Patent-payment termination amount qualifies for capital gain treatment

Plain-English summary

A partnership owned by individuals transferred patent-related rights to an unrelated company in exchange for payments based on product sales. When the parties later terminated that agreement, part of the termination payment was allocated as the final payment of the company's original obligations. The IRS ruled that this allocated amount qualified as long-term capital gain under IRC § 1235 for each individual partner's distributive share, provided each partner qualified as a holder. The IRS did not decide whether the original transfer actually conveyed all substantial rights to a patent.

Ruling snapshot

• Question: Does the allocated final payment for ending patent-transfer payment obligations qualify as long-term capital gain under IRC § 1235?
• Outcome: approved, provided each individual partner qualifies as a holder
• Key authorities: IRC § 1235; Treas. Reg. § 1.1235-2

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201701009 Third Party Communication: None
Release Date: 1/6/2017 Date of Communication: Not Applicable
Index Number: 1235.00-00
Person To Contact:
---------------------- ----------------------------, ID No. --------------
---------------------------- -----------------
------------------------ Telephone Number:
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------------------------------ Refer Reply To:
------------------------------------ CC:PSI:5
PLR-119807-16
In Re: ---------------------- Date:
October 05, 2016

                                                   LEGEND

Year 1: -------

Year 2: -------

Date 1: ---------------------------------------

Date 2: -------------------------------------

PRS: ------------------------
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LLC: --------------------------------
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PR1: ----------------------
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PR2: ----------------------
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PR3: --------------------
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PR4: --------------------
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Rights: -----------------------------------------------------------------------------------------
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Product: ------------------------------------------------------------------------------------------
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Agreement 1: ---------------------------------------------------------

Agreement 2: ------------------------------------------------------------------------------------------

$a ------------------

$b ------------------

Dear ---------------------:

This responds to a letter dated --------------------, together with subsequent
correspondence, submitted on behalf of PRS by its authorized representative,
requesting a ruling under § 1235 of the Internal Revenue Code (Code).

                                                 FACTS

PRS is a state law limited liability company classified as a partnership for Federal tax
purposes. PR1, PR2, PR3, and PR4 are individuals within the meaning of § 1235, and
the only partners in PRS.

On Date 1, PRS and LLC, an unrelated entity, entered into Agreement 1. Pursuant to
Agreement 1, PRS transferred its Rights in Product to LLC in consideration for LLC’s
PLR-119807-16 3

payments, based on the sales of Product, to PRS. PRS represents that the transfer of
its Rights in Product under Agreement 1 was a transfer of property consisting of all
substantial rights to a patent within the meaning of § 1235. In Year 1 and Year 2, PRS
and its partners reported the payments received from LLC as payments from the sale or
exchange of a capital asset held for more than 1 year, under § 1235.

On Date 2, PRS and LLC entered into Agreement 2 by which they terminated
Agreement 1, pending the acquisition of LLC by an unrelated third-party. Agreement 2
confirmed that PRS had transferred its Rights in Product to LLC pursuant to
Agreement 1. Agreement 2 required that LLC pay PRS a termination payment in the
amount of $a, of which $b was allocated as final payment for the termination of LLC’s
payment obligations under Agreement 1.

You have requested a ruling that the portion of the termination payment in the amount
of $b that was allocated as final payment for the termination of LLC’s payment
obligations under Agreement 1 qualifies as long-term capital gain under § 1235.

                               LAW AND ANALYSIS

Section 1235(a) of the Code generally provides that a transfer (other than by gift,
inheritance, or devise) of property consisting of all substantial rights to a patent, or an
undivided interest therein which includes a part of all such rights, by any holder shall be
considered the sale or exchange of a capital asset held for more than 1 year, regardless
of whether or not payments in consideration of the transfer are – (1) payable periodically
over a period generally coterminous with the transferee’s use of the patent, or (2)
contingent on productivity, use, or disposition of the property transferred.

Section 1.1235-2(a) of the Income Tax Regulations provides that the term “patent”
means a patent granted under the provisions of title 35 of the United States Code, or
any foreign patent granting rights generally similar to those under a United States
patent. It is not necessary that the patent or patent application for the invention be in
existence if the requirements of § 1235 are otherwise met.

Section 1.1235-2(b)(1) provides that the term “all substantial rights to a patent” means
all rights (whether or not then held by the grantor) which are of value at the time the
rights to the patent (or an undivided interest therein) are transferred. The term “all
substantial rights to a patent” does not include a grant of rights to a patent – (i) which is
limited geographically within the country of issuance; (ii) which is limited in duration by
the terms of the agreement to a period less than the remaining life of the patent;
(iii) which grants rights to the grantee, in fields of use within trades or industries, which
are less than all the rights covered by the patent, which exist and have value at the time
of the grant; or (iv) which grants to the grantee less than all the claims or inventions
covered by the patent which exist and have value at the time of the grant. The
circumstances of the whole transaction, rather than the particular terminology used in
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the instrument of transfer shall be considered in determining whether or not all
substantial rights to a patent are transferred in a transaction.

Section 1235(b)(1) provides that for purposes of § 1235 the term “holder” means any
individual whose efforts created the property. Section 1.1235-2(d)(1)(i) provides that
the term “holder” means any individual whose efforts created the patent property and
who would qualify as the “original and first” inventor, or joint inventor, within the
meaning of title 35 of the United States Code.

Section 1.1235-2(d)(2) provides that although a partnership cannot be a holder, each
member of a partnership who is an individual may qualify as a holder to his share of a
patent owned by the partnership. For example, if an inventor who is a member of a
partnership composed solely of individuals uses partnership property in the
development of his invention with the understanding that the patent when issued will
become partnership property, each of the inventor’s partners during this period would
qualify as a holder. If, in this example, the partnership were not composed solely of
individuals, nevertheless, each of the individual partner’s distributive shares of income
attributable to the transfer of all substantial rights to the patent or an undivided interest
therein, would be considered proceeds from the sale or exchange of a capital asset held
for more than 1 year.

Based on the information submitted and the representations made, and provided that
each individual partner qualifies as a holder, we conclude that the portion of the
termination payment in the amount of $b that was allocated as final payment for the
termination of LLC’s payment obligations under Agreement 1 qualifies as long-term
capital gain under § 1235 as to each individual partner’s distributive share of income
attributable to the transfer.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, no opinion is expressed or implied concerning whether PRS’s
transfer of its Rights in Product under Agreement 1 was a transfer of property consisting
of all substantial rights to a patent within the meaning of § 1235.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

This ruling is based upon information and representations submitted by the taxpayer
and accompanied by a penalty of perjury statement executed by an appropriate party.
While this office has not verified any of the material submitted in support of the request
for rulings, it is subject to verification on examination.
PLR-119807-16 5

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

                                               Sincerely,



                                               Theresa M. Melchiorre
                                               Acting Assistant to the Branch Chief
                                               Branch 5
                                               Office of the Associate Chief Counsel
                                               (Passthroughs and Special Industries)

Enclosures (1)
Copy for § 6110 purposes

cc: