Certain self-created intangible assets no longer qualify as capital assets under the Tax Cuts and Jobs Act (TCJA). As a result, these assets no longer qualify for preferential long-term capital gain tax rates when sold in 2018 and beyond. Instead, gains from selling affected intangible assets are taxed at higher ordinary income rates.
Affected Taxpayers and Assets
This unfavorable TCJA change can obviously affect individuals who create intangible assets. But it can also affect corporations, partnerships and limited liability companies (LLCs) that receive contributions of intangibles assets from the individuals who created them.
The change potentially applies to the following types of self-created intangible assets:
- Models and designs (patented or not), and
- Secret formulas and processes.
“Self-created” means created by the personal efforts of the taxpayer. Presumably, that means created by an actual human being rather than by a taxable “person” such as a corporation, partnership or LLC.
Contributions to Another Taxable Entity
What happens when an affected intangible asset is contributed to another taxable entity? The unfavorable non-capital-asset treatment rule applies if the tax basis of the intangible in the hands of the new owner is determined in whole or part by reference to the basis of the person who created it.
Take a scenario where an affected intangible asset is contributed to a corporation, partnership or LLC tax-free in exchange for stock, a partnership interest or an LLC membership interest. A later sale of the intangible asset by the entity will produce ordinary income or loss, rather than capital gain or loss.
Special Rule for Patents
Self-created patents are now generally excluded from the definition of a capital asset. However capital gain treatment is still available under current law after certain transfers by an individual patent holder.
The IRS concluded in several Private Letter Rulings (PLRs) that individual patent holders who transferred patents to an LLC classified as a partnership in exchange for a membership interest retained their status as patent holders under Internal Revenue Code Section 1235. So, the contributing individual's share of any gain upon the LLC's subsequent sale of the patent could qualify as long-term capital gain.
As under prior (pre-TCJA) law, the following types of intangibles are also generally excluded from the definition of a capital asset:
- Literary, musical and artistic compositions,
- Letters and memoranda held by the taxpayer for whom they were prepared or produced, and
- Similar property.
There's one important exception: Taxpayers can elect to treat musical compositions or copyrights in musical works as capital assets.
We Can Help
In most cases, you can't do much to avoid the unfavorable tax treatment of affected self-created intangible assets under the TCJA. However, when affected intangibles are sold with other capital gain assets, making a supportable allocation of more of the sale price to the other assets will help ease the tax pain. Contact your tax advisor if you have questions or want more information about the treatment of self-created intangible assets.