Charitable Gifts Of Intellectual Property

At a Glance

Intellectual property--patents, copyrights, trademarks, trade secrets, artworks, musical compositions, and other similar or related property rights--are an increasingly popular form of charitable giving. Such gifts can offer attractive tax-planning advantages for philanthropic-minded individuals. However, income, gift and estate tax considerations make careful planning essential prior to making such gifts.

At the outset of this discussion, it may be helpful to recall a bedrock principle of federal income taxation -- the "fruit and tree" doctrine. Under this doctrine, the fruit (income) must be taxed to the tree (taxpayer) which bore it. Although there are some exceptions, the law generally does not approve the assignment of income without an assignment of the property that produces the income.

Patents and Other Capital Assets

Internal Revenue Code Section 1235 provides that certain proceeds from the sale of patents or patent rights may be treated by the inventor and certain other individuals as capital gain. Such patent royalties must derive directly or indirectly from the sale of these rights under an arrangement by which the purchaser pays the seller at a fixed rate per unit produced, or at a fixed percentage of the proceeds (e.g., 10% of gross sales).

Copyrights or similar property, when not held by the person whose efforts created it (e.g., an author), or by transferees whose basis is determined by reference to the basis of the creator (e.g., persons who received a copyright by gift), may also be treated as capital assets.

As a capital asset, a patent held more than one year is subject to the 30%-of-adjusted-gross-income limitation on deductibility (with a 5-year carryover of any excess) when given to charity. Moreover, gifts of patents historically have been deductible at fair market value without reduction by the gain that would have been recognized on a sale of the asset. However, the American Jobs Creation Act of 2004 added patents to the types of property gifts for which the amount of the contribution is limited to the lesser of the fair market value or basis. This applies to charitable gifts of patents made after June 3, 2004.

There is a silver lining inside this cloud. Donors of patents may elect to take additional deductions for royalty income earned by the charitable donee in the years following the gift. The deductible amount decreases on a sliding scale; 100% of the charity's income is deductible in the first two years, declining gradually thereafter, in accordance with the following table:

Year 1

100% (of qualified donee income)

Year 2

100%

Year 3

90%

Year 4

80%

Year 5

70%

Year 6

60%

Year 7

50%

Year 8

40%

Year 9

30%

Year 10

20%

Year 11

10%

Year 12

10%

Year 13+

no deduction

The IRS issued temporary and proposed regulations, as well as a notice, in 2005 to provide guidance to taxpayers and charities concerning implementation of the rules for gifts of intellectual property [T.D. 8206; Reg. Sec. 6050L-2T; Notice 2005-41].

The donor must inform the donee organization at the time of contribution that he or she intends to treat the contribution as subject to the additional charitable deduction provision for income received in respect to the qualified intellectual property. The donor's notice must be written and contain the following items:

image\bullet.jpg The donor's name, address, tax year and employer identification number

image\bullet.jpg A description of the qualified intellectual property in sufficient detail to identify the property received by the donee

image\bullet.jpg The date of the contribution to the donee

image\bullet.jpg A statement that the donor intends to treat the contribution as a qualified intellectual property contribution for purposes of IRC Sec. 170(m) and IRC Sec. 6050L

Once the donor gives timely notice of his intent to take a deduction, the donee organization files an informational return for the gifts of qualified intellectual property made after June 3, 2004. The donee organization must furnish the donor with a copy of the return. The return must include the following items:

image\bullet.jpg The donee's name, address, tax year and employer identification number

image\bullet.jpg The donor's name, address, tax year and employer identification number

image\bullet.jpg A description of the qualified intellectual property in sufficient detail to identify the property received by the donee

image\bullet.jpg The date of the contribution to the donee

image\bullet.jpg The amount of donee's net income for the tax year attributed to the qualified intellectual property (determined without the Code Sec. 170(m) limits that would exclude income not reported to the donee, income received ten years after the initial contribution, and income beyond the legal life of the qualified intellectual property)

image\bullet.jpg Other information as specified by the form or its instructions.

The donee organization is not required to file an informational return if:

image\bullet.jpg The qualified intellectual property produced no net income for the donee's tax year.

image\bullet.jpg The qualified intellectual property contribution is for a tax year beginning after the expiration of the legal life of the donated qualified intellectual property.

image\bullet.jpg The tax year begins more than 10 years after the date of the qualified intellectual property contribution.

