Still thinking about the $5 million gift opportunity? Think patents.

Taxes and estate planning are on the minds of many as the 2012 year winds down and the Bush tax cuts may be coming to an abrupt end. Among the biggest concerns is the likely expiration of the $5 million gift tax exemption. So it’s good news to know that a patent estate can be a real boon to estate planning.

Gifting patents can transfer significant value to the next generation and also address specific concerns:
  • Independent valuation for the IRS
  • Control of the family business
  • Flexibility to sell the business
  • Restricted use of the transferred intellectual property

Patents are usually unvalued and hence a real challenge in family offices for estate planning. But used properly, patents other IP assets can provide value for both intergenerational changes in control and/or minimizing estate taxes. Carthage Intellectual Capital Management (‘Carthage’) has proprietary processes to help family businesses and their tax and estate planning professionals. Here is a case in point:

Suppose a family business with patents or other IP does not intend to transfer the business yet from a parent generation to successor generations. The parent generation wants to make an effective gift of business assets within the $5 million gift tax limitation. But the business does not want to jeopardize ongoing control of the business. Further, the business will ideally want a reversible transaction should future business circumstances need to repatriate the IP assets. Finally, the transaction should be straightforward and not raise valuation questions with the IRS or other taxation authorities. With the caveat that the following is a hypothetical and not a definitive recommendation, here is how IP can be considered in a gifting situation.

First we assume there are intellectual property (IP) assets (patents, trademarks, and copyrights are preferred) that confer substantial economic value to the business. If these have been internally created, the balance sheet will typically not show this value. An IP holding enterprise is then formed to receive the IP and the license-back is created with the principal business. The enterprise may then be gifted to a family trust whose principal purpose is to maintain the IP assets, and receive and distribute back royalties to family members participating in the trust (other entities may be equally suitable but we call them a ‘trust’ as a generic description). In this case, the license back will depend on future occurrences as to when or how much royalty is paid as an annual rate for the license back itself. This in effect defers the need to value the IP assets at anything above the tax free gift basis at the time of gifting as there is not a fully defined income stream upon which to base a higher asset value.

Control of the IP is determined by the license which remains with the operating business and will typically be an exclusive license. The business can separately reserve a ‘put’ to reacquire the IP holding company at its nominal gift value less amortization at a future date, should the business need to repatriate the IP assets themselves (say, for a sale to a third party). This makes the transfer effectively reversible by the parent generation through the operating business. So long as the nominal value of the reversal is the same as the gift it further minimizes the risk of IRS valuation challenges.

If in the future the business is sold to a third party, a more substantial license royalty can be triggered as a consequence of the sale. The necessary use of the IP becomes a warranty obligation of the purchaser as the transferee of the license back. The sale price of the business may then consider the present value of the license back royalties payable to the trust. The selling family business can accept a lower effective sale price from  purchaser because the seller will be required to pick up the license back and make royalty payments triggered by the sale event. For the purchaser, the deductibility of the royalties is generally less that the borrowed capital and associated costs to acquire all assets in a fee simple transaction which can tolerate some purchase premium in a competitive bid situation.

The trust receives and distributes royalty income on a current basis and does not require a change in basis in the IP assets. The certainty of future royalty payments that rests on the degree of risk of warranty default can allow the trust to borrow a principal sum based on the pledge of the continuing royalty income. This principal can be distributed to the trust beneficiaries tax free as an advance on future income. Running interest payments together with amortization of the IP transfer basis will offset future income taxes as a deductible trust expense. Alternately, the trust can sell off the IP assets and realize capital gains at that time for a distribution and liquidation of the trust itself.

Once again, Carthage has extensive experience and the patented processes that can guide family businesses through evaluation of their IP assets and the transactions that can satisfy their estate planning needs. Because these are sophisticated transactions, you will want to consult legal and accounting professionals to determine the suitability of IP for tax and estate planning purposes. But the good news is that Carthage will be there to help you when the time is right to unleash another hidden value of your IP. For questions please contact Carthage at