Donation of Intellectual Property: What Does It Look Like? - Part 4

Donation of Intellectual Property: What Does It Look Like? - Part 4

Article posted in Intangible Personal Property on 8 January 2015| 2 comments
audience: National Publication, Dennis Walsh, CPA | last updated: 26 October 2016
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By: Dennis Walsh, CPA

In this final installment of the series, we’ll build further on the case study in Part III by considering some important planning points regarding the donation of an intellectual property asset, for both a donor and donee organization.  A range of issues and risks should be considered relating to such transfers including, in typical transactions: 

Unrelated business income

The receipt of royalties by a charitable organization, less all deductions directly connected with such income, is exempt from treatment as unrelated business income, except to the extent that the asset is debt-financed. 1

However, when the operation of a trade or business activity is unrelated to the accomplishment of an organization’s exempt purposes, as in scenario two of the case study, the donee organization will report the unrelated business income on IRS Form 990-T, Exempt Organization Business Income Tax Return, and compute corporate income tax on net earnings in the same manner as a C corporation.

Before undertaking such an activity, a preliminary evaluation should be made as to whether the income from an unrelated business might be considered substantial in relation to the exempt activities of the donee, taking into account the amount of staff time and other resources to be applied to the respective activities.  It may be prudent to operate an unrelated business as a separate legal and taxable entity in order to safeguard the tax exempt status of the donee organization.  In this case, after-tax earnings of the business may be passed to the parent exempt organization as dividends exempt from unrelated business income tax. 2

As noted in scenario two, Tacky Images also would serve ABC’s printing and graphic design needs in support of its exempt activities.  Accordingly, shared operational costs,  such as for facilities, equipment, staff, etc., would need to be allocated between ABC’s commercial and exempt activities on a reasonable and consistent basis in order to properly measure its unrelated business taxable income.  This also would be necessary before allocating costs among ABC’s functional expense activities.

Other donee concerns

ABC’s counsel also should consider liability issues, including the potential assumption of Tacky Images’ known and unknown liabilities (e.g., for contracts, torts, and environmental issues) that may attach to transferred assets.

The form of legal entity within which the donee organization will operate the business should be considered as well.   For example, Tacky Images might be operated as an activity of ABC, a limited liability company (LLC) with ABC as sole member, or as a separate entity that is not disregarded for federal income tax purposes.  This decision will involve multiple factors, with legal liability and protection of tax-exempt status of primary concern. 

For more on issues of interest to a charitable organization considering accepting a donation of a business interest, see Partnership Interests Aren’t Simple Gifts for Charities.

Form of asset transfer

Since Tacky Images is operated by Dan Donor as a disregarded LLC and therefore treated as a sole proprietorship for income tax purposes, the charitable donation of the business would be deemed to involve separate donations of the individual assets comprising the business, with each carrying unique tax attributes.  Accordingly, along with his advisors, Dan should evaluate the tax effect of the transfer of the individual assets to assure that the projected tax benefits meet his expectations.

For example, a contribution of depreciable personal property used in a trade or business, such as equipment, generally offers limited tax benefits to a charitable donor because of the typical lack of economic appreciation and short depreciable tax life of such property.  Prior depreciation deductions reduce the cost basis of the property, and any gain realized upon sale results in ordinary income to the extent of the previous deductions.  The fair market value used for a charitable deduction must be reduced by any such ordinary income element.

Mitigating the basis limitation

When an individual donor’s basis in a qualified IP asset is minimal, thought might be given to a bargain sale to the charity at a pre-tax price that results in total consideration equivalent to the tax savings that would be realized if a fair market value deduction were allowable for an outright donation.  In this way, a donor may receive a more substantial benefit from the charitable transfer of an IP asset than what would be realized from tax saved through a basis deduction alone, in addition to receiving contribution deductions in later years.  And a donee organization may enjoy a generous return on its bargain investment.

In determining the amount of an initial charitable deduction and any taxable gain to be recognized from a bargain sale, however, the donor must allocate basis between the gift and sale elements, based on the respective ratios of the gift value and sale price to the total fair market value of the asset, as provided under the bargain sale rules. 3  For more on bargain sales and how wealth replacement might be used in connection with such a transfer, see Navigating the Charitable Transfer of a Partnership Interest: A Planner’s Guide.

