Sale ................................ 6-122

2. License Versus Sale Determination ....................... 6-124a. Transfers Considered a Sale ............................... 6-124b. Transfers Considered a License ......................... 6-124

3. Computer Software Tax Consequences of Sales .... 6-125a. Determining Gain or Loss Realized ................... 6-125b. Determining Gain or Loss Recognized ............... 6-126

4. Character of Gain or Loss on Sale .......................... 6-128a. Self-Developed Computer Software Sold

Only as a Copyright............................................. 6-129

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b. Self-Developed Computer Software Sold as a Patent or Trade Secret ..................................... 6-129i. SoftwareThatQualifiesforCapitalGain

Treatment Under Section 1235 ..................... 6-129ii. Software That Does Not Qualify Under

Section 1235 .................................................... 6-130c. Purchased Computer Software and Works-

for-Hire Creations ............................................... 6-130i. Inventory ......................................................... 6-131ii. Trade or Business Property ........................... 6-131iii. Special Rule for Business That Expensed

Software Development Costs Under Section 174 ...................................................... 6-131

5. Overriding Characterization Provisions ................ 6-132a. Section 1245 Depreciation Recapture ................ 6-132b. No Recapture Required for Software

Development Costs .............................................. 6-132F. Domain Names .............................................................. 6-133

1. QualificationasProperty ........................................ 6-1332. Application of Section 1253..................................... 6-137

a.DefinitionofTrademark ..................................... 6-137b.DefinitionofTradeName ................................... 6-137c. Application to Domain Names That Function

as Trademark Equivalents ................................. 6-1383. Application of General Characterization

Provisions................................................................. 6-138a. Capital Asset ....................................................... 6-138b. Quasi-Capital Assets ........................................... 6-139c. Section 1245 Depreciation Recapture ................ 6-139

G. Web Sites and Web Content ......................................... 6-1401. Web Site Structure .................................................. 6-1402. Web Content ............................................................ 6-141

a. Copyrightable Content ........................................ 6-141b. Noncopyrightable Content .................................. 6-143

Chapter 7: Taxation of Intellectual Property Litigation .............. 7-1 I. Tax Treatment of Intellectual Property Litigation Costs ..... 7-2

A. Litigation Costs in Patent Cases ...................................... 7-41. Litigation Costs in Cases Concerning Patent

Asset Ownership ......................................................... 7-42. Litigation Costs in Patent Infringement Cases ......... 7-6

B. Litigation Costs in Copyright Cases ................................ 7-91. In General .................................................................... 7-92. Copyright Registration Costs ..................................... 7-93. Costs Incurred in Copyright Suit to Recover

Lost Income and Protect Copyrights ........................ 7-10C. Litigation Costs in Trademark Cases ............................ 7-10

1. Costs of Defending Trademark Registrations in Cancellation Proceedings .......................................... 7-11

2. Litigation Costs in Trademark Infringement Cases .......................................................................... 7-12

3. Litigation Costs Incurred in Unfair Competition Claims ................................................... 7-16

II. Tax Treatment of Damages Awards and Settlement Proceeds in Intellectual Property Suits ............................... 7-18A. Damages Awards/Settlement Proceeds in Patent

Infringement Cases ......................................................... 7-20B. Damages Awards/Settlement Proceeds in Patent

Cases Involving Injury to Capital Structure and Goodwill .................................................................... 7-23

C. Damages Awards/Settlement Proceeds in Copyright Infringement Cases ....................................... 7-24

D. Damages Awards/Settlement Proceeds in Trademark Cases ............................................................ 7-25

E. Damages Awards/Settlement Proceeds in Trade Secret Misappropriation Cases ............................ 7-28

F. Independent Contractors and the Self-Employment Tax ................................................................................... 7-30

G. Tax Treatment of Arbitration Awards for Providing “Ideas” to Employers ....................................................... 7-30

III. Tax Treatment of Awards of Attorney’s Fees and Costs ..... 7-32 IV. Tax Treatment of Payments to Others for Discontinuing

Use of a Trademark .............................................................. 7-33 V. Tax Treatment of Payments of Acquired Intellectual

