Intellectual property assets are intangible products or creations of the mind that may receive protection under the law. The most common types of intellectual property (IP) that a client might consider gifting to charity include copyrights, trademarks and patents. While making a charitable gift an IP asset can provide a client with tax benefits, the legal complexities that surround these types of gifts necessitate a deeper understanding of these assets prior to making a charitable transfer. As such, it is crucial that advisors have a firm grasp on how these gifts operate in order to best serve their clients' needs and objectives.
This article will explain the basic rules surrounding charitable gifts of IP assets and the opportunities that exist for IP asset owners. It will shed light on the tax benefits associated with charitable gifts of IP and identify practical issues for clients who are considering charitable transfers of IP assets. By understanding the rules and nuances that apply to charitable gifts of IP assets, advisors will be better equipped to guide clients in the right direction and accomplish their goals in a tax-efficient manner.
COMMON TYPES OF IP GIFTS
A copyright is an intangible property right that protects original works, including literary, artistic, dramatic, pictorial, graphic, audio, sculptural, audio-visual and architectural works. The owner of a copyright has the exclusive right to reproduce the copyrighted work, to prepare derivative works, to distribute copies of the copyrighted work for sale or lease, to perform the copyrighted work publicly or to publicly display the copyrighted work. A copyright is a property right that is separate from the copyrighted work. For example, an individual might own the copyright to a manuscript and a different person may own the manuscript itself.
A trademark is a word, phrase, symbol or design that is used to identify a maker of a commodity offered for sale. Common examples include company names, logos, taglines and product names. However, a trademark could also be a particular shape, sound, color or scent that is used to identify or distinguish a particular commodity. A trademark can be registered with the United States Patent and Trademark Office (USPTO). Both registered and unregistered trademarks reflect the right to legitimate use of the mark, but only a registered trademark gives the owner the exclusive right to use the mark nationwide on, or in connection with, the goods and/or services listed in the registration.
A patent is an intangible property right that protects an invention. The owner of a patent has the right to exclude others from making, using or selling the patented invention for a number of years. In the United States, the USPTO grants patents to inventors after the inventor publicly discloses the invention by filing a patent application. The most common type of patent is a utility patent, which is granted to an individual who discovers or invents "any new and useful process, machine, article of manufacture or composition of matter, or any new and useful improvement thereof." 35 U.S.C. Sec. 101.
GENERAL RULE FOR CHARITABLE GIFTS OF IP
A donor who makes a charitable gift of an IP asset is entitled to a deduction that is equal to the lesser of the property's basis or fair market value. IP assets are considered capital assets if the taxpayer purchased or inherited the asset. As such, the deduction for charitable gifts of IP assets will be limited to 30% of the donor's adjusted gross income (AGI) in the year of the gift with the excess carried forward up to five additional years.
After the gift is made, the donor may be able to claim additional deductions based on the income produced by the IP asset. Under Sec. 170(m) of the Internal Revenue Code, the donor may be entitled to additional deductions for the percentage of qualified donee income (QDI) derived by the charity from the IP asset. QDI includes any net income received by or accrued to the charity allocable to the IP itself, including royalties or other net income. I.R.C. Sec. 170(m)(3). The deductions may be taken for up to 10 years. Sec. 170(m)(5).
In order to take advantage of these additional deductions, the donor must provide written notice to the charity at the time of the contribution that the gift is to be treated as a qualified intellectual property contribution for purposes of Sec.170(m)(5) and Sec. 6050L. Sec. 170(m)(8)(b). Each year, the charity will be required to report the amount of qualified donee income (QDI) on Form 8899, Notice of Income from Donated Intellectual Property.
