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Converting R & D Income to Capital Gains

Do you think you are too busy to find time to for long-term tax planning regarding the R&D aspect of your business?  This article explains why you should think again.

An extraordinary tax benefit which is available to owners of a business involving R&D is the opportunity to convert future income to capital gains. Imagine being taxed at a maximum of 15%, instead of 35%, which means bringing home 85¢ on the dollar, instead of 65¢. That’s 30.7% more take-home. From a calendar perspective, being taxed at the higher rate is like working from January 1 through March 22 each year just to pay the extra taxes.

OK, I have your attention. So how does it work? The short answer is (i) you shift the R&D function out of the corporation (e.g. to an "R&D partnership" in which you hold 99%), (ii) you create a new company, and (iii) the R&D partnership licenses the technology to that new company (the "licensee") which then operates the business, either directly or by contracting with your corporation.

Needless to say, the long answer is more complicated and there are traps for the unwary. But the important point to note is that there is a lot of flexibility, so the technique should be tailored to fit your circumstances and avoid disruptions.

Tax discussion. Internal Revenue Code §1235 provides that 100% of royalties from certain licenses are taxed as long-term capital gains. There are two major obstacles. The first is that the license has to be issued before the technology is "reduced to practice". That is, it only works for products, improvements or software not yet fully developed.

The second obstacle is that the licensee cannot be a "related person." That means the owners of the technology (i.e., the R & D partnership) and persons related to such owners (e.g., your spouse and kids) cannot collectively own 25% or more of the licensee. That seems like a big obstacle until you realize that (i) the 75.1% interests held by unrelated persons can be nonvoting interests (i.e., your 24.9% controls the licensee), and (ii) the license can be for, say, 80% of the profits, which means the unrelated persons are only getting 75.1% of 20%, or 15.02%. And if the unrelated persons are selected key personnel or salespersons, that money can be in lieu of compensation. Clearly, long-term tax planning for profitable R&D activities is a very good idea.

 (c) 2-15-2008 Steven M. Chamberlain.  All rights reserved.  Republication with attribution is permitted.