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Technology Transfer Tactics Technology Transfer Tactics Audioconference on Audioconference on

The IRS Targets TTOs: Hot Spots for Tax Compliance and Audit Avoidance Strategies

September 15, 2009

Bertrand M. Harding, Jr.111 Oronoco Street

Alexandria, VA 22314bharding@erols.com

http://www.bhardinglaw.com

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Tax Treatment of Royalty Payments to Employees:  Overview of Issues Discussed

Issue No. 1:  Should the payment be treated as a royalty or as additional wages?

Issue No. 2:  Issues raised in connection with "capital stock" royalty payments 

Issue No. 3:  How is the employee taxed on the royalty payment received?

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Tax Treatment of Royalty Payments

Issue No. 1: When a college or university makes a royalty payment to an employee in connection with an invention or other intellectual property created by the employee, should the payment be treated as a bona fide royalty payment or instead as wages?

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This issue arises because most schools require employees to transfer to the school all patent and other intangible property rights created during course of employment

When school licenses technology created by employee, the royalty payments are made to the school, not to the employee

But most schools have written “patent policies” under which the school agrees to share a portion of the royalty it receives with the employee/inventor

The question is whether the payment made by the school to the employee/inventor will be treated as a royalty or as wages

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In either case, the employee will be subject to income tax on the amount of the payment received

But if the payment is treated as a royalty, income tax does not have to be withheld by the school from the payment, and the royalty is reported by the school on Form 1099-MISC, not Form W-2

Also, the royalty is not treated as compensation for services rendered; therefore, neither the school nor the employee is subject to FICA tax if the payment is a bona fide royalty

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Factors Used to Distinguish Royalty From Wages

Factor No. 1: Fixed royalty payment: The amount of the royalty should be a fixed amount and the school should not be able to be vary the amount of the royalty

Factor No. 2: Royalty dependent on benefit to the school: The royalty should bear a relationship to the income derived by the school under the license agreement (e.g., 25% of amount of royalty received from third party), and not be a lump sum amount

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Factor No. 3: Continuation of royalty after termination or change in policy: If the school changes the terms of its patent policies, or terminates those policies altogether, the employer/inventor should continue to receive his or her royalties under the agreement

Factor No. 4: Continuation of royalties after termination of employment or death: The employee/inventor should continue to receive the royalty after his/her termination of employment, and if the person dies while receiving the royalty, the employee’s heirs should continue receiving payments

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Schools should review their patent policies to see that they contain all of these factors

To the extent that some factors are absent, consideration should be given to revising the policies

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Issue No. 2: What if the royalty is not paid in cash, but through the distribution of capital stock in the licensee company?

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In some cases, particularly involving start-up companies, the school/licensor agrees to receive shares of stock in the licensee company instead of a cash royalty

Under many patent policies, the school agrees to issue to the employee/inventor stock equal to the same percentage as for cash royalties

For example, University licenses technology to X Company and receives in return 1000 shares of X Company stock. Under University’s patent policies, the employee/inventor has the right to 25 shares of X Company stock

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A “stock royalty” raises two issues not raised by a cash royalty:

1. Constructive receipt. This issue arises where the school delays the issuance of the stock to the employee/inventor at the request of the company. If the employee/inventor has a legal right to obtain possession of the stock, he will be taxed on its value even if not distributed

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2. Valuation of the amount of the royalty. The issue here is date on which the stock should be valued for purposes of determining the amount of the royalty. The IRS and the courts say that the valuation date is not the date that the stock certificates are received by the taxpayer, but the date that the shares are delivered to the transfer agent or broker for delivery to the taxpayer

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Schools that make capital stock royalty payments to employee/inventors should also review their patent policies to see if they properly cover the related tax issues

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Issue No. 3: How is the employee/ inventor taxed on the royalty received?

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This issue arises because of section 1235 of the Internal Revenue Code, which says that an inventor can treat a royalty payment as long-term capital gains if the royalty is paid in return for the inventor’s transfer of “all substantial rights” in the patent

Under most school patent policies, employees are required to transfer to the school “all substantial rights” that they may have in any patents or other technology that they may create

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Thus, the issue is whether the employee/inventor can treat royalties received from the school as long-term capital gains

See Technical Advice Memorandum 200249002 for a ruling where the IRS approved capital gains treatment for royalties paid by a university to an employee/professor

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How the employee/inventor decides to report the royalties for tax purposes on his or her income tax return is, of course, an issue for the individual, not the school

But this issue can impact the school in determining how to report the royalty payment

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While a royalty must be reported on Form 1099-MISC, no reporting is required if an employer makes a capital gains payment to an employee

While most schools report these royalty payments on Form 1099-MISC, a few do not report them on the theory that they are capital gains payments