The amount of the QDI deductions is determined on a sliding percentage scale basis and is limited to 10 years beginning on the date of the contribution. The deduction is only available for QDI in excess of the donor's original deduction. The deduction amount starts at 100% of the QDI in excess of the donor's original deduction in year 1 and declines to 20% by year 10. Sec. 170(m)(7).
|Tax Year||Deductible Percentage|
Rose invented and obtained a patent for a state-of-the-art inflatable life raft that, despite its compact size, is able to carry twice the number of people as current inflatable models. Her $100,000 cost basis consists of development costs, including material and labor. Experts predict there will be high demand for Rose's patented device and assign a fair market value of $1,000,000 to the patent and device. Rose would like to make a gift of the patent and her rights to the life raft to her favorite charity. Her advisor informs her that, pursuant to Sec. 170(m), the patent is qualified intellectual property and, therefore, eligible for additional deductions after the gift. In order to receive these benefits, Rose's advisor assists her in putting together written notice to her favorite charity of her intention to treat the gift as a qualified intellectual property contribution.
In the year of her gift, Rose will claim a basis deduction of $100,000. The charity, in return, licenses the patent to a manufacturer. Two years later, her favorite charity is beginning to receive substantial royalties. Because the income is derived from the patent, Rose can claim additional charitable deductions. The patent earns $500,000 in year two, which exceeds her original deduction by $400,000. As such, the patent has produced $400,000 of QDI. Assuming that, following year two, the patent produces $100,000 of QDI each year, her deductions will be as follows:
|Year||Deductible %||QDI||Deduction Amount|
The charity will be required to file Form 8899 each year to report the amount of QDI to the IRS and provide a copy to Rose to substantiate her deduction.
CREATORS OF COPYRIGHTED WORKS AND CARRY-OVER BASIS COPYRIGHT HOLDERS
Copyrights are not considered capital assets if they are owned by the individual who created the copyrighted property or received by an individual as a gift from the creator of the copyrighted property during life (i.e., someone who has received a "carry-over basis" from the creator). Sec. 1221(a)(3); Reg. 1.1221-1(c)(1). As such, these copyright gifts will be subject to the 50% (rather than 30%) AGI deduction limitation. Charitable deductions for gifts of copyrights held by a donor whose personal efforts created the property, or who has received a carry-over basis, will be limited to cost basis.
In addition, gifts of copyrights held by the creator (or a donor who received a carry-over basis from the creator) are not considered qualified intellectual property for purposes of additional QDI deductions under Sec. 170(m). As such, any royalties or net income received by the charity derived from the copyright cannot be deducted by the donor in future years.
Jack is an author of a copyrighted novel. He wants to gift his copyright and his novel to his favorite charity. Jack spent approximately $1,000 on legal fees and costs associated with registering and maintaining his copyright. Because he is the creator of the copyrighted work, his charitable income tax deduction for his gift will be limited to his basis, which in this instance is $1,000. Jack will not be able to claim deductions in future years for royalties that the charity derives from the novel. This is because the copyright is not qualified intellectual property since it was created through the personal efforts of Jack. As such, the total deduction that Jack will be able to claim is $1,000.
Recall that, whether the owner of a copyright can deduct QDI will depend on if the copyright is considered qualified intellectual property under Sec. 170(m). If the donor receives the copyright interest as a gift from the creator of the copyrighted work during life, then the donor will have a carry-over basis from the creator and, therefore, will not be able to deduct QDI. If, on the other hand, the donor inherited the copyright after the death of the creator, then the donor will not have a carry-over basis and will be able to deduct QDI.
Many years later after authoring numerous best-sellers Jack gifted one of his manuscripts (manuscript A) and its copyright to his cousin Molly. He also executed his will and provided that his brother, Fabrizo, would receive a manuscript (manuscript B) and its copyright upon Jack's death. Five years after Jack's death, Molly and Fabrizo decide to make charitable gifts of their manuscripts to Jack's favorite charity in his honor. Jack's original cost basis for both manuscripts was $1,000. Upon his death, the fair market value of each manuscript was $250,000.
Because Molly received the gift during Jack's life, her basis is Jack's original basis of $1,000. Therefore, she would receive a $1,000 deduction for her charitable gift. Because she has a carry-over basis from the manuscript's original creator, she will not be able to claim QDI deductions for future royalties received by the charity.
