As a general matter, the Tax Code treats assets held for investment purposes as capital assets. Per section 1221 of the Tax Code, capital assets qualify for preferential capital gains rates. Preferential capital gains rates only apply to capital assets held for at least one year, which the tax code refers to as long-term capital gains. In light of this, the creation and acquisition of Intellectual Property (“IP”) may provide a business with significant tax advantages if the IP asset is considered a capital asset with long-term capital gains.

Section 1221 of the Tax Code specifies the requirements for treating IP as a capital asset. In particular, the Tax Code deems Trademarks, Trade Names, and Goodwill as capital assets because they are investment assets. Further––and advantageous to an inventive entity––is the favorable tax treatment provided by congress for self-created patents. Section 1235 of the Tax Code provides that a self-created patent will become a capital asset upon creation and further provides for immediate long-term capital gains treatment without requiring a one-year holding period.

Moreover, the Code provides that property held by a taxpayer is a capital asset except for the items enumerated within section 1221(a).  Notably, a taxpayer whose personal efforts are used to create a copyright will be excluded from being in possession of a capital asset––the policy behind this is that gains from personal efforts should be taxed as ordinary income just as wages and salaries are taxed as ordinary income.

Although both a corporation and LLC can own a capital asset, section 1201 of the Tax Code excludes a standard “C” corporation from taking advantage of preferential capital gains rates. To illustrate this, consider the following example: A team of two inventors newly discover a patentable idea and invest $100,000.  Once they reduce their idea to practice, they are officially in possession of a capital asset under section 1235 of the tax code. Continuing with the example, the inventors decide to sell their asset to another entity for $1,100,000. Upon selling their capital asset, the government will tax the inventors at the preferential capital gains rate of 20%, which would result in net income after tax (“NIAT”) of $800,000 as opposed to the ordinary personal income rate of 39.6%––i.e., NIAT=$604,000. Notably, in this example, I omitted state taxation to simplify the math.

In light of section 1201 of the Tax Code, inventors can only obtain capital gains at 20% provided that they are not formed as a standard “C” corporation. Accordingly, selecting an LLC or S-corp will provide members with the ability to capture preferential capital gains rates on their self-created patents.