Potential Federal Tax Consequences for the Sale of a Medical Patent

Medical Patents Broker Inc.
By Kenneth Pearce, President

First, I am not a tax expert. My CPA does my taxes. It seems like Congress makes changes to the Tax Code every session—some for which I consider the better, and some for the not-so-good.

Second, the federal tax considerations can affect the "net-in-pocket" after the sale. On the upside, my first CPA was a former IRS auditor, and he always said: “Even if the tax rate is 99%, you get to keep a penny!”

Let’s start with the premise that your medical patent is a one-in-a-zillion event: the buyer paid $3MM straight-up cash with no strings attached. Every situation is different, and the "entity" holding the patent can change everything.

It is MPB’s understanding that the US Tax Code works like this:

1. a) The Individual Inventor’s "Super-Power" (Section 1235): Many think inventors pay ordinary income tax. Actually, if an individual inventor transfers "all substantial rights" to a patent, Section 1235 kicks in. This allows the inventor to receive Long-Term Capital Gains treatment (15-20%) immediately—even if they haven't held the patent for a year. No Social Security or Medicare "Self-Employment" taxes usually apply to this capital sale.
2. b) The "Non-Inventor" Individual: If you aren't the inventor but you bought into the patent before it was "reduced to practice," you are still a "holder" and get that same Capital Gains treatment. If you bought it after it was already working, you generally have to hold it for more than a year to get the lower rate.
3. c) The Corporate Trap (C-Corp & S-Corp): Except in rare circumstances, when a corporation is the owner, it pays the corporate tax rate (currently 21%).
4. d) The LLC "Pass-Through": If inventors transfer the patent to a single-member LLC, the IRS usually "looks through" the LLC. The inventor can still use Section 1235 to get that Long-Term Capital Gains rate without waiting for a year to pass.
5. e) The "Dirty Laundry" Rule: To get any of these benefits, the title must be clean. If you don't transfer "all right, title, and interest," the IRS may call it a "license" instead of a "sale," and your Capital Gains could turn back into Ordinary Income.

Why does this matter?

• The Rate: Long-term capital gains are typically taxed at 0%, 15%, or 20%, depending on your income. Ordinary income tax can go as high as 37%.
• The Shortcut: Under Section 1235, it appears that you can get the long-term rate even if you sell the patent the day after it’s issued.

Does your current patent holding structure protect your "Net-in-Pocket," or are you handing a third of your $3MM to the IRS by mistake?