Donation of Intellectual Property: Part 2

Donation of Intellectual Property: Part 2

Article posted in Intangible Personal Property on 22 December 2014| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 26 January 2015
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Summary

In the second installment on his review of the donation of Intellectual Property, Dennis Walsh digs more deeply into issues of valuation.

by Dennis Walsh, CPA

In part 1 of this series we introduced intellectual property and federal tax law provisions regarding the charitable contribution of IP.  In this second part, we’ll begin by illustrating application of these rules for the donation of a specific IP asset, and then introduce techniques for the valuation of IP in general.  We’ll also discuss issues surrounding the computation of qualified donee income and related reporting by the donee organization.

All section references are to the Internal Revenue Code and Regulations.

Examples

The following examples illustrate the donation of an intellectual property asset, including some of the nuances associated with the donation of a copyright in particular.  For each situation, assume that the fair market value of a copyright donated by Sandy to XYZ Charity arising from a book manuscript is $100,000 and that book sales are generating $10,000 per year in royalties.

Example (1): Sandy authored the manuscript and her basis is $1,000, consisting of legal fees and costs associated with registration and protection of the copyright.  Under Section 170(e)(1)(B)(iii), the donation does not qualify as a contribution of qualified intellectual property because it was created through the personal efforts of the holder as described in Section 1221(a)(3)(A).  Accordingly, Sandy is not eligible for additional contribution deductions under Section 170(m) for royalties subsequently received by XYZ Charity.  The copyright is not a capital asset in Sandy’s hands and remains ordinary income property regardless of her holding period, since it was created through her personal efforts.  Her charitable deduction is therefore $1,000, consisting of the copyright fair market value of $100,000, reduced by $99,000 of ordinary income that would be realized if she had sold it instead, as required by Section 170(e)(1)(A), effectively limiting her charitable deduction to her basis. 

Example (2): Sandy purchased all rights and interests in the manuscript and the related copyright as an investment for $75,000 three years ago.  The copyright is qualified intellectual property and Sandy provides the required notice to XYZ Charity that she intends to treat the donation as such.  Sandy’s initial deduction is $75,000, consisting of the copyright fair market value of $100,000, reduced by $25,000 of long-term capital gain that would be realized if she had sold it instead, as required by Section 170(e)(1)(B)(iii), limiting her charitable deduction to her basis.  She is also eligible to annually deduct, as additional charitable contributions, a portion of net royalty income subsequently received by XYZ Charity in excess of her initial deduction, until the 10th anniversary of her contribution.

Example (3): Sandy acquired the copyright by gift from her mother prior to her mother’s death.  Her mother authored the manuscript and had a basis of $1,000.  Under Section 1015, Sandy’s carryover basis in the gift property is her mother’s basis.  Under Section 170(e)(1)(B)(iii), the donation does not qualify as a contribution of qualified intellectual property because Sandy’s basis for determining gain from a sale or exchange is determined by reference to the basis in the hands of a taxpayer whose personal efforts created the property, as provided in Section 1221(a)(3)(C),.  Accordingly, Sandy is not eligible for additional contribution deductions under Section 170(m) for royalties subsequently received by XYZ Charity.  Sandy’s charitable contribution for donation of the copyright is $1,000 as computed in example (1).

Example (4): Sandy acquired ownership of the manuscript and related copyright by specific bequest from her mother’s estate.  Accordingly, her basis under Section 1014 is $100,000, representing the fair market value as included in the decedent’s estate, and the asset is long-term capital gain property upon receipt by Sandy.  The copyright is qualified intellectual property and Sandy provides the required notice to XYZ Charity that she intends to treat the donation as such.  Sandy’s initial deduction is $100,000, consisting of the copyright fair market value of $100,000, which is the same as her basis, and therefore no reduction to fair market value is required in determining the deductible amount of her contribution.  She is also eligible to annually deduct, as additional charitable contributions, a portion of net royalty income subsequently received by XYZ Charity in excess of her initial deduction, until the 10th anniversary of her contribution.

Valuation

Since IP can take many forms, the planning process for assigning value should start with an analysis of what constitutes the property and its associated rights.  As provided in Internal Revenue Manual guidance, the property should:1

  • Be subject to specific identification and a recognizable description
  • Be subject to legal existence and protection, which may be incorporated within a larger entity
  • Be subject to private ownership and be legally transferable
  • Generate some measurable amount of economic benefit
  • Potentially enhance the value of assets with which it is associated

A market, cost, or income based approach is typically used to identify one or more specific methodologies for valuing IP.  The frequent lack of an active market involving sufficiently comparable property will often render a market-based approach inapplicable for valuation of an IP asset.

Identifying and quantifying costs necessary to create or reproduce a unique IP asset result in practical difficulties for the cost approach as well, which does not account for the value of future earnings.  However, the cost approach may provide a good basis for determining a value ceiling.

Projected revenue, or costs that could be saved through ownership of an IP asset, such as by relief from royalty payments, may be used to directly estimate an asset’s value by reference to comparable royalty rates.  Alternatively, an asset’s value may be estimated indirectly from net earnings of an entity as a whole, after adjustment for reasonable return on other assets.  This approach imputes a value to IP by estimating excess earnings resulting from its addition to the acquiring entity.