The IRS has issued a revenue ruling on the deductibility of gifts of patents in three situations [Rev. Rul. 2003-28, 2003-11 I.R.B. 594]. All involve gifts the donors gave with restrictions, and, in two situations, the restrictions proved fatal to the deduction.

Situation #1. Donor transferred a patent license to charity, while retaining ownership of the patent itself. The IRS ruled that this was analogous to the rent-free use of property [see Reg. Sec. 1.170A-7(a)(1)], and denied an income tax charitable deduction under the partial-interest rule [IRC Sec. 170(f)(3)].

Situation #2. Donor transferred a patent to a university but retained a form of reversionary interest. The gift was made contingent on the university's continued employment of a particular faculty member for another 15 years. This condition was not so remote as to be negligible [see Reg. Sec. 1.170A-1(e)], the IRS ruled, since the university might very well not employ the individual for 15 more years. Again, the charitable deduction was denied.

Situation #3. Donor gave a patent to a university, subject to a three-year restriction on the university's right to license or transfer the patent to a third party. The IRS ruled this gift deductible, and not a prohibited partial interest or reversionary gift. The restriction could affect the valuation of the gift [see Reg. Sec. 1.170A-1(c)].

Copyrights and Other Ordinary Income Property

Most copyrights, literary and musical compositions, works of art, and similar property when held by their creator, or by someone whose basis is calculated by reference to the basis of their creator, are ordinary income property. That is, their sale would generate ordinary income for the creator of the item.

A charitable reduction rule requires that when creators, or donees of creators, donate these types of property, the deductible amount is limited to the lesser of fair market value or the creator's cost of creating the property. This charitable reduction rule requires that the fair market value of such property at the time of the gift be reduced by the amount of gain that would have been ordinary income or short-term capital gain if the donated property had been sold.

However, when the donor is not the creator, as when the copyright has been acquired through gift, inheritance or purchase, the copyright historically has been treated as a capital asset. That has meant that such a donor could deduct a charitable gift of the copyright at fair market value without reduction to basis.

That all changed with the American Jobs Creation Act of 2004, which extends the reduction rule to all holders of copyrights, whether they are the creators or other parties. On the positive side, additional deductions are allowed for up to 10 subsequent years if the charity receives royalty income from the copyright. These deductions are subject to the same phase-down percentages after the second year as is the case for patent royalties.

Fractional Interests

Generally, an income tax charitable deduction is allowed for a gift of intellectual property if such a gift represents an individual's entire interest in the property, regardless of whether the donor owns 100% or not. Such a deduction may also be taken for a gift of a fractional interest, usually described as a percentage of an intellectual property interest held jointly with another.

A charitable donation of less than a donor's entire interest in an intellectual property is generally not deductible. In such cases, proper planning can often structure transactions so that similar results may be obtained while allowing for deductibility.

In donating intellectual property, the taxpayer cannot expect or receive a full benefit or in-kind return in exchange for the transfer. Any consideration that the donor expects in return must be of token or nominal value and not a quid pro quo [see I.R.C. §6115(b)]. If the taxpayer receives a return benefit incidental to his gift, the taxpayer must reduce the amount of contribution relative to the value of that benefit

Click here to see the 2023 Token Benefits Limits.

Especially for gifts of intellectual property, the taxpayer must provide to the I.R.S. an adequate substantiation of the contribution or gift [see Reg. Sec. 1.170A-13]. The danger is the over-valuation of the intellectual property for purposes of ballooning the potential charitable deduction. The donor should obtain a qualified appraisal to guard against an I.R.S. allegation of over-valuation [see Reg. Sec. 1.170 A-13(c)(3)].

In Closing

Tax considerations with respect to gifts of intellectual property can be complex and potentially confusing. For example, if a patent is used in a trade or business, it can normally be depreciated (often as IRC Section 197 property). Deductions for charitable contributions may be reduced by such depreciation deductions that have been taken with respect to the donated property.

To assure that the full tax benefits of charitable gifts of intellectual property are obtained, donors should work closely with representatives of the charity involved, and with their own tax advisors.

 

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