John R. Bullis: Royalty income was ordinary, not capital gain

Spiridon Spireas is a pharmaceutical scientist who invented some drug delivery techniques.

He signed a licensing agreement with Mutual Pharmaceutical Company in 1998 so he didn’t have to develop the technology alone.

The development of a practical liquisolid formulation and clinical testing as well as getting FDA approval and doing the marketing all was done per the agreement. Sales were made and Spireas was paid the 20 percent royalty.

He reported royalty income of just more than $40 million in years 2007 and 2008.

He reported the income as long-term capital gain. In 2013, IRS sent him a notice for about $5.8 million claiming the income was only reportable as ordinary income, not long-term capital gain with the special low tax rates for capital gains. The IRS argued he didn’t transfer all of his rights in the patent as is required for capital gain tax treatment. IRS said the agreement only gave Mutual the right to sell products Mutual and Spires unanimously selected. The Tax Court agreed with IRS finding he granted far less than all substantial rights to the patent.

He appealed to the Third Circuit Court of Appeals (we are in the Ninth Circuit).

The Third Circuit found he was taxable as ordinary income. One of the judges didn’t agree with the decision.

The final decision seemed to hinge on interpretation of the facts and circumstances to determine if substantially all rights were transferred or not.

If you or someone you know has a patent, it’s important for them to work with the right attorney firm to be sure any agreement is clear and complete. You can see how $5.8 million in tax is certainly worth doing the court case to see if that has to be paid or not.

Did you hear? “Down deep in every soul is a hidden longing, impulse and ambition to do something fine and enduring. If you are willing, great things are possible to you,” by Grenville Kleiser.

John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.