Property Liabilities ............................................................... 7-34 VI. ImpactofTaxesinCalculatingInfringingProfits .............. 7-36

Chapter 8: Taxation of Intellectual Property Held by Business Entities ......................................................... 8-1

I. Introduction ............................................................................. 8-3 II. Intellectual Property Held by Corporations .......................... 8-3

A. Taxation of C Corporations ............................................... 8-3B. Taxation of S Corporations ............................................... 8-4C. Acquisition of Intellectual Property by Corporations...... 8-5

1. Shareholder-Level Consequences ............................... 8-62. Corporate-Level Consequences ................................... 8-73. The “Property Transfer” Requirement ...................... 8-84. Section 482 Allocations ............................................. 8-105. Assignment of Income ............................................... 8-11

D. Sales and Licenses of Intellectual Property by C Corporations................................................................. 8-111. In General .................................................................. 8-112. The Personal Holding Company Tax ....................... 8-12

E. Sales and Licenses of Intellectual Property by S Corporations ................................................................. 8-141. In General .................................................................. 8-142. Special Problems for Certain S Corporations

With Excessive Royalty Income ................................ 8-15

xxxii Intellectual Property Taxation

a. Penalty Tax on Passive Investment Income ........ 8-15b. Termination of Election ........................................ 8-16

F. Transactions Between Related Corporations: Section 482 ....................................................................... 8-16

G. Distributions of Intellectual Property to Shareholders .................................................................... 8-17

H. Taxable Asset and Stock Acquisitions ........................... 8-181. Taxable Asset Acquisitions ....................................... 8-18

a. Allocation of Purchase Price Under Section 1060 ........................................................... 8-18

b. Amortization of Acquired Intangibles Under Section 197 ................................................. 8-20

2. Taxable Stock Acquisitions ....................................... 8-20I. Tax-Free Reorganizations ............................................... 8-21

1. Types of Acquisitive Reorganizations ...................... 8-22a. A Reorganizations ................................................. 8-22b. B Reorganizations ................................................. 8-22c. C Reorganizations ................................................. 8-22d. Type-A Triangular Mergers .................................. 8-23

2. The Judicial Doctrines Applicable to Reorganizations ......................................................... 8-23

3. Tax Consequences for the Parties to a Reorganization: The Operative Provisions .............. 8-24

III. Intellectual Property Held by Unincorporated Entities (Partnerships and Limited Liability Companies) ............... 8-25A. Types of Unincorporated Entities .................................. 8-25B. TaxClassificationofUnincorporatedBusinesses ......... 8-26C. Basic Tax Rules Under Subchapter K ............................ 8-26

1. Pass-Through Taxation ............................................. 8-262. Maintenance of Capital Accounts ............................. 8-273. Maintenance of Outside Basis .................................. 8-274. Comparison of Partnerships with S Corporations ... 8-285. Example: Intellectual Property Held

by a Partnership ........................................................ 8-28D. Acquisition of Intellectual Property by Partnerships ... 8-29

1. Partner-Level Consequences .................................... 8-292. Partnership-Level Consequences ............................. 8-323. The “Property Transfer” Requirement ..................... 8-33

E. Partnership Dispositions of Contributed Intellectual Property ....................................................... 8-33

F. Research and Development Activities by Partnerships .................................................................... 8-341. The Rise of R&D Limited Partnerships ................... 8-342. The Impact of Green, Post-Snow Cases, and

I.R.C. §469 ................................................................. 8-353. The Continuing Utility of R&D Limited

Partnerships .............................................................. 8-39a. Demonstrating a Realistic Prospect of

Entering Into a Trade or Business ....................... 8-39

Detailed Table of Contents xxxiii

b. Avoiding I.R.C. §469 .............................................. 8-43G. Sales and Licenses of Intellectual Property by

Partnerships .................................................................... 8-441. Characterization of Gains and Losses from

Sales of Intellectual Property—General Rule ......... 8-442. Characterization of Gains and Losses from

Sales of Contributed Intellectual Property .............. 8-44H. Sale and Liquidation of Partnerships and

Interests Therein ............................................................. 8-461. Sale of Partnership Interests .................................... 8-462. Liquidation of Partnership Interests ....................... 8-47