A question arises as to whether a donor’s additional charitable contributions from net income received by the donee in subsequent years would also need to be bifurcated between the gift and sale portions, either by the donee organization in determining the amount of qualified donee income reportable to the donor on IRS Form 8899, Notice of Income from Donated Intellectual Property, or by the donor prior to application of the annual percentage reductions for additional contributions under Section 170(m)(7).  This situation is not addressed in current guidance.

It is reasonable that Treatment as a qualified intellectual property contribution would not apply to the extent that property is transferred in exchange for consideration.  In addition, valuation of a charitable donation of property and application of the bargain sale rules when required is a responsibility of the donor.  Planners for the donor and donee organization should have a documented understanding of how qualified donee income will be determined and reported on Form 8899.

When the sale of a qualified IP asset by an individual would result in long-term capital gain, thought might also be given to a fair market value sale to a third party, followed by contribution of the after-tax proceeds to the charity, subject to the annual 50% of adjusted gross income limitation and five-year carryover of any unused amounts.

Under current law, long-term capital gain is taxed at a rate lower than the rate applied to ordinary income.  A charitable contribution of the proceeds may then be deducted at the donor’s higher marginal rate applied to ordinary income, creating a potential net tax savings from the rate differential.

However, future contribution deductions arising from net income produced by the asset will not be available in such case.  Therefore, tax savings from the contribution of cash realized from a fair market value sale, in excess of tax paid on the capital gain, should be compared to the present value of estimated tax savings that would result from a cost-basis deduction for donation of the asset along with future deductions arising from income received by the charity.

If income produced by the asset is forecast to be substantial, particularly if expected to be realized primarily in the early part of the ten-year period, it is more likely that the present value of tax savings from an outright gift will exceed the tax benefit available from a sale and donation of the cash proceeds.

The following examples help illustrate this comparison.

Assume that Sandra owns qualified intellectual property she acquired by purchase and holds for investment. Her basis is $30,000.  The IP has a current fair market value of $100,000 and produces annual income of $10,000.  Sandra would like to transfer this value to Favorite Charity in a manner that maximizes her tax savings.  Her marginal federal tax rate is 33%, long-term capital gain rate 15%, and   average rate of return on alternative investments 6%.

In this scenario, the present value of tax savings does not differ greatly between the two alternatives.  Both Sandra and Favorite Charity might therefore prefer the certainty associated with current realization of cash from sale to a third party and avoidance of risk relating to future receipt of income from the intellectual property.

Now let’s assume that instead of income being received evenly over the ten-year period, that the same amount of income is expected to be received but within the initial 5 year period.

Here, the significantly higher expected tax savings arising from an outright donation might justify the risks associated with realization of future deductions from income produced by the IP asset.

Life expectancy

Because additional charitable contributions arising from qualified donee income can span a period of up to ten years, consideration should be given to an individual donor’s life expectancy, projected taxable income, marginal tax rates, and the resulting likelihood that a donor will fully benefit from the additional deductions during lifetime.  There is no provision for continuation of additional deductions by a donor’s estate or a beneficiary of the estate in the event that a donor dies before the end of the 10-year period.

For married persons, joint ownership of the asset prior to donation should be considered as a way to help reduce this risk.  A transfer of a property interest between married individuals is eligible for unlimited exemption from gift tax.

When an IP asset owner is of advanced age and estate tax is not in play, an opportunity for enhancing income tax deductions may arise for a beneficiary of the estate by delaying charitable donation of the asset until after the owner’s death.  By bequeathing ownership of the asset to a beneficiary with charitable goals similar to that of the decedent, the Section 1014 basis adjustment to fair market value by the estate may result in a much larger initial deduction for a subsequent gift by the beneficiary.

In addition, a high-income beneficiary may realize greater tax savings from the additional contribution deductions than the decedent would have realized if the asset had been gifted to charity during lifetime.  An expert appraisal will be essential to support the value assigned by the estate, and withstanding an IRS valuation challenge is not guaranteed. 

