New Tax Act Disqualifies Self-Creations from Capital Gains Treatment

TCJA: Gain or Loss from the sale, exchange or other disposition of a self-created patent, invention, model or design, secret formula or process are no longer treated as the sale of a capital asset under section 1221(a)(3).

The Tax Cuts and Jobs Act (the “TCJA”) was signed into law by President Trump on December 22, 2017. The provisions of the Act are effective for tax years began after January 1, 2018 and several provisions will expire on December 31, 2025. The TCJA presents numerous tax law changes that will impact businesses.

Tax Cuts and Jobs Act Revision Explained

The Tax Cuts and Jobs Act revision in the area of self-created patents and inventions present a fundamental shift from the definition of a “capital asset” and ancillary rules regarding timing and character of income as it pertains to self-created works.

Note: under the new rules, gain or loss on the disposition of other self-created intangibles, such as personal goodwill, client lists, customer contracts, etc., are still eligible for capital gain treatment. This provision also applies to disposition of self-created property after December 31, 2017.

In effect, the TCJA amended IRC Section 1221(a)(3) to expand the types of self-created property that are excluded from the definition of a capital asset. Certain self-created items were already excluded from the definition of a capital asset before the expansion of Section 1221 including “a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by”a taxpayer whose personal efforts created the property or (in the case of a letter, memorandum, or similar property) a taxpayer for whom the property was produced.

Further, this property is also excluded from the definition of a capital asset if it is held by a taxpayer who acquired the property from the creator as a gift. The TCJA expansion added additional property subject to this exclusion rule: “a patent, invention, model or design (whether or not patented), a secret formula or process.”

Amendment to Code Section 1231(b)(1)(C)

A conforming amendment to Code Section 1231(b)(1)(C) excludes this same property from the definition of “property used in a trade or business” for purposes of Section 1231. Under the new amendment a self-created patent, model or design, secret formula or process is not a capital asset and is not subject to Section 1231. The effect of this provision is to treat gain or loss from the sale or disposition of these assets as ordinary income.

Several commentators have noted that the TCJA creates an unresolved conflict between amended Section 1221(a)(3) and Section 1235. Section 1235(a) provides that a transfer (other than by gift, inheritance, or devise) by a “holder” of property consisting of all substantial rights to a patent or an undivided interest in a patent is treated as the sale or exchange of a capital asset held for more than one year.

The term “holder” includes an individual who created the property. Thus, if an individual whose personal efforts created a patent sells the patent, Section 1235 dictates that the gain is long-term capital gain and Section 1221(a)(3) dictates that the patent is not a capital asset. Commentators have noted that Section 1235 should take priority because it essentially says that gain from the sale of a self-created patent is long-term capital gain and does not make this result contingent on the patent’s status as a capital asset.

Note: the House version of the legislation would have amended Section 1221(a)(3) and would have repealed Section 1235. The final version of the legislation amended Section 1221(a)(3) but left Section 1235 in place.

Contact a Trusted Tax Lawyer Today

If you have tax law questions regarding how the new Tax Cuts and Jobs Act affects your business, please contact a Wright Firm, LLP tax lawyer at (972) 353-4600 or visit thewrightlawyers.com for more information.