I. Business and Estate Planning With Partnerships ........ 8-48

Chapter 9: Taxation of Intellectual Property Held by Non-ProfitOrganizations(andCharitableContributions of Intellectual Property) ...................... 9-1

I. PropertyHeldbyNonprofitOrganizations ............................ 9-2 II. Requirements for Charitable Tax Exemption ....................... 9-3 III. CommercialActivitiesofNonprofitsandthe

Unrelated Business Income Tax ............................................ 9-4A. The Impact of Commercial Activity on Tax

Exemption .......................................................................... 9-4B. The Unrelated Business Income Tax ............................... 9-5

1. Royalties From Licensing of Intellectual Property ....................................................................... 9-6

2. Research Income .......................................................... 9-73. Gain From the Sale of Intellectual Property ............. 9-8

C. Tax Treatment of Employees Who Work for NonprofitOrganizations ................................................... 9-8

IV. Charitable Contributions of Intellectual Property ................ 9-9A. General Requirements for Charitable Tax Deduction ...... 9-9

1. Contribution of Property ........................................... 9-10a. Contribution Requirement .................................... 9-10b. Property Requirement ........................................... 9-10

2. “To or for the Use of” ................................................. 9-123. QualifiedCharitableDonees ..................................... 9-134. Partial Interest Restrictions ..................................... 9-14

a. Patents ................................................................... 9-15b. Copyrights .............................................................. 9-16

B. Amount of Charitable Deduction .................................... 9-19C. Percentage Limitations on Amount Currently

Deductible ........................................................................ 9-21D. Reporting and Substantiation Requirements ................ 9-21

1. Donors ........................................................................ 9-222. Donees ........................................................................ 9-23

xxxiv Intellectual Property Taxation

Part III: Structuring Ownership of Intellectual Property: U.S. and International Tax Planning Strategies

Chapter 10: Use of Domestic Intellectual Property Holding Companies ................................................... 10-1

I. Introduction ........................................................................... 10-2 II. Structure (and Tax Advantages) of Domestic IP

Holding Companies ............................................................... 10-3A. NontaxBenefits ............................................................... 10-4B. TaxBenefits ..................................................................... 10-5C. The IP Holding Company Model: A Closer Look

attheStructureandTaxBenefits .................................. 10-6 III. Tax Consequences of Formation: Contribution of IP by

Parent Company in Exchange for Stock of IP Holding Company .................................................................. 10-7A. Tax Treatment of Parent Company at Formation ......... 10-7

1. In General .................................................................. 10-72. The Property Transfer Requirement ........................ 10-83. Stock Basis and Holding Period ............................. 10-11

B. Tax Treatment of IP Holding Company at Formation ...................................................................... 10-11

IV. Tax Consequences of License-Back Arrangement: Payment of Royalties by Parent Company to IP Holding Company ........................................................... 10-12A. General Tax Rules ......................................................... 10-12

1. Royalties Paid by Parent Company: Deductible .... 10-122. Royalties Received by IP Holding Company:

Exempt From Taxation ........................................... 10-13B. Closing the Loophole: State Responses to

IP Holding Companies .................................................. 10-141. Asserting Nexus Over the Out-of-State

IP Holding Company ............................................... 10-15a. Background .......................................................... 10-15b. The Geoffrey Decision .......................................... 10-16c. State Court Decisions Post Geoffrey ................... 10-18

i. Louisiana ........................................................ 10-18ii. Massachusetts ................................................ 10-20iii. Missouri .......................................................... 10-22iv. New Jersey ...................................................... 10-24v. New Mexico ..................................................... 10-27vi. North Carolina ................................................ 10-30vii. Oklahoma ........................................................ 10-31

viii. West Virginia .................................................. 10-332. Disallowing the Parent Company’s Deduction

of Royalty Payments ............................................... 10-35a. Background .......................................................... 10-35b. Risk of Disallowance of Deduction for

Royalty Payments................................................ 10-37

Detailed Table of Contents xxxv

c. Risk That Royalties Will Be Subject to Transfer Pricing Adjustments ............................ 10-38

