In speaking with creators of intellectual property and their legal advisors about tax issues, a question often arises as to the availability of capital gain treatment for the transfer of copyrights and computer software.The context is usually as follows:
Client, a corporate entity, developed a software product through its employees and independent contractors, which contractors previously assigned all of their intellectual property rights in the work product to Client.Client would like to sell the software product to a third party.Can Client achieve capital gain treatment?
This fact pattern raises two related tax issues: First, whether Client is deemed to have personally created the software, and second whether the software is considered a copyright or some other type of intangible asset for tax purposes.
What Are Self-Created Copyrights?
The usual refrain is that self-created copyrights are excluded from capital gain treatment, but that third party copyrights (e.g., those created by a third party and acquired by purchase) can often give rise to capital gain treatment if transferred in a sale or exchange.1 In determining whether a copyright is self-created the general rule looks to whether the copyright was created by the taxpayer's "personal efforts."While it is usually uncontroversial to determine if a natural person created a copyright - for example, an artist who painted a picture - there are significant unresolved issues as to whether a corporation or other legal entity can "personally" create a copyright.
The treasury regulations state that property is created by a taxpayer's personal efforts if the taxpayer performs "creative or productive work which affirmatively contributes to the creation of the property, or if such taxpayer directs and guides others in the performance of such work."2 However, the regulations go on to provide that a taxpayer, "such as [a] corporate executive, who merely has administrative control of [the creative personnel] and who does not substantially engage in the direction and guidance of such persons in the performance of their work, does not create property by his personal efforts."3
By focusing on the natural persons - the creative personnel and the "mere" corporate executives - this regulation evidences an interest in the efforts of the individuals.However, the regulation is silent as to whether the personal efforts of these individuals can be attributed to a corporation or other legal entity, such as Client in the example above.
There are two separate authorities, a case and an administrative ruling, which have some bearing on this issue.4 In each of these authorities, the taxpayer was a corporation which produced copyright materials (one produced television programs and the other produced motion pictures).Just like Client in the hypothetical above, these taxpayers were corporate entities and their copyrighted materials were produced by agents acting on their behalf.Although the cases focused on whether the taxpayers could obtain capital gain treatment on the transfer of these copyrights, the Internal Revenue Service never raised the argument that the copyrights were ineligible for capital gain treatment because they were self-created.
While there is no binding authority specifically confirming this conclusion, it leads one to believe that a copyright can only be personally created by a natural person.If so, works for hire or copyrights otherwise held by a corporation or other legal entity generally should be outside the scope of the rule that denies capital gains treatment to self-created copyrights.
Is Computer Software A Copyright For Purposes Of These Rules?
An interesting issue that arises in these circumstances, and others, is whether computer software is a copyright for purposes of these rules.Of course, the classification of computer software has long eluded the legal world with a myriad of interesting legal and tax issues - a fair description of which would take up more pages than are available in this periodical.Instead, then, the focus here is whether computer software is a "copyright" for purposes of the self-created copyright rules discussed above, or whether it is something else entirely.
The treasury regulations take the position that the self-created copyright rules apply to "any property eligible for copyright protection (whether under statute or common law), but [not to] a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law."5 In essence, this creates three possibilities:
(i) a patent,
(ii) an invention, or
(iii) a design which is protected only under the patent law and not under the copyright law.
Computer software can potentially fall into any of these categories.First, if the software is subject to a patent, it seems pretty clear that it is outside the scope of the self-created copyright rules - even if the property also could be protected under copyright law.This is consistent with the statutory scheme as a whole, which subjects copyrights but not patents to this somewhat unique treatment.
The same concept should apply to an invention - though this term is not defined in the regulation and therefore could be subject to a variety of nebulous and conflicting interpretations. Most computer programmers would view much of the code that they create as something "invented" even though it may also be subject to copyright protection.Clarity here would be a welcome change.
Finally, the regulations state that a "design" must be protected only under patent law and not under copyright law to escape the rules on self-created copyrights.In one case, the tax court ruled that the transfer of designs and design patents was eligible for capital gain treatment under section 1235 of the Code without examining whether the property should have been considered self-created copyrights under this rule.6 This case was based on section 1235 which creates special rules for self-created patents that apply in lieu of other capital gains provisions under certain circumstances - this allows for self-created patents precisely that which would be disallowed for self-created copyrights.On balance then, this case could be understood to stand only for a simple lesson of tax law:If you can't succeed under one provision of the Code, you should consider other provisions!
In a separate case, the tax court ruled that the sale of computer software is subject to the self-created copyright rule because it is entitled to copyright protection - regardless of the fact that the taxpayer did not file for copyright protection.7 Unfortunately, the taxpayer in that case did not raise the argument that his software was an "invention" or otherwise entitled to protection under other intellectual property laws.Therefore, this case does not provide a solid understanding of the issues encountered in this area or how they can be sensibly resolved.
In the meantime, while we are hoping for clarity to prevail eventually, careful attention should be paid to the tax treatment of any transfer of intellectual property interests - including copyrights - to ensure that the transaction reflects the most desirable tax position available under the circumstances.
1 E.g., Sections 1221(a)(3) and 1231(b)(1)(C) of the Internal Revenue Code of 1986, as amended (the "Code"). Special rules apply to a "letter, memorandum or similar property," which are outside the scope of this article.
2 Treas. Reg. § 1.1221-1(c)(3).
4Desilu Products, Inc. v. Comm'r, T.C. Memo 1965-307 (1965); Revenue Ruling 55-706 (1955).
5 Treas. Reg. § 1.1221-1(c)(1).
6Gilson v. Comm'r, T.C. Memo 1984-447 (1984).
7Levy v. Comm'r, T.C. Memo 1992-471 (1992).
Daniel L. Gottfried is a business tax attorney in the Hartford office of Day Pitney LLP. This article is written for educational and informational purposes only.It is not intended and should not be construed as legal or tax advice.© 2008 Daniel L. Gottfried and Day Pitney LLP, all rights reserved.