Royalties taxed as ordinary income.

Occasionally we come across a tax case that reminds us how important it is for patent lawyers to understand some basic tax concepts.  This is particularly true when a client enters into a patent licensing agreement, and can greatly reduce his or her tax burden by paying capital gains tax rates on royalty payments instead of ordinary income tax rates.

In Spireas v. Commissioner, No. 17-1084, 2018 U.S. App. LEXIS 7504 (3d Cir. Mar. 26, 2018), Dr. Spiridon Spireas, a former Ph.D. student at St. Johns University, earned approximately $40 million in royalties from licensing his patented technology to Mutual Pharmaceuticals over just two years. If those earnings were taxed as ordinary income, Spireas owed a 35 percent tax; if they were taxed as capital gains he owed just 15 percent.

26 U.S.C. § 1235(a) determines whether royalties are taxed at capital gains or ordinary income tax rates.  For royalty payments to be taxed as capital gains, the payments must be received “in consideration of” “[a] transfer . . . of property consisting of all substantial rights to a patent.” Section 1235's basic requirements are straightforward. To qualify for capital-gains treatment, income must be paid in exchange for a “transfer of property” that consists of “all substantial rights” to a “patent.”

In Spireas v. Commissioner, Dr. Spireas and his former advisor at St. Johns University, Dr. Sanford Bolton, had invented “liquisolid technology,” a term used to describe certain drug-delivery techniques meant to facilitate the body's absorption of water-insoluble molecules taken orally.   In 1998, Drs. Spireas and Bolton entered into an exclusive license agreement with Mutual Pharmaceuticals that granted Mutual “[t]he exclusive rights to utilize the Technology,” but “onlyto develop [liquisolid drug] Products that Mutual . . . and [Spireas] . . . [would] unanimously select.”  No drugs were identified in the 1998 agreement.  In 2000, however, Dr. Spireas and Mutual entered into a second agreement under which Dr. Spireas agreed to develop felodipine using the liquisolid technology.  

Dr. Spireas disputed the IRS’s decision to tax his royalties as ordinary income, and appealed his dispute all the way to the Third Circuit Court of Appeals. Dr. Spireas ended up losing in the Third Circuit, and paying ordinary income taxes on the royalties, but not because the royalties did not qualify for Section 1235 treatment.  Dr. Spireas lost the case because, to qualify for Section 1235 treatment, he had to have transferred all substantial rights to the patent in one single transaction. When he appealed the tax assessment to the Tax Court, he argued that both agreements – the 1998 and 2000 agreements – were needed to transfer all substantial rights in the patent.  He reversed course when he appealed the Tax Court’s decision to the Third Circuit, and argued that he had transferred all substantial rights to felodipine in the 1998 agreement, but it was too late.  The Third Circuit held that Dr. Spireas had waived the argument, and did not allow Dr. Spireas to take a different position than he had taken in the Tax Court.

As patent lawyers, we should remember that royalties can in some instances qualify for capital gains treatment, and structure patent royalty agreements as well as possible to transfer “all substantial rights” in the patent, when consistent with the client’s objectives.  If Dr. Spireas was correct in his argument to the Third Circuit, the 1998 agreement qualified for Section 1235 capital gains treatment because it transferred all substantial rights in liquisolid felodipine technology, even if felodipine was only one of many potential drug products covered by the patent.