3. Enacting “Add-Back” Statutes ................................ 10-42a. Background .......................................................... 10-42b. Sample Add-Back Statutes ................................. 10-43c. Illustrative Cases ................................................ 10-43

i. Alabama .......................................................... 10-43ii. New Jersey ...................................................... 10-46iii. Virginia ........................................................... 10-46

4. Adopting “Combined Reporting”............................. 10-46a. Background .......................................................... 10-46b. Illustrative Cases ................................................ 10-48

i. Arizona ............................................................ 10-48ii. Illinois ............................................................. 10-48iii. Indiana ............................................................ 10-49iv. Maryland ......................................................... 10-50v. New York ........................................................ 10-55vi. Virginia ........................................................... 10-62

5. IP Holding Company as Franchisor and State Income Tax on Royalty Payments ................ 10-63

6. Summary ................................................................. 10-64 V. Tax Consequences of Dividend Distributions to

Parent Company ................................................................. 10-65 VI. Some Nontax Concerns About Patent Holding

Companies ........................................................................... 10-66A. RecoveryforReasonableRoyaltyandLostProfits ...... 10-66B. Jurisdictional Concerns ................................................ 10-68C. Standing ......................................................................... 10-70

Chapter 11: Use of Foreign Intellectual Property Holding Subsidiaries ................................................. 11-1

I. Introduction ........................................................................... 11-3 II. U.S. Jurisdiction to Tax ........................................................ 11-5

A. Individuals ....................................................................... 11-5B. Corporations .................................................................... 11-6C. Partnerships .................................................................... 11-7

III. Outbound Transactions ........................................................ 11-7A. General Taxing Rules ..................................................... 11-7B. Special Rules for Personal Holding Corporations ......... 11-9

1. Domestic Corporations .............................................. 11-92. Foreign Corporations .............................................. 11-10

C. The Foreign Tax Credit ................................................. 11-131. In General ................................................................ 11-132. Foreign Tax Credit Limitation ............................... 11-15

D. Deduction Relating to U.S. Production Activities ....... 11-181. Deduction Percentages ............................................ 11-182. Deduction Limited to Wages Paid .......................... 11-183. QualifiedProductionActivitiesIncome ................. 11-19

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4. Trade or Business Requirement ............................. 11-225. Pass-Through Entities ................................................11-226. ExpandedAffiliatedGroups ................................... 11-237. Net Operating Loss ................................................. 11-23

IV. Inbound Transactions ......................................................... 11-23A. General Taxing Rules ................................................... 11-23B. Taxation of Business Income ........................................ 11-24

1. “Engaged in a Trade or Business” in the United States ........................................................... 11-24

2. “Effectively Connected Income” .............................. 11-26a. Periodic Income and Certain Other U.S.

Source Income ...................................................... 11-26b. All Other U.S. Source Income ............................. 11-27c. Certain Foreign Source Income .......................... 11-28

3. Treaty Exceptions.................................................... 11-28C. Taxation of Nonbusiness Income from

U.S. Sources ................................................................... 11-291. “Fixed or Determinable, Annual or

Periodical” Income ................................................... 11-292. Treaty Exceptions.................................................... 11-31

V. Source Rules ........................................................................ 11-35A. The Income Source Rules .............................................. 11-36

1. Personal Services .................................................... 11-362. Royalties .................................................................. 11-36

a. In General ............................................................ 11-36b. Cascading Royalties ............................................ 11-39

3. Sales ......................................................................... 11-424. Infringement Awards .............................................. 11-47

B. Deduction Allocation and Apportionment Rules ......... 11-511. In General ................................................................ 11-512. Research and Development Expenditures ............. 11-54

VI. The Role of Treaties ............................................................ 11-55A. In General ...................................................................... 11-55B. The Relationship Between Treaties and the Code ...... 11-55C. Sample Tax Treaty Provisions ...................................... 11-56

VII. The Migration of IP Offshore .............................................. 11-57 VIII. Anti-Deferral Provisions ..................................................... 11-59

A. Subpart F: Controlled Foreign Corporations .............. 11-591. Foreign Base Company Income .............................. 11-60

a. Foreign Personal Holding Company Income ..... 11-60b. Foreign Base Company Sales Income ................ 11-60c. Foreign Base Company Services Income ........... 11-62