Use of the above direct or indirect income method in conjunction with discounted cash flow techniques may be the best way to value the earnings potential of an IP asset.  Discounted cash flow analysis is forward looking in that it considers the expected net cash flows to be generated over the remaining economic life of the asset, and the risks associated with achieving the cash flow through the selection of an appropriate discount rate.

Qualified donee income

As introduced in Part I, in addition to a potential charitable income tax deduction for the contribution of an IP asset, a donor is permitted to deduct additional amounts in later years as charitable contributions, based on the amount of qualified donee income, consisting of royalties or other net income, accrued or received by the donee during such years.2  For this purpose, “qualified donee income” (QDI) includes net income derived by the donee properly allocable to the intellectual property itself, as opposed to any activity in which the intellectual property is used. 3

In determining QDI, neither the Code nor Regulations provide any guidance or safe harbor provisions for distinguishing net income attributable to the intellectual property versus an activity within which the property is used.  Presumably, accounting for net income from such property should follow identification of revenue, assignment of direct costs, and allocation of indirect expenses of the donee organization in the same manner as for an unrelated business income activity, whether or not so classified by the donee.

In such case, where facilities and personnel are used both to carry on exempt activities and to conduct unrelated trade or business activities, expenses such as depreciation, salaries, and similar items of overhead attributable to such facilities and personnel must be allocated between the two uses on a reasonable basis. 4 ­ Common allocation bases include time spent, square footage of facilities, miles driven, and units of output.

Congress anticipated a potential need for, and so authorized, the issuance of future regulations or other guidance on determining net income from qualified intellectual property in situations where the property is used by the charitable donee organization for the direct accomplishment of its exempt purposes, as distinguished from a separate commercial activity. 5

A question arises as to whether qualified donee income within the meaning of Section 170(m)(3) should include the proceeds from a subsequent sale or disposition of qualified intellectual property by a donee organization.  The February 2004 Joint Committee on Taxation description of the revenue provisions of H.R. 4520, the American Jobs Creation Act, states That additional deductions are based on royalties or other revenue from the property, and that other revenue for this purpose includes sales proceeds and net income derived by the donee that is properly allocable to the property. 6  However, later pre-enactment reports do not contain such a reference to sale proceeds, nor is this reference contained in the enacted Statute, or in Regulations or authoritative guidance issued to date.

The inclusion of sale proceeds as qualified donee income would appear consistent with the intent of Congress in limiting a charitable contribution of IP to value that can be realized in a market transaction, as opposed to a speculative appraisal.  And as a practical matter, making a distinction between net income and sale proceeds could raise a myriad of interpretive issues in the case of a disposition of less than all of a donee’s rights and interests in an IP asset, such as where income rights are severed from ownership of the underlying asset.  Would the proceeds from the sale of such rights be viewed as qualified donee income or as from a disposition not reportable to the donor on IRS Form 8899, Notice of Income from Donated Intellectual Property?  Further guidance in this area appears to be needed.

Reporting issues

When considering the acceptance of a gift of intellectual property, the donee should not overlook the potential administrative burden that may result from the requirement that Form 8899 be provided to a donor within 30 days after the end of the organization’s fiscal year, with no opportunity for a filing extension. 7

Depending on accounting complexities associated with the asset and need for determination of indirect costs properly allocable to the income it produces, it may be simply impracticable for a charity to comply with this reporting requirement in such a compressed time frame.  Penalties relating to the donee reporting requirements set forth at Section 6050L and the related Form 8899 are found at Sections 6721 through 6724.

In many situations, income received from an IP asset will not pose difficulty with respect to the timely identification and reporting of net income attributable to the asset, such as when revenue is derived through a donee’s licensing of an asset to another party.

On the other hand, carving net income attributable to certain IP assets used directly by the donee for the production of income, such as from the trademark of a going business subsequently operated by the donee, likely would require concurrent completion of the annual IRS Form 990 and Form 990-T (when required) prior to providing Form 8899 to a donor. 

With this additional background, in Part III of this series we’ll walk through a comprehensive example of the donation of a trademark under two scenarios.  We’ll suggest an approach for determining the trademark’s value and illustrate the projection of income and cumulative deductions for the donor.

Click the links below to read more:

Part 1
Part 3
Part 4
 

  • 1. IRM 4.48.5.2.3 (07-01-2006)
  • 2. IRC § 170(m)(1)
  • 3. IRC § 170(m)(3), IRS Notice 2005-41 (Internal Revenue Bulletin June 6, 2005)
  • 4. Treas. Reg. § 1.512(a)-1(c)
  • 5. IRC § 170(m)(10)(D)(ii)
  • 6. DESCRIPTION OF REVENUE PROVISIONS CONTAINED IN THE PRESIDENT’S FISCAL YEAR 2005 BUDGET PROPOSAL, Prepared by the Staff of the JOINT COMMITTEE ON TAXATION, February 2004
  • 7. Treas. Reg. § 1.6050L-2(d)(2)

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