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The Tax Man Provides Some Help - New Opportunities for Tax Savings on the Sale of Intellectual Property Assets

| Lee C. Hodge Lee C. Hodge

Many taxpayers are familiar with the term "Code § 1031 like-kind exchange" ("1031 Exchange"), but many technology executives do not realize that they can engage in a 1031 Exchange with respect to intellectual property assets such as patents, copyrights, trademarks, and trade names.  In Chief Counsel Advice 20091106 ("CCA 20091106"), the Internal Revenue Service ("IRS") changed its position and now allows taxpayers to engage in 1031 Exchanges of trademarks, trade names, mastheads, and other intellectual property rights.  This change allows taxpayers to sell their intellectual property rights and defer paying tax on the gain realized from the sale.

A Primer on 1031 Exchanges

Overview

Section 1031(a) of the Internal Revenue Code generally provides that a taxpayer does not recognize gain on the disposition of business or investment property if the business or investment property is exchanged for business or investment property of a "like kind" to the property being relinquished.  While this rule seems simple enough, its application has spawned countless lawsuits, scholarly articles, and debates.

The "Like Kind" Requirement

The IRS has long held that all real property is of a "like kind" to other real property, so a taxpayer can exchange an apartment complex for a farm and recognize no gain on the disposition if the properties are of equal value. 

With respect to tangible personal property such as office furniture or automobiles, one piece of tangible personal property is considered to be of "like kind" to another piece of tangible personal property if the pieces of property are either (i) in the same "General Asset Class" (as listed in Treasury Reg. § 1.1031-2(b)(2)) or (ii) in the same "Product Class" (as listed in the North American Industry Classification System). 

With respect to intangible personal property such as intellectual property, there are no "General Asset Classes" or "Product Classes," so two items of intangible personal property will be of "like kind" only if both (i) the nature or character of the rights involved (e.g., patent v. copyright) are identical and (ii) the nature and character of the underlying property to which the intangible personal property relates (e.g., book v. movie) are identical.  However, prior to CCA 20091106, the IRS took the position that intellectual property rights other than patents and copyrights could never be of "like kind" to other intellectual property rights because such rights were too closely related to a business's goodwill, an amorphous asset, which can never be of "like kind" to any other asset.  As will be discussed below, CCA 20091106 changed this analysis, but also left many questions unanswered.

Types of 1031 Exchanges

The most basic type of 1031 Exchange is a transaction where Taxpayer A exchanges Property 1 for Taxpayer B's Property 2 and Properties 1 and 2 are of "like kind."  In this instance, if the properties are of equal value, neither taxpayer will recognize any taxable gain on the disposition of the property.

A more complex type of 1031 Exchange is a "deferred" exchange under which Taxpayer A sells Property 1 to Taxpayer B and then purchases Property 2 from Taxpayer C up to 180 days after the sale of Property 1.  There are many requirements that must be met to complete a successful "deferred" exchange, including the use of a "qualified intermediary" to hold the sales proceeds from Property 1 until they can be used to purchase Property 2, but these requirements are beyond the scope of this article.  

An even more complex type of 1031 Exchange is a "reverse" exchange under which Taxpayer A purchases Property 2 from Taxpayer B and later sells Property 1, which Taxpayer A held at the time of purchase of Property 2, to Taxpayer C.  Like a "deferred" exchange, there are many requirements that must be met to complete a successful "reverse" exchange, including the use of an "exchange accommodation titleholder" and a "qualified intermediary," but these, too, are beyond the scope of this article. 

The various types of 1031 Exchanges provide taxpayers with a tremendous amount of flexibility in structuring the acquisition and disposition of property to meet their specific needs.  However, there are a number of pitfalls a taxpayer must avoid to complete a successful 1031 Exchange, especially if the taxpayer uses a "deferred" or "reverse" 1031 Exchange structure.  Before entering into any such transaction, a taxpayer should consult with an attorney or other tax professional with extensive experience structuring 1031 Exchanges.

CCA 20091106

In CCA 20091106, the IRS finally accepted the reality that trademarks, trade names, mastheads, and customer-based intangibles (such as customer lists) may be of "like kind" to other trademarks, trade names, mastheads, and customer-based intangibles if:

  1. The intellectual property right being relinquished can be separately described and valued apart from goodwill;
  2. The nature and character of both intellectual property rights involved (e.g., trademark v. masthead) are identical; and,
  3. The nature and character of the property to which the intellectual property right relates (e.g., book v. movie) are identical. 

While CCA 20091106 provides that intellectual property rights may be of "like kind" to other intellectual property rights, the IRS clearly advised that all trademarks will not automatically be of "like kind" to all other trademarks, and this limitation also applies to the other types of intellectual property rights discussed in CCA 20091106.  Additionally, the IRS advised that such intellectual property rights must always be able to be separately described and valued apart from goodwill, so the main issue almost always will be whether requirements (ii) and (iii) listed above are met.  The IRS has not provided much guidance on the standard that will be applied to determine if those requirements are met, except for an old example in the IRS Regulations that provides that a movie copyright and a song copyright are not of "like kind" based on the different nature and character of the underlying properties. 

Planning Opportunities

Business Swaps

Due to the flexibility offered by the various 1031 Exchange structures, both buyers and sellers of businesses may be able to allocate a portion of the purchase price to intellectual property rights and defer taxable gain by acquiring other intellectual property rights of "like kind" within 180 days after the date of the original transaction.  For instance, Taxpayer A may sell its software development business and allocate $10 million of the purchase price to software copyrights and then purchase $10 million of other software copyrights.  Using such a structure, Taxpayer A would be able to defer the payment of tax on the gain related to the $10 million received for its software copyrights rather than paying tax on $10 million in the year of the transaction.  In addition, if Taxpayer A was in the software development business and Taxpayer B also was in the software development business, they may be able to exchange their businesses or certain business lines within their businesses and use a 1031 Exchange to defer tax on the gain related to the real property, tangible personal property, and intellectual property rights associated with such businesses.

Direct Dispositions of Intellectual Property Assets

Taxpayers also can use a 1031 Exchange to defer gain that otherwise would be recognized in connection with the direct disposition of intellectual property rights.  If Taxpayer A desires to sell Copyright A that relates to a software product, Taxpayer A can sell Copyright A and use the sale proceeds to purchase Copyright B relating to another software product, thereby deferring the payment of taxes that otherwise would be due from Taxpayer A as a result of the disposition of Copyright A.

Conclusion

Business owners, business executives, and their advisors need to be aware of the possible tax savings that can be generated as a result of CCA 20091106.  While CCA 20091106 leaves some questions open (such as how strictly the IRS will apply the "nature and character" rules), there is no doubt that CCA 20091106 provides taxpayers with the opportunity to realize significant tax savings.  1031 Exchanges must meet a number of requirements.  Therefore, it is important for any business or individual desiring to undertake a 1031 Exchange of intellectual property assets to contact an attorney or other tax professional with extensive experience structuring 1031 Exchanges to ensure that such 1031 Exchange is successful.

© 2010, Ward and Smith, P.A.

For further information regarding the issues described above, please contact Lee C. Hodge.

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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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