Intellectual property (IP) is considered to be creations of the mind that are used in business. This includes patents, designs, copyrights, trademarks, or branding. As well as being the result of creative efforts, IP can be a strategic tool for your company’s growth and profitability.
Like all assets, recognition or financial benefit from IP is protected by law. But that also means that creating, owning, selling or licensing intellectual property comes with several tax implications.
Understanding Intellectual Property in Tax Terms
Intellectual property in business can take a number of forms. It might be patented to protect your innovations through exclusive ownership rights. There are also trademarks to build your brand identity and distinguish you from others. You may have copyrights to preserve your ownership or original works and create income through licensing and distribution. Or you could have trade secrets that give your business a competitive edge.
Regardless of what kind of IP your company has, according to the IRS, it’s considered a capital asset. And how it’s handled can have a number of tax implications.
For instance, a patent is usually held on a capital account and depreciates at a rate of 25% a year. Trademarks are also held in income accounts, while copyrights can be held in capital accounts or as inventory.
When your IP becomes impaired or obsolete, you may be able to recognize this as a loss on your tax return.
Of course, you’ll also need to factor in transfer pricing and withholding taxes if you transact with IP across states or borders.
The role of IP in business strategy and valuation
Because it’s considered an asset, intellectual property can help you maximize your business’ potential. By securing a competitive advantage, generating additional revenue streams, or reducing your tax liability, IP can bolster your profitability. Moreover, it can help you secure financing, attract investors, and even mitigate financial risks.
But to do so, you need to understand how to leverage your IP, and that extends to your tax strategy.
Tax Considerations in IP Creation
Creating intellectual property goes beyond adding an asset to your balance sheet. With thoughtful planning, you can also use IP to bolster your tax strategy.
For example, many of the expenses tied to creating IP are tax deductible. This includes wages and salaries of staff involved in the process, costs of materials used for research and development (R&D), and consultant fees.
It’s also possible to capitalize and amortize development costs over the economic life of the intellectual property. That way, you recover a portion of your investment through deductions over time. This requires recognizing these costs as an asset on your balance sheet instead of immediately expensing them.
While the period of time over which you can amortize the costs varies, under Section 197 of the Internal Revenue Code, IP is generally amortized over 15 years.
Tax credits as incentives for IP creation
The IRS offers a number of incentives for R&D activities, which include intellectual property creation. For instance, there is an R&D tax credit for qualified expenditures such as those listed above, as well as contract research expenses.
Another option is the Qualified Small Business Payroll Tax Credit for Increasing Research Activities. This allows you to apply part of your R&D tax credit against payroll taxes instead of income taxes.
A number of states also offer additional R&D incentives which can be combined with federal credits, to maximize the financial advantages of creating IP. 
A tax professional can help you navigate the terrain of credits and deductions, to ensure that your company makes the most of its IP creation.
Tax Implications of Owning Intellectual Property
If you use the intellectual property you own for business purposes, it’s generally considered a Section 1231 asset, or an ordinary asset. This means that if you sell IP, you’ll need to report this income on your tax return. Also, if it qualifies as a capital asset held for longer than a year, your gains are subject to long-term capital gains tax.
But what if you purchase IP? Buying intellectual property means you’ll take an income tax basis on the asset equal to its cost. And just as when you’re the creator, you can amortize the IP over a 15-year useful life. However, remember that depending on the type of IP and where to purchase it – especially if it is software – you may be subject to sales tax or use tax.
Holding IP in different jurisdictions
Different jurisdictions have varying tax regimes where intellectual property is concerned. For example, some areas have lower tax rates, or tax treaties in place that can reduce withholding taxes.
Under federal tax law, US shareholders must include their share of IP income in their gross income, regardless of where the money is actually distributed. This includes passive income like royalties. However, under the 2017 Global Intangible Low-Taxed Income (GILTI) scheme, shareholders can include part of the company’s income on their tax return, to avoid moving IP to low-tax jurisdictions.
Another popular option is to establish IP holding companies to hold and manage intellectual property, especially if international trade is involved.
