Since many of you like to take the extension to file taxes these days (we did), and you have a little time to prepare for next April, now is a good time as any to apply the “early bird gets the worm” strategy should any of the following issues ring a warning bell in the back of your mind.  Sure, we are not accountants or tax attorneys, so don’t take anything we say here as tax advice.  That being said, trade secrets can have tax consequences that you may want to discuss with your honest-to-Pete tax advisor. 

Are trade secrets taxable property?  Short answer, yes.  What, did you think the IRS is going to miss a chance to bleed you?  But like most things tax related, the specifics are somewhat buried in the forest of dead trees that make up the current tax code.  Under 26 U.S. Code § 170 “Charitable, etc., contributions and gifts” various intellectual properties including trade secrets are recognized as tax related assets:  “(e) Certain contributions of ordinary income and capital gain property … (1) General rule … The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of - … (A) the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of the contribution), and (B) in the case of a charitable contribution - … (iii) of any patent, copyright (other than a copyright described in section 1221(a)(3) or 1231(b)(1)C)), trademark, trade name, trade secret, know-how, software (other than software described in section 197(e)(3)A((ii)), or similar property, or applications or registrations of such property, or … the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution).”  Whew!  And, we thought patent law was indecipherable! 

From the convoluted verbosity above, you can see why you are going to need a joint sit down with your tax advisor and your attorney to figure out the best joint tax and legal positioning to take on your trade secrets and other intellectual property.  But it seems that you can get some type of tax benefit for giving trade secrets, “know how” and other IP assets away as a charitable contribution.  Big whoop.  Most people want to make money from their trade secrets rather than give them away.  And honestly, can anyone think of a charity that would want or use a trade secret from the paint and coatings industry? If you do, please contact us and we will be sure that our not-for-profit entity has been set up to receive them! 

Another issue that arises is the difference between a trade secret and know-how.  The IRS has generally long viewed know-how as existing based on a trade secret status, as having or including a secret process or formula that is not necessarily patentable, and that it can be duplicated by an employee that leaves the company.  Know-how in this view falls under the trade secret umbrella and the proceeds from the sale of know-how can be taxed as a capital gain.  In regards to trade secrets, any benefit of the capital gains rate may be lost if the IRS rules that the confidential information did not classify as a trade secret (i.e., property), such as not being protected by adequate secrecy (hint, hint . . . . see previous iPaint articles).  However, the subject of know-how has produced differing opinions between courts and the IRS in various cases.  In some court rulings non-secret information (e.g., manuals, easily reversed engineered processes) was viewed as know-how and still taxable as property in the sale of a business.  The tax issues with trade secrets and know-how gets even more complicated when your business is international, another topic to raise during the sit-down with your advisors.

Given the treatment of trade secrets and other IP as property, there may be several ways to categorize R&D costs of their development for reducing your tax bill.  The sit-down topics include the research and development (R&D) deduction or the R&D tax credit (if it is currently renewed – the tax code is always changing).  For example, based on the Snow v. Commissioner U.S. Supreme Court ruling, a partnership investor may be able to deduct the expenses related to developing a product even though the product has not been offered for sale or sold.  And if you wind up meeting all the various criteria for both the R&D deduction and the R&D tax credit, the formula can become complicated as you need to subtract one from the other in determining the final deduction.  Keep good records, and hope your tax advisor’s computer is up to the task.

If you write a check and buy (e.g., lump sum payment, installment fees, renewal fees) intellectual property for your business, you also may be able to amortize over 15 years the cost of the purchase per 26 U.S. Code § 197.  The qualifying intangible property under § 197(d)(1)(C)(iii)  includes “any patent, copyright, formula, process, design, pattern, know-how, format or other similar item,”  So “trade secret” is not named, but “know-how” and “other similar items” are named.  Another topic for discussion at the sit-down.  Intangible property that the taxpayer creates rather than purchases may also be eligible under § 197(c)(2) if it was created “in connection with a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof.”  Should § 197 not be applicable, then have your advisor mull over the potential for counting the cost under R&D expenses (§ 174), depreciation (§ 167), or even ordinary business expenses (§ 162). 

Now suppose you sell a trade secret or other intellectual property.  The way you “sell” it can have a big impact on your tax bill, specifically whether it qualifies as ordinary income vs. a capital gain.  The considerations are whether you only partly transfer (i.e., license) the property vs. exchange all substantial rights of the property; and whether the property qualifies as the provision of services or a non-capital asset vs. a capital asset (e.g., one held for more than one year).  As you can guess, meeting the two later categories will get you into the capital gain bracket, if that is desirable to you.  In Pickren v. United States 378 F.2d 595 (5th Cir. 1967) the transfer of rights and interest of secret formula to liquid wax products and trade names were viewed by the Fifth Circuit Court of Appeals as warranting the application of the transfer of patent rights, which under current 26 U.S. Code § 1235 would constitute a sale of a capital asset if all substantial rights were transferred.  However, royalty payments under a licensing agreement for the formula and trade names was viewed as ordinary income.  The IRS has generally categorized this “secret formula” type of information as “know-how.” 

Finally, how about the situation where your trade secret was misappropriated, and you win damages and/or settle the case?  Well, in Freda v. Commissioner of Internal Revenue, 2011 WL 3802707 (August 26, 2011, 7th Cir. 2011) (Freda), the way the tax rate on $15.3 million in damage payments was decided really gives notice to all litigators.  The circumstances involved were C&F Packing Co., Inc. (C&F) freezing cooked sausages for Pizza Hut, Inc. (Pizza Hut), and providing confidential disclosure of the trade secret for the freezing process to Pizza Hut due to quality control concerns.  Pizza Hut then allegedly disclosed C&F’s trade secret to other sausage producers that partly took over production, at lower cost of course.  After many legal battles over a decade, C&F won $10.9 million in damages for claims of “lost profits, lost opportunities, operating costs, and expenditures.”  That award was reported as about $8 million in long-term gain and the rest as ordinary income.  The IRS was OK with that filing.  A related court case claiming trade secret misappropriation was settled for $15.3 million, which after expenses, legal fees, and a payment to a former shareholder, C&F reported about $6 million in cash as a long term capital gain.  However, the IRS took the view that the settlement was ordinary income, the result being that $700,000+ in taxes were owed by C&F’s shareholders.  The problem for C&F in the trade secret misappropriation case was the type of claim made.  The Court indicated that if C&F sought remedy for replacement of capital destroyed or injured, then the payment would have been a return of capital “and not taxable,” rather than ordinary income for payment of lost royalties and profits.  Ouch.  Goes to show that getting the whole team together to play war games is really key to long-term success.

So, repeating the disclaimer here that your authors have any tax expertise whatsoever, do yourself a favor.  Know enough to know how little you know (the mark of the truly educated).  And, beware of tax advice regarding taxable consequences of trade secret development, ownership, protection, licensing and sale.  Such advisers will need to be of a special sort, and have demonstrable expertise in the area. There are certainties in life – death, taxes.  Don’t smoke, our best advice (as non-doctors), for the former.  Pay what you owe, but don’t forget to consider the tax consequences of your trade secrets, our best advice (as non-tax specialists), for the latter.