Rev. Rul. 57-40

Advice has been requested whether an amount received by certain taxpayers for granting a corporation an option to acquire at a later date an exclusive license to patents which they hold will qualify for capital gain treatment under the provisions of section 1235 of the Internal Revenue Code of 1954.

In the instant case, an inventor assigned to his uncle, in return for a substantial amount of capital which he invested in the promotion of an invention prior to its actual reduction to practice, a five percent interest, and to his wife and son each an equal interest, in the invention. The inventor thereafter promoted the formation of a corporation to develop the invention. In accordance with an agreement, the parties for a stipulated amount granted the corporation an option to acquire an exclusive license to the invention. The corporation upon payment of a fixed amount could exercise or close the option at any time within a twelve month period or it could for a prescribed payment extend the option for six months. Upon exercise of the option, the corporation agreed to enter into a license agreement providing for the payment of a specified percentage of the sale price of each article produced under the agreement. It was mutually agreed that a sum equal to the amount paid for the option would be deducted from the amounts accruing in excess of the amounts payable by the corporation on the first 25,000 articles during the first and each succeeding year until such deductions equal the amount paid for the option.

Section 1235 of the Code provides, in part, as follows:

(a) GENERAL.-A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 6 months, regardless of whether or not payments in consideration of such transfer are-

(1) payable periodically over a period generally coterminous with the transferee's use of the patent, or

(2) contingent on the productivity, use, or disposition of the property transferred.

(b) `HOLDER' DEFINED.-For purposes of this section, the term `holder' means-

(1) any individual whose efforts created such property, or

(2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither-

(A) the employer of such creator, nor

(B) related to such creator (within the meaning of subsection (d)).

(c) EFFECTIVE DATE.-This section shall be applicable with regard to any amounts received, or payments made, pursuant to a transfer described in subsection (a) in any taxable year to which this subtitle subtitle A applies, regardless of the taxable year in which such transfer occurred.

(d) RELATED PERSONS.-Subsection (a) shall not apply to any sale or exchange between an individual and any other related person (as defined in section 267(b)), except brothers and sisters, whether by the whole or half blood.

In Senate Report No. 1622, 83rd Congress, 2nd Session, at page 440, it is stated with respect to section 1235(b), in part, as follows:

* * * A `holder' is defined as any individual whose efforts created the patent property transferred, by which is meant the `first and original' inventor (or joint inventor) within the meaning of section 31 of title 35 of the United States Code. Individuals not eligible to qualify as such `first and original' inventor will not qualify under this definition: for example, the inventor's employer may not here qualify, even though he may be the equitable owner of the patent by virtue of an employment relationship with the inventor. However, your committee is desirous of extending the scope of this section to cover (in addition to inventors) those individuals who contribute financially toward the development of the invention. Accordingly, paragraph (2) of subsection (b) also includes within the definition of `holder' any other individual who acquired his interest in such property in exchange for consideration in money or money's worth (i.e., consideration capable of present valuation in monetary terms) actually paid to the creator prior to the time when the invention (to which the patent rights relate) is actually reduced to practice (as compared to `constructive' reduction to practice). This paragraph does not include any individual who is either an employer of any creator or related to any such creator within the meaning of subsection (d) ; however, the section does apply to all qualifying individuals, whether amateur or professional, regardless of how often they may have sold their patents. The section is not applicable to any other purchasers or assignees. Italics supplied.

In accordance with section 1235 of the Code, an express assignment of patent rights by an inventor or an exclusive license of the right to manufacture, use, and sell, the invention for the life of the patent can qualify as a `sale or exchange' of capital assets held for more than six months; therefore, for taxable years to which section 1235 is applicable (see section 1235(c) and 7851(a)(1)(A)), the inventor can obtain long-term capital gain treatment on amounts received pursuant to such a transfer irrespective of whether the consideration may be payable periodically during the transferee's use of the patent or is contingent on the productivity, use or disposition of the property transferred.

Payments which come within the scope of the section include but are not limited to amounts which are payable over a period generally coterminous with the transferee's use of the patent, or amounts which are measured by a fixed percentage of the selling price of the patented article, or are based on units manufactured or sold, or any other method measured by profits, production, sale, or use.

If an inventor sells, assigns or grants an exclusive license of property consisting of all substantial right, title and interest in and to the patent, to other than a related person (brothers and sisters excepted) as defined in section 267(b) of the Code, such sale or transfer ordinarily constitutes a sale or exchange of a capital asset held for more than six months regardless of the period the patent is actually held. Under an option agreement constituting an executory contract to assign the patent and invention at a future date, where there is no present transfer of property in the invention, there is no sale within the purview of the statute.

Accordingly, it is held that the amount received by a taxpayer for granting to a corporation an option to acquire an exclusive license to patents which he holds, such amount to be applied against installment payments representing a percentage of the selling price of articles sold under the license, constitutes an amount received from the sale of a capital asset held more than six months in the year the option is exercised, provided the transaction entered into in granting the license qualifies as a sale or exchange of a capital asset as provided in section 1235 of the Code. However, in the event the option is allowed to lapse, the fee retained by the taxpayer should be treated as ordinary income in the year the option lapses. See Virginia Iron Coal and Coke Company v. Commissioner , 37 B.T.A. 195, affirmed 99 Fed.(2d) 919, certiorari denied 307 U.S. 630.

After the exercise of the option, amounts received under the contract by any person who is a `holder' within the meaning of section 1235 of the Code (in this instance the amounts received by the investor's uncle as well as amounts received by the inventor) constitute amounts received from the sale or exchange of a capital asset. Amounts received by related persons (in this instance the inventor's wife and son) who have been assigned interests are not subject to capital gain treatment under section 1235.

It is assumed for the purpose of this ruling that more than 50 percent in value of the outstanding stock of the corporation which will acquire all substantial rights to the patent is not owned, directly or indirectly, within the meaning of section 267(b) of the Code, by or for any individual from whom such rights are acquired.