2. Special Exceptions to Foreign Base Company Income ..................................................... 11-62

B. Section 482: Transfer Pricing Rules ............................. 11-63C. Section 367(d): Transfers to Foreign Corporations ..... 11-63

1. Section 367(a) .......................................................... 11-632. Section 367(d) .......................................................... 11-64

Detailed Table of Contents xxxvii

3. Treatment of Boot in a Section 367(d) Transaction .............................................................. 11-65

4. Foreign Tax Credit Limitation ............................... 11-66D. Passive Foreign Investment Company Rules .............. 11-66

IX. International Tax Planning Strategies: The Use of Foreign IP Subsidiaries and Repatriation Techniques ..... 11-67A. Double Irish Structure .................................................. 11-67

1. Step 1 ....................................................................... 11-682. Step 2 ....................................................................... 11-683. Step 3 ....................................................................... 11-694. Step 4 ....................................................................... 11-695. Step 5 ....................................................................... 11-70

B. Double Irish With Dutch Sandwich Technique ........... 11-70C. Repatriation Techniques ............................................... 11-70

X. Section 482 Transfer Pricing: A Closer Look ..................... 11-71A. What is Transfer Pricing? ............................................. 11-71B. Transfer Pricing Methods for Transfers and

Licenses of Intellectual Property .................................. 11-731. Comparable Uncontrolled Transaction (CUT)

Method ..................................................................... 11-742. ComparableProfitsMethod(CPM) ........................ 11-753. ProfitSplitMethod .................................................. 11-79

a.ComparableProfitSplitMethod ......................... 11-80b.ResidualProfitSplitMethod .............................. 11-80

4. “Commensurate With Income” Requirement ......... 11-81C. Ownership of Intangible Property ................................ 11-82

1. Determining the Owner of an Intangible Under Current Regulations .................................... 11-83

2. Determining Arm’s-Length Consideration Under Current Regulations .................................... 11-83

3. Historical Background: The 1968 Developer- Assister Regulations and DHL ............................... 11-84

D. Cost-Sharing Arrangements ......................................... 11-901. Sharing Intellectual Property Development

Costs in Proportion to Reasonably Anticipated Benefits. ................................................................... 11-91a. Intangible Development Costs ............................ 11-91b.ReasonablyAnticipatedBenefits ........................ 11-95

2. Platform Contribution Transaction (PCT) Payments ................................................................. 11-95

E. Information Reporting Requirements .......................... 11-98F. Transfer Pricing Penalties ............................................ 11-99

1. Transactional Penalty ............................................. 11-992. Net Adjustment Penalty ......................................... 11-993. Safe Harbor Exceptions .......................................... 11-99

G. Services Transactions That Effect a Transfer of Intangible Property ..................................................... 11-100

H. Advanced Pricing Agreements (APAs) ....................... 11-101

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Part IV: Estate Planning and Valuation

Chapter 12: Estate Planning for Intellectual Property ............... 12-1 I. Introduction ........................................................................... 12-2 II. Addressing Intellectual Property in an

Estate Plan ............................................................................ 12-3A. Identifying and Valuing Intellectual Property

in the Estate .................................................................... 12-3B. Deciding How to Transfer Intellectual Property ........... 12-4C. The Careful Drafting of Lifetime Gifts and

Testamentary Bequests ................................................. 12-5D. Choosing a Special Executor for Intellectual

Property ........................................................................... 12-5 III. An Overview of the Estate and Gift Taxes .......................... 12-6

A. The Estate Tax ................................................................ 12-7B. The Gift Tax ..................................................................... 12-9C. Special Valuation Rules ................................................ 12-10

IV. Mitigating the Effects of the Estate and Gift Taxes ......... 12-11A. Choosing Between Lifetime Gifts and

Testamentary Bequests of Intellectual Property ........ 12-11B. Utilizing the Marital Deduction and

Charitable Deduction .................................................... 12-121. The Gift Tax Marital Deduction ............................. 12-122. The Estate Tax Marital Deduction ......................... 12-133. The Charitable Deduction ....................................... 12-14

