Donation of Intellectual Property: What Does It Look Like? - Part 3

Donation of Intellectual Property: What Does It Look Like? - Part 3

Article posted in Intangible Personal Property on 6 January 2015| comments
audience: National Publication, Dennis Walsh, CPA | last updated: 20 January 2015
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Summary

In the third part of his series, Dennis Walsh will walk through a case study to examine what the valuation and tax effect of the donation of an intellectual property asset can look like in practice.

By Dennis Walsh, CPA

In parts one and two of this series we introduced tax features relative to a charitable contribution of intellectual property, reviewed the relevant 2004 changes to Internal Revenue Code Section 170, highlighted methodologies for valuing intellectual property assets, and considered issues surrounding the determination and reporting of qualified donee income by the donee organization.  In this third part, we’ll walk through a case study to examine what the valuation and tax effect of the donation of an intellectual property asset can look like in practice.

Background

Tacky Images, LLC, is a printing and graphic design business owned and operated by Dan Donor.  Dan and his capable employees have grown this successful business through their personal efforts and reputation for delivering creative and dependable service. 

Since Dan purchased Tacky Images as a promising young business 5 years ago, it has experienced steady growth above industry averages under Dan’s leadership.  Dan is nearing retirement and is contemplating his options for transitioning the business.  He believes that substantial growth lies ahead given the businesses’ strong brand and the industry’s positive outlook.

Dan opposes selling the business currently since he does not feel that a sale would capture the full value of the Tacky Images brand at this point in the business life cycle.  Instead, Dan feels that the brand’s value can be best exploited through its future earnings.  He believes that prospective cash flow generated from the brand in the hands of ABC Nonprofit, along with his transitional involvement in the business, will add more value for ABC as compared to an immediate sale of the business and the contribution of the cash proceeds to ABC. 

Tacky Images’ sales for the most recent year were $1 million.  Free cash flow, after reasonable compensation to Dan, has grown by an average of 30% per year and was $200,000 for the most recent year.  Net accounting income has tracked similarly during this period as well.  The entity has no liabilities other than accounts payable from operations.  It is treated as a sole proprietorship for federal income tax purposes.

Dan is financially independent.  ABC is a charitable organization exempt under Section 501(c)(3), and Dan is a passionate supporter of ABC’s mission.   He is considering a major gift to help sustain ABC’s services to the community.

As his principal advisor, Dan has asked you to help him evaluate two scenarios involving the charitable contribution of the Tacky Images brand to ABC.

One scenario would involve assignment of all of Dan’s rights and interests in the Tacky Images registered trademark to ABC as a charitable contribution.  ABC then could license the trademark to a commercial entity, with Dan agreeing to act as a temporary consultant to the new operator.

Dan would sell or lease the business’s tangible assets, depending on the needs and preferences of the new operator, and would make a charitable contribution to ABC of net cash received from the sale or ongoing lease of such property.

In the second scenario, Dan would assign his rights and interests in Tacky Images’ trademark to ABC, along with an outright donation of the tangible assets and a cash donation of $100,000 for working capital, in order to enable ABC to continue to operate Tacky Images as a going concern.  In addition to providing ABC with a  new funding stream from the commercial operation, Tacky Images would serve ABC’s printing and graphic design needs for the production of its program, development, and administrative materials so that ABC would no longer need to outsource these services.

Dan would pledge his intent to serve as CEO of the Tacky Images operation, with reasonable compensation, for a period sufficient to transition key customer relationships and train his successor, and would remain available on an advisory basis after leaving his employment with ABC.  Dan informally discussed the two scenarios with ABC’s Board Chair, and she is amenable to ABC considering accepting a gift of the trademark as well as taking over the business operations. 

Valuation of initial contribution

After taking a closer look at the financial history of the business and the industry in general, we decide to estimate the current trademark value under the indirect income method with discounted cash flow analysis.  A discount rate of 11% will be used, consisting of a 3% yield on the 10-year U.S. Treasury Note (representing an appropriate risk-free yield) and a risk premium of 8% (determined to be appropriate for Tacky Images’ industry and market).

