Many entrepreneurial owners face difficult decisions when they look to sell their businesses. For inventors, sometimes the most valuable assets they can sell are the patents and other proprietary know-how they created or obtained over the years.
Sales of patents bring into play many legal considerations. For example, if the patent is owned by an entity instead of the individual entrepreneur, the buyer may want to purchase the ownership interests of the entity (e.g., stock in a corporation or membership interests in a limited liability company) rather than the patent itself in order to obviate the need to transfer the title to the patent.
For this column, however, let’s consider a narrower set of issues: the potentially unintended consequences that may occur when, for whatever reason, the buyer and seller cannot agree on the terms of a “final” sale.
In some transactions, the buyer may desire to pay over a term of months or years. At the same time, the seller may want to retain the right to reacquire the patent or know-how in the event the buyer is unable to make one or more future payments. In these situations, the transaction may look more like a license of the technology than an outright sale.
From the seller’s perspective, a sale is usually preferred because the seller may be able to pay tax on the sale of the intellectual property at capital-gains rates, which are currently (in most cases) preferential to ordinary rates. Conversely, the buyer may prefer a license if the buyer’s license expenditures could be expenses instead of capitalized. That is because the buyer’s expenses may be deductible from income in the current period. Compare that to capital expenditures; in some cases, they may be subject to capitalization or amortization over many years.
Assuming that parties desire to structure the transaction as a sale for tax purposes, the issue that most commonly arises is how to determine the difference between a license and a sale. In making this determination, a number of factors must be considered.
Threshold among those factors is whether the buyer manifests an intent at the time of the transaction to transfer all of the buyer’s rights, title and interest in the intellectual property to the buyer. That being said, it is possible to retain one or more rights in the intellectual property, so long as the right(s) reserved is/are not “substantial” in relation to the other transferred rights.
Whether a right is “substantial” must be analyzed in each instance. For example, the buyer’s ability to reacquire the property in the event of the buyer’s inability to satisfy the purchase terms usually will not be considered a substantial right (i.e., such a right will not bar sale treatment).
Other factors that should be considered include ensuring the form of the agreement is that of a sale. In this regard, the most common potential pitfall I see is that agreements pertaining to the transfer of intellectual property with payments made over time, is the express characterization of the arrangement as a “license agreement.” Although it is true that substance may trump form, referring to a sales contract as a “license” can raise many questions about the nature of the transaction, including whether the buyer in fact intended to transfer the patent, or whether the payments are merely a stream of royalties instead of installment or contingent payments. For this reason, it is often important to avoid the term “license” at all costs if the parties intend the transaction to qualify for sale treatment, even though the terms license and royalties may be the standard parlance of the trade.
The buyer in its due diligence should verify whether it will own all incidents of ownership of the intellectual property. If the seller purports to be selling all of the seller’s rights, title, and interest in the property, but those are subject to obligations owed by the seller to a prior owner of the property, the transaction may not qualify as a sale. Although this is usually discoverable during the buyer’s review of the property’s title, the buyer should consider requiring the seller to represent and warrant the seller’s ownership of the property.
In summary, many owners looking at a business transition will want to sell patents or other know-how, either in a merger transaction with another entity or in an outright sale of the property. When this occurs, the parties to the transaction should carefully consider the substance and form of the transaction to ensure each obtains the mutually beneficial business and tax advantages of the transaction.
Dan Eller is a shareholder in the Portland office of Schwabe, Williamson & Wyatt, and a member of its business transitions group. He focuses on tax and business law, and advises clients in both transactional and controversy matters. Contact him at (503) 796-3762 or firstname.lastname@example.org.