Donor compliance

With certain exceptions, Section 170(f)(3) provides that no charitable contribution deduction is allowed for a transfer to a charity of less than the taxpayer’s entire interest in property.  For example, if a donation agreement states that a transfer to the donee of the taxpayer’s interests in a patent is subject to a right retained by the taxpayer to manufacture or use any product covered by the patent, the taxpayer has transferred a nondeductible partial interest in the patent. 4

As for other gifts of non-cash property, a donor must obtain a written confirmation from the donee organization that identifies the donor, the date of contribution, and provides a description, but not the value, of the property.  The donee also must state that no goods or services were provided in exchange for the contribution, if that is the case.  If any type of economic benefit is provided to a donor in connection with a contribution, a so called quid pro quo donation, the donee organization generally must provide a good faith estimate of the benefit’s value, and the donor must reduce the deductible amount of the contribution accordingly.  See IRS Publication 1771 for more information and exceptions.

The donation of qualified intellectual property is specifically excepted from the requirement for a qualified appraisal for the donation of noncash property valued at more than $5,000. 5  However, a statement must be attached to the donor’s tax return showing how the deductible amount was determined, and specific sections of IRS Form 8283, Noncash Charitable Contributions, must be completed by the donor.  The donee’s acknowledgment of the donation in Part IV of Form 8283 also must be obtained in order to claim a deduction for the initial contribution.

Since the amount deductible for the  contribution of a qualified IP asset cannot exceed the donor’s adjusted basis, a donor must be able to substantiate, when reasonable, that the value of the asset exceeds its basis at the time of the contribution.  In no case can an income tax deduction for the charitable contribution of non-cash property exceed the property’s fair market value.

In contrast, the determination of additional contributions reported annually to a donor on Form 8899 is in the hands of the donee organization.  Accordingly, advisors for the donor and donee should have an advance understanding of how qualified donee income will be calculated and assure that the donee organization has the ability to undertake this determination.

Conclusion

The 2004 amendments to Section 170 created a potentially valuable opportunity for a gift of intellectual property, particularly for high marginal rate donors who do not need the income produced by such property.  A donor may experience satisfaction from enhancing the sustainability of a favored charity by providing a future income stream to the charity while enjoying both current and future income tax savings as a result.

However, an IP asset derives value only from the expectation of future cash flow associated with specific rights, and the inherent uncertainty of earnings stemming from such rights requires careful timing of asset valuation and transfer in order to maximize cash flow to the charity and tax benefits to the donor.  In addition, all substantial rights in the property must be relinquished, which may result in no certainty of future income to the charity and no additional tax savings to the donor. 

Therefore, an assessment should be made of whether the donee organization has the capacity to exploit the asset and manage production of income in accordance with its contemplated use, and to meet accounting and reporting requirements in an accurate, timely, and sufficiently transparent manner that is likely to satisfy the donor. 

Other key indicators in evaluating a charitable gift, versus an alternative donation of cash realized from the sale or continuing operation of the asset include:

  • Donor’s basis relative to asset value
  • Expected duration of asset value
  • Life expectancy of the donor
  • Projected estate value

For individual donors in particular, the complexities associated with the valuation of intellectual property rights, projection of income and estate tax effects, and other charitable and estate goals combine to require a team planning approach.  The expected charitable and tax benefits should justify planning and gift administration costs.

Click the links below to read more:

Part 1
Part 2

Part 3
 

  • 1. IRC § 512(b)(2)
  • 2. IRC § 512(b)(1)
  • 3. IRC § 170(e)(2), IRC § 1011(b), examples at Treas. Reg. § 1.1011-2(c)
  • 4. IRS Notice 2004-7 (Internal Revenue Bulletin January 20, 2004)
  • 5. IRS Publication 561, IRS Form 8283 instructions

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Re: Donation of Intellectual Property: What Does It Look ...

Can legal documents be considered intellectual property if they are contracts necessary for the opperation of the non profit?

Re: Donation of Intellectual Property: What Does It Look ...

I would tell you to check with counsel on that but my first reaction would be not. They are work product

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