Because Fabrizo inherited the copyright and copyrighted work after Jack's death, his basis is equal to the fair market value of the copyright at Jack's death. Therefore, he will receive a $250,000 basis deduction for his charitable gift. In addition, because he does not have a carry-over basis, the copyright is qualified intellectual property. Therefore, Fabrizo will be able to deduct future royalties received by the charity as QDI.
PARTIAL INTEREST RULE
Under Sec. 170(f)(3), a charitable deduction will not be allowed where a donor transfers less than his or her entire interest in the property. The partial interest rule may arise in a variety of circumstances related to gifts of IP assets. For example, a donor who owns both a copyright and the underlying copyrighted material cannot claim a charitable deduction if the donor gifts the copyright only and retains the copyrighted asset. The donor who owns both the copyright and copyrighted material must make gifts of both interests to claim a charitable deduction. If, however, the donor only owns the copyright and not the copyrighted work, then he or she could make a charitable gift of the copyright alone and receive a charitable deduction, since the copyright in that instance is the donor's entire interest in the property.
The partial interest rules also dictate that a donor cannot hold onto certain rights related to the IP asset. For example, a donor cannot make a charitable gift of a patent while retaining the right to manufacture the patented product. Nor could a donor make a gift of a trademark to charity but retain the right to prescribe the standard of quality of products or services sold under that trademark. In both instances, the donor would be giving a nondeductible partial interest in the IP asset.
Generally, a charitable gift of property over $5,000 in value will require a qualified appraisal. Reg.1.170A-13(c). However, donations of intellectual property are excluded from this requirement. See IRS Pub. 561 and IRS Form 8283 Instructions. The value of the IP gift will still need to be determined and recorded on Form 8283. As such, the question becomes: how is the value of the IP asset determined?
Typically, the charity will consult an intellectual property valuation professional. Most often, the valuator will determine the IP's fair market value by using an income-based approach. This method forecasts future financial earnings results based on historical financial data, market trends and comparable income for similar assets. Taking these, and other data, into consideration, the valuator will forecast the present value of the IP asset's future income in determining the fair market value of the IP asset.
UNRELATED BUSINESS INCOME TAX
Under Sec. 511, the unrelated business income of an exempt organization is subject to tax. Unrelated business taxable income is defined as the gross income derived by any organization from any "unrelated trade or business" regularly carried on by the organization, less the allowable deductions directly connected with the conduct of that trade or business. Sec. 512(a)(1). In the context of IP assets, the question arises whether income produced by a donated IP asset is classified as unrelated business income.
Luckily, under Sec. 512(b)(2) royalties are classified as passive income and therefore not subject to unrelated business income tax (UBIT), except to the extent that the asset is debt financed. The definition of a royalty is exceedingly broad and extends to virtually all payments for the right to use intellectual property. Sec. 1.512(b)-1(b).
Charitable organizations should be cautious, however, before involving themselves in the IP's underlying trade or business. While receipt of passive royalty income is excluded from UBIT, actively participating in, and performing services for, an unrelated trade or business is not. Thus, if income can be traced to services performed, rather than the royalty income, the charity could be opening itself up to risk and potential UBIT consequences. Sierra Club, Inc. v. Commissioner, 86 F.3d 1526 (9th Cir. 1996). As such, organizations should exercise caution when executing royalty agreements in connection to donated IP assets.
While a charitable gift of an IP asset can be an effective way to secure tax benefits and accomplish a client's charitable goals, IP owners and their advisors should work together to ensure that the charitable transfer is accomplished in a tax-efficient manner in order to avoid potential issues that can arise. IP owners and their advisors should consider the value of the owners' cost basis relative to the IP asset's fair market value, as well as the estimated value and timing of the asset's revenue stream in future years. These considerations will help the client to arrive at a charitable strategy that will meet personal and financial objectives. While there are many complexities in this area, charitable gifts of IP assets should not be overlooked, as the benefits and opportunities associated with these gifts can often outweigh potential hurdles in the planning process.