Key Takeaways

  • Intellectual property (IP) taxation depends on whether the IP is self-created or acquired, and how it's used or sold.
  • Self-created works like music or books are generally taxed as ordinary income, not capital gains.
  • Acquired IP may qualify for capital gains treatment if not held for sale in the ordinary course of business.
  • Businesses must align IP strategy with global tax laws to minimize risks and maximize returns.
  • Methods like amortization and the income forecast method help determine how to deduct IP-related expenses.

Understanding the taxation of intellectual property is important if you plan to develop your own intellectual properties or if you plan to invest in those that others have created.

The Internal Revenue Code places certain "non-favorable" treatments on intellectual properties the creator may offer for sale, such as:  

  • Literary works  
  • Music compositions  
  • Artistic compositions  
  • Video games  
  • Television shows
  • Movies  
  • Books

Other types of intellectual property that may be included in a general type of intangible assets may also be treated as capital assets when the creator offers them for sale. These properties can be subject to special regulations regarding the product's useful life, which specify how to amortize the cost associated with an intangible asset. Some examples of intellectual properties that may fall under this category include:  

  • Trade secrets
  • Formulas  
  • Operational knowledge  
  • Techniques, methods, or processes related to secrecy

Understanding Legal Implications

Gaining an understanding of the legal and tax implications associated with intellectual property can be quite an intimidating task. Many large companies have experts at their disposal to account for the sale and the ownership of intellectual property properly. 

However, most individuals rarely have the necessary understanding of the legal implications of intellectual property, despite the fact that the latter plays an important role in the United States economy.

As a consequence, creators and their tax advisors, should they have any, are usually not as familiar with the tax issues that apply to their specific professions as they could be. Adequate planning and reporting of income gained from intellectual property can have a rather significant effect on a creative person's tax liabilities. The way in which intellectual properties are treated for the purpose of taxation is normally determined by:

  • Considering the property's nature.
  • How a person came to be in possession of it.

There are a number of factors that determine whether the cost associated with developing an intellectual property might have to be reported on the creator's personal taxes, being rendered ineligible for deduction or amortization, and if the property is eligible to be immediately expensed. 

Some of these factors include:  

  • The purpose of the intellectual property  
  • The nature of its development  
  • The intellectual property's useful life

It may be possible to determine the eligibility for amortization of the cost associated with purchasing an intellectual property by using the income forecast method.

Amortization and Expense Treatment of Intellectual Property

Intellectual property with a determinable useful life may qualify for amortization under Section 197 of the Internal Revenue Code. This provision allows purchasers to deduct the cost of qualifying intangibles over 15 years, even if the asset becomes obsolete earlier.

However, costs incurred in creating IP (e.g., research and development) may not be immediately deductible unless they meet the criteria under Section 174. Under the amended Section 174 rules effective from 2022, R&D expenditures—including those for software development—must be capitalized and amortized over five years (15 years if incurred outside the U.S.).

For assets with income potential tied to future earnings (e.g., film rights or patented software), the "income forecast method" may be used to amortize costs based on projected future income. This approach can more closely align deductions with revenue generation.

Tax Classifications for Intellectual Property

Intellectual property may be classified as a capital asset, ordinary income property, or amortizable intangible asset, depending on its origin and use. The IRS does not allow creators of self-produced IP—such as authors, artists, and composers—to treat income from the sale of their works as capital gains. Instead, the proceeds are taxed as ordinary income.

By contrast, purchasers of IP (e.g., corporations buying patents or copyrights) can often classify the IP as a capital asset. This allows them to treat gains on resale more favorably under capital gains tax rules, unless the IP is held primarily for sale in the ordinary course of business.

Aligning Business Strategy and Tax Planning for Intellectual Property

Today, many companies are looking for new ways to increase their profits and revenues with continuing to manage costs and cash flow effectively. This makes developing an effective tax plan for intellectual property a good idea. Properly handling intellectual properties is a great way to help companies:

  • Generate high value
  • Address the risks associated with taxation and manage them effectively

Failing to address these issues properly can potentially lead to higher tax burdens on a global level. It could also limit the company's ability to effectively make important decisions after taxation. 

Most business leaders do not have the time it takes to consider intellectual property as a critical business issue properly. They are often much too involved in the company's real-life situations, which can determine the company's failure or success.

International Tax Considerations for Intellectual Property

As businesses expand globally, intellectual property tax planning becomes increasingly complex. Companies must navigate various tax regimes that treat IP transfers and royalties differently. Key global considerations include:

  • Transfer pricing rules: Multinational entities must set arm's-length pricing for intercompany transfers of IP, including royalties, licenses, and development costs.
  • Location of IP ownership: Jurisdictions offering favorable tax treatment for IP (e.g., Ireland, Singapore) may encourage companies to relocate IP holdings, though this requires compliance with substance-over-form requirements.
  • BEPS (Base Erosion and Profit Shifting) compliance: OECD initiatives have tightened scrutiny on IP-related tax planning, requiring alignment of profits with economic activity.

Misalignment between where IP is owned and where it is used can result in significant tax penalties and compliance risks.

How Should the Creator of Intellectual Property Expect to Be Treated?

The following types of intellectual property will not be eligible for treatment as capital gain in the event the property is sold:  

  • Self-created copyrights  
  • Literary works  
  • Music compositions  
  • Artistic compositions

The Tax Court, for example, has determined that the concept of a television show is not eligible for such treatment.

Intellectual property that has been purchased is usually eligible to receive treatment as a capital asset when it has been sold. This is unless the owner possesses the intellectual property for the primary intention of selling it to customers in the regular course of daily business. A couple of examples of these situations can include:  

  • Non-customized computer software  
  • Video games

When the copyright and the software are purchased, it can be considered as a capital gain. However, the sale of the copyright, along with the code behind the software, would not be considered as a capital gain.

Licensing vs. Selling Intellectual Property

Licensing intellectual property rather than selling it outright can change how the income is taxed. Royalties from licensing agreements are typically treated as ordinary income. However, structuring agreements strategically may provide opportunities to reduce tax burdens.

For example, licensing software or patented technology through a corporate entity may allow for more favorable deductions and income deferral. Additionally, licensing allows creators to retain ownership while generating recurring revenue streams, potentially reducing the risk of triggering a taxable capital transaction.

Whether licensing or selling, creators and investors must evaluate the downstream tax impact on income, deductions, and estate planning.

Frequently Asked Questions

1. Is income from selling self-created intellectual property taxed as capital gain?  

No, creators of works such as books, music, or artwork generally recognize ordinary income, not capital gain, when they sell their creations.

2. Can intellectual property be amortized for tax purposes?

Yes, if the intellectual property has a determinable useful life and qualifies under Section 197, it can be amortized over 15 years.

3. What is the income forecast method?

It is a method that allows amortization of IP-related expenses based on the projected income the IP is expected to generate over its useful life.

4. How is acquired intellectual property treated for tax purposes?

Acquired IP may qualify as a capital asset, and gains on its sale can be taxed at capital gains rates, unless the IP is held for sale in the ordinary course of business.

5. What global tax issues affect intellectual property?

Cross-border IP strategies must address transfer pricing, IP ownership jurisdiction, and compliance with global standards like OECD's BEPS framework.

If you need help with the taxation of intellectual property, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.