Business Law
Converting R And D Income To Capital Gains

Extraordinary Tax Benefits for R&D Businesses

An extraordinary tax benefit available to business owners engaged in research and development (R&D) is the opportunity to convert future income into long-term capital gains, regardless of the holding period.

How It Works

The short version of the strategy involves three steps:

1. Shift the R&D function into an R&D partnership in which you have an interest.
2. Create a new company.
3. Have the R&D partnership license the technology to the new company (the “licensee”), which then operates the business directly or by contracting with your corporation.

The long answer is more complex and comes with potential pitfalls. However, the technique is highly flexible and can be tailored to your circumstances to avoid business disruptions.

Tax Discussion

Internal Revenue Code §1235 provides that 100% of royalties from certain licenses can be taxed as long-term capital gains. There are, however, two major obstacles:

1. Technology Must Not Be Reduced to Practice

The license has to be issued before the technology is considered “reduced to practice.” In other words, this strategy only applies to products, improvements, or software that are not yet fully developed.

2. The Licensee Cannot Be a Related Person

The licensee cannot be a related person. That means the owners of the technology (i.e., the R&D partnership) and related parties (such as your spouse and children) cannot collectively own 25% or more of the licensee.

While this may seem restrictive, creative structuring provides solutions:

• The 75.1% interest held by unrelated persons can be nonvoting interests, leaving your 24.9% in control.
• The license can be structured for, say, 80% of profits, meaning unrelated persons holding 75.1% are effectively entitled to just 15.02%.
• If those unrelated persons are key personnel or sales staff, their share can replace direct compensation.

Conclusion

With proper planning, owners of businesses engaged in R&D can leverage this strategy to convert ordinary income into long-term capital gains, potentially saving a lot of taxes.