We estimate that the fair market value of Tacky Images’ tangible assets, consisting of real estate and equipment, is $600,000 and that an expected return of 8% from the lease or direct use of these assets in the business is reasonable.  The same rate of return is expected from the working capital of $100,000.

Dan believes that a 20% average growth rate for sales and free cash flow is sustainable for the next five years and will trail off to an average 3% rate thereafter.  Our projection of initial discounted cash flows will extend 5 years and will employ the Gordon growth model 1 to estimate the terminal value of cash flows to be received in later years.

With these assumptions, including an adjustment for the expected return on tangible assets, we preliminarily estimate the trademark’s value to be $3.6 million.  Dan acquired the Tacky Images trademark for $450,000 in connection with his purchase of the business, and his unamortized basis under Section 197 is $300,000.  Accordingly, his charitable deduction for the initial contribution of the trademark to ABC is $300,000, which is substantially less than its estimated fair market value.

If Dan had instead created the trademark through his own efforts, his basis would be limited to any costs incurred to develop and maintain the trademark to the extent not previously deducted under other Code provisions.

Although the amount of Dan’s charitable deduction is well below the trademark’s estimated value, as typically will be the case, Dan now has a better sense of what the trademark might fetch as part of an alternative sale of the business. 

Calculation of additional contributions

We now turn to estimating the additional charitable contributions to be generated from ABC’s continuing use of the trademark, based on Dan’s best estimates of Tacky Images’ business outlook.

Scenario One: License of trademark

We’ve determined that a comparable trademark royalty rate in Tacky Images’ industry and market is 10% of sales.  It is assumed that the trademark could be licensed to another entity at this rate for a ten-year period.  With this information, we can project the royalty revenue and resulting additional contributions over the ten-year period, assuming that annual sales grow by 20% for each of the initial five years and by 3% for each year thereafter.

The following planning worksheet shows the calculation of ABC’s projected qualified donee income (QDI), which is annually computed and reported to the donor and the IRS by the donee organization on Form 8899, Notice of Income from Donated Intellectual Property, along with the computation of allowable additional contributions to be separately determined by the donor.

Direct costs of $10,000 relating to transfer and licensing of the trademark are assumed to be incurred by ABC in the initial year.  Any costs incurred to maintain or collect royalties would have been charged against net income reported to Dan.  An allocable portion of annual management and general expenses, such as ABC’s shared accounting and governance-related costs, also are charged against QDI.

(Values expressed as $1,000’s)

With this data in hand, pro forma income tax returns can be prepared that include Dan’s other expected income, deductions, and credits over the ten-year period in order to estimate his cumulative tax savings.

Scenario Two: Donee operation of business

In this scenario, ABC assumes Tacky Images’ operations as an unrelated business activity.  Let’s fast-forward ten years to see how the business performed during this time and determine Dan’s additional contribution amounts.

Costs of products produced for ABC’s use in the conduct of its exempt functions have been allocated to such activities so that net income properly reflects the results of the commercial unrelated business only.

Had it not been for a large payout from settlement of a customer lawsuit in year four, Dan’s Had it not been for a large payout from the settlement of a Tacky Images customer lawsuit in year 4, Dan’s estimate of 20% growth in free cash flow for the initial five years would have been sustained.  The combination of an economic recession and the loss of several key customers also hit the business hard during years six and seven.

In spite of these setbacks, Tacky Images generated sufficient net income for Dan to deduct the applicable percentages of qualified donee income realized in profitable years in excess of his initial $300,000 deduction.

In the final installment of this series, we’ll build further on the case study by introducing some important planning points surrounding the donation of a qualified intellectual property asset, for both a donor and donee organization, and summarize factors indicating preference for a contribution of this type of property over the donation of cash arising from its sale or continuing use by the owner.

Click the links below to read more:

Part 1
Part 2
Part 4

  • 1. Expressed as a fraction, the numerator of which is the terminal year cash flow multiplied by the assumed perpetual growth rate, and the denominator of which is the assumed discount rate less the risk-free rate of return.

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