C. Utilizing Family Limited Partnerships and Limited Liability Companies ........................................ 12-14

D. Obtaining Life Insurance to Satisfy Estate Tax Obligations ............................................................. 12-15

E. Deferring Payment of Estate Tax on Intellectual Property ..................................................... 12-16

V. Income and Deductions in Respect of a Decedent ............. 12-17A. Income in Respect of a Decedent (IRD) ........................ 12-17B. Deductions in Respect of a Decedent (DIRD) .............. 12-18

Part V: Internet Taxation

Chapter 13: Internet and E-Commerce Taxation ......................... 13-1 I. The Internet Tax Freedom Act ............................................. 13-2 II. State Tax Decisions Interpreting ITFA ............................... 13-3 III. State Internet Sales or Use Taxation .................................. 13-5

A. SubstantialNexusStandard—OfflineEnvironment ...... 13-5B. Substantial Nexus—Internet Implications .................... 13-6C. States’ Sales Tax on Electronic Commerce

Transactions .................................................................. 13-15D. Taxation of Payment of Shipping Charges of

the Purchase of Products at Web Sites ........................ 13-75

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E. Ad Valorem Taxes of Goods Sold to Out-of-State Retail Customers Through the Internet ...................... 13-75

F. Patent Drawings Delivered to Clients Electronically and Sales Tax ........................................ 13-76

IV. State Taxation of Online Delivery of Digitized Photographic Images .......................................................... 13-77

V. State Taxation of Online Delivery of Digitized Music Recordings ................................................................ 13-79

VI. StateTaxationofOnlineSalesofGiftCertificatesat the Taxpayer’s Web Site ..................................................... 13-80

VII. State Taxation of Database Licenses Over the Internet ... 13-81 VIII. State Taxation of Web Site Development Services ........... 13-83 IX. Federal Taxation of Web Sites—Development Costs ........ 13-86

A. Anatomy of a Web Site .................................................. 13-861. Treatment as Software Development ..................... 13-862. Treatment as Copyright Development ................... 13-873. Treatment as Advertising ....................................... 13-87

B. Costs of Developing Web Site Structure ...................... 13-871. Treatment as Software............................................ 13-87

a. In-House Development Costs.............................. 13-87b. Payments to Third-Party Software Developers. ... 13-88c. Amortization/Depreciation Options.................... 13-89

2. Treatment as Advertising ....................................... 13-89C. Costs of Developing Copyrightable Web Contents ...... 13-89

1. Capitalization .......................................................... 13-902. Exceptions to Capitalization ................................... 13-91

D. Costs of Developing Noncopyrightable Web Content .... 13-921. Treated as Advertising ............................................ 13-932. Not Treated as Advertising..................................... 13-93

a. Content That Lasts Less than One Year ........... 13-93b. Content That Extends Beyond a Year................ 13-93

E. Costs of Developing Web-Based Advertising ............... 13-94F. Costs of Developing Web-Based Catalogs .................... 13-95G. TaxCreditforWebSites’ModificationExpenses

in Compliance With the Americans With Disabilities Act .............................................................. 13-98

X. Federal Taxation of Domain Names—Registration, Acquisition, and Advertising Costs .................................... 13-98A. Initial Costs to Register a Domain Name .................... 13-98

1. Capitalization of Registration Costs ...................... 13-982. 12-Month Rule ......................................................... 13-99

B. Initial Costs to Purchase a Domain Name ................ 13-100C. Amortization of Capitalized Registration and

Purchase Costs ............................................................ 13-1001. Domain Names Functioning as Trademarks ....... 13-1002. Generic Domain Names Not Protected

Under Trademark Law ......................................... 13-101D. Later Costs in Developing Goodwill in Domain Name ... 13-102

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Appendix A: Table of Internal Revenue Code Sections ..................A-1Appendix B: Table of Treasury Regulations ....................................B-1Appendix C: Miscellaneous Administrative Actions .......................C-1Appendix D: Selected State Statutes Relating to Intellectual

Property Holding Companies ..................................... D-1

Table of Cases ................................................................................ TC-1Index ................................................................................................IN-1About the Authors ..........................................................................AU-1

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