With these factors in play, it’s clear that efficient IP income reporting and planning can significantly affect your tax liability.
Tax Aspects of Licensing Intellectual Property
You can receive income from licensing your intellectual property, by allowing another business to use your copyrighted, trademarked or patented material.
For tax purposes, licensing revenue is recognized as ordinary income, to be taxed in the year in which your business receives or accrues the funds.
Withholding taxes on cross-border IP licensing
If you have cross-border licensing agreements, the revenue you receive may be subject to withholding tax. This is essentially a substitute for income tax across countries. These taxes can be quite high (up to 35%) if there isn’t a tax treaty in place.
However, not all countries have the same rates. Moreover, regions like the Netherlands and Switzerland don’t impose withholding tax at all.
In countries with tax treaties, you must provide Form W-8BEN with your tax return to certify this status and claim any benefits.
Deductions and expenses related to IP licensing
As mentioned above, many of the expenses associated with creating and owning intellectual property are deductible. And the same is true for licensing.
Your legal fees, registration fees, and amortization of costs associated with IP licensing can be deducted. Similarly, if you are purchasing licenses, the royalties you pay for this are usually deductible as ordinary and necessary business expenses.
If the intellectual property in question is subject to sales tax, other deductions are available. These include freight and shipping, credit and returns, and volume discounts. But keep in mind that these can be capped, according to the terms of your licensing agreement.
Structuring licensing agreements for tax efficiency
Your licensing agreements can have a significant impact on your tax strategy. So there are a few things to consider. For example, owning IP outright rather than licensing it, or establishing a holding company, offers different benefits and deductions, as outlined above.
You should also consider whether your business will enter into Advance Pricing Agreements (APAs) with tax authorities. These outline the terms surrounding the treatment of cross-border IP payments.
When it comes to structuring these agreements, it’s essential to consult a tax professional. They’ll be able to help you tailor your agreement to align with your tax strategy, to save you time and money.
International Tax Considerations
Global tax challenges in managing IP mainly arise because of differences in tax regulations. This includes double taxation, digital taxation, and Base Erosion and Profit Shifting (BEPS). BEPS was set up by the Organization for Economic Cooperation and Development to combat tax avoidance strategies around IP activity.
So it’s no surprise that many multinational corporations structure their IP operations to minimize their taxes. Usually, this is done through transfer pricing. Essentially, this is setting the price of transactions between separate entities in a business, to reduce tax exposure.
A key aspect of transfer pricing is IP valuation, or assigning a monetary value to your intellectual property. There are three main methods used to do this:
- The income method values IP on the basis of the money it’s expected to generate, adjusted to the present-day value.
- The market method compares the value of your intellectual property with a similar asset under similar circumstances.
- The cost method establishes value by calculating the cost of a similar IP asset.
Accurate valuation is critical; if the IRS determines that your intellectual property is not correctly valued, you may be liable for penalties and fines.
Recent developments and changes in tax laws
Tax laws are always changing, and this includes those governing intellectual property. After all, cryptocurrency, blockchain, and non-fungible tokens (NFTs) are also entering the world of intellectual property, further affecting the tax implications.
It’s therefore essential to work with a tax professional who can help you navigate the laws and regulations surrounding IP.
Planning and Strategy for IP Tax Management
The earlier you integrate IP creation and licensing into your tax planning strategy, the better. By ensuring that tax-efficient structures are in place from the start, you’ll reduce your tax liability and maximize benefits.
This includes considering where you register and hold your intellectual property, and how you’ll amortize the costs associated with it.
Tax professionals like Fusion CPA can help you set up the best tax and IP strategies for your needs. We provide expert guidance on tax laws, tailored strategies to reduce how much you pay the tax man and constant support. That way, our team can help your business thrive and put money back in your pocket.
Of course, our team of outsourced CPAs can also help you with accounting for intellectual property, to help you focus on what matters: your bottom line.
For more information on how best to account for intellectual property, or the tax implications of IP, schedule a Discovery Call with one of our CPAs.
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