Summary of Federal Laws
Tax Issues Related to Employment
A royalty is a payment for the use of a valuable intangible property right. Section 1235 of the U.S. tax code allows inventors to recieve long term capital gain treatment on royalties received for a patent if the rights in the patent are transferred to a third party.
A question that comes up in the university context is how to treat income received by faculty members when it is received as a result of an invention by the faculty member that is considered "institutional research" and then licensed by the school to a third party. In this situation, institutions usually give the faculty member a portion of the royalty payments for the licensed invention.
The choices are to treat the income to the faculty member as ordinary income reportable on a W-2 form, or royalty income subject to the more favorable capital gains treatment. A recent IRS ruling (released Dec. 6, 2002) addresses this issue. Below is a write up of the ruling by Sean P. Scally, University Counsel and Tax Attorney, Vanderbilt University.
Many institutions, mine included, have technology ownership policies required by faculty/employees which provide, as a condition of employment, the University/College retains ownership of all intellectual property (IP) rights (patents, software copyrights, etc) issued on the basis of any institutional research. The institution then, typically, licenses the IP to a third-party in exchange for a royalty payment. As is typical of such policies, the inventor (faculty/employee) then enjoys some portion of the royalty payments received by the institution. It has been a matter of considerable interest as to whether the payment to the faculty/employee should be regarded as additional compensation for services (ordinary income to the recipient reportable on IRS Form W-2) or as a royalty (subject to more favorable capital gains tax rate treatment and probably reportable on IRS Form 1099-MISC) under IRC 1235.
In a Technical Advice Memorandum (TAM 200249002, dated August 8, 2002, and released December 6, 2002), the IRS has ruled that the payment should be treated as long-term capital gain under IRC 1235. Acknowledging that the issue of whether the payment is for the transfer of a patent versus compensation in exchange for employment services is a question of fact, the ruling notes that the faculty member of the subject institution (a state university) was not hired as an inventor, therefore, the payment was not properly regarded as compensation for such services. The ruling also discusses other IRS guidance, as well as authority from the U.S. Tax Court on the issue, and decided to follow two 1963 decisions (Chilton, 40 TC 552 (1963); McClain, 40 TC 841 (1963)) which held that similar payments to employees who were not hired as inventors, but who had agreed to assign any inventions to their employer, should be treated as IRC 1235 capital gain payments.
The remaining question left unanswered in this recent IRS guidance is whether such payments should be regarded as "royalty" payments and reported on the Form 1099-MISC or if payments could be deemed the sale of a capital asset, thereby not reported anywhere on any form. Given the breadth of the Form 1099 instructions, and that the payments are being made in the course of the institution's "business" arrangement with its faculty/employees, I would hazard the guess that the safest course of action is issue the Form 1099-MISC and avoid any failure to report penalty. If coded right on the Form 1099, it will not be subject to self-employment tax obligation by the recipient faculty/employee. Be mindful also that the TAM is not binding "precedent" on the IRS, but most taxpayers can rely upon such guidance as a reflection of the IRS's mindset over a particular issue.
links updated 6/25/08 rab
Links checked July 9th, 2010, FJL.