Many modern businesses rely heavily on intangible assets, such as goodwill, trademarks, customer lists, proprietary processes and intellectual property. These assets can hold significant value, especially when a business is sold, ownership changes hands, or intellectual property is licensed or transferred.
But when it comes to federal income tax treatment, not all intangible assets are treated the same.
In general, intangible assets may qualify as capital assets. When sold, capital assets typically generate capital gains or losses. This can be favorable because long-term capital gains are generally taxed at lower federal rates than ordinary income. However, certain self-created intangible assets may not qualify for capital gain treatment.
What Are Self-Created Intangibles?
A self-created intangible is an asset created through the personal efforts of the taxpayer. This can include situations where the taxpayer directly contributed to creating the asset or directed and guided others in producing it.
This concept is straightforward when the taxpayer is an individual. However, it can also apply to corporations, partnerships and limited liability companies that receive intangible assets from the individuals who created them.
The tax treatment depends on the type of intangible involved.
Self-Created Intangibles That May Produce Ordinary Income
Some self-created intangibles are treated as noncapital assets for federal income tax purposes. When these assets are sold, the result is generally ordinary income or loss rather than capital gain or loss.
This treatment may apply to self-created assets such as:
- Patents
- Inventions, models or designs
- Proprietary formulas or processes
- Copyrights
- Literary, musical or artistic compositions
It can also apply to letters, memorandums or similar property prepared or produced for the taxpayer.
This ordinary income treatment is often less favorable because ordinary income tax rates can be higher than long-term capital gains rates.
What Happens When These Assets Are Transferred?
If a self-created noncapital intangible is contributed to another taxable entity, the unfavorable tax treatment may follow the asset.
This can happen under the “substituted basis” principle. For example, if the creator contributes a self-created intangible to a partnership in a tax-free transaction, the partnership generally takes the creator’s tax basis in the asset. As a result, the asset may continue to be treated as a noncapital asset.
The same concept can apply to tax-free contributions to LLCs treated as partnerships and to corporations. If the entity later sells the asset, the gain or loss may be treated as ordinary rather than capital.
Self-Created Intangibles That May Receive Capital Gain Treatment
Not all self-created intangibles receive unfavorable treatment. Some are generally treated as capital assets, which means a sale may produce capital gain or loss.
These may include:
- Goodwill or going concern value
- Workforce in place
- Business books and records
- Business operating systems
- Customer-based intangibles, such as client or customer lists
- Supplier-based intangibles, such as favorable supplier contracts
These assets are often sold along with other business assets. Because different types of assets may receive different tax treatment, it’s important to properly allocate the total purchase price among the assets being sold.
These allocations should be based on fair market value and carefully documented. Buyers and sellers may have different tax objectives, and the IRS may closely review allocations involving intangible assets.
What About Intangibles Created by Employees?
The tax treatment may differ when intangible assets are created by employees and owned by the business.
In one IRS ruling, intangible assets created by employees and held by a corporation were not considered to have been created by the corporation’s personal efforts. As a result, the assets were treated as capital assets owned by the business.
A similar result may apply to intangibles created and owned by partnerships, LLCs taxed as partnerships, or S corporations, depending on the facts.
Plan Carefully Before Selling or Transferring Intangibles
The tax rules for intangible assets can be complex, especially when self-created assets are involved. Some self-created intangibles may trigger ordinary income treatment, while others may qualify for more favorable capital gain treatment.
If you’re planning to sell, transfer or license intangible assets, it’s important to understand the potential tax consequences before finalizing the transaction. Careful planning and documentation can help you avoid surprises and support your tax position.
Contact us to discuss how these rules may apply to your business.
