As we’ve noted elsewhere, filing a patent application is an expensive process. However, patent application costs are tax deductible. And with a carefully structured financial plan, you can significantly reduce taxes on the income generating from patent licensing fees for up to 15 years. Here’s how.
Creating a Patent Holding Company
First, you want to make sure that you place your patent within a business entity–either a sole proprietorship, partnership, or LLC—as a capital asset. It’s important that the entity chosen be taxed as an individual or partnership, not as a corporation.
Creating a company for your patent is crucial. If you are ever sued because of the patent and/or the products it spawns, your personal assets are protected. Only the revenue and property within the business entity can be touched.
Now, for inventors of normal means, one of the best ways to earn an income from a patent is by licensing the patent out to third parties in return for royalty payments. The use of a business entity for your patent provides a major benefit when it’s time to pay taxes on your yearly royalties.
Deducting Patent Costs vs. Amortization
The costs associated with the patent—namely, patent application fees and legal costs, as well as research and development expenses you paid to someone else—can be deducted from the company’s taxes.
There are two ways to handle these deductions. If you like, you can simply deduct the entirety of the expenses from that year’s taxes as a business expense. This will give you a large, single year benefit. However, all the revenue generated by the patent will be taxed as ordinary income. Depending on how much money you make, the marginal tax rate that you pay is probably between 40% and 50% in California.
However, there’s an attractive alternative to a simple deduction. You can instead choose to capitalize the costs associated with the patent by amortizing them. Amortization is similar to depreciation—both involve taking the upfront expense of an asset and spreading that cost across its useful lifespan. In the case of a patent, instead of taking a single deduction, you can essentially amortize this cost—and thus, the corresponding tax deduction—over a period of 15 years.
Amortizing Patent Expenses Reduces the Taxes on Your Revenue
The real kicker of amortization is that it’s not about the upfront write-off on your taxes: it’s about the benefits for your revenue. When you amortize your costs, your licensing revenue isn’t taxed as ordinary income, but instead as capital gains.
Remember how normal revenue can be taxed as much as 50%? The taxation rate for capital gains is between 15 and 20%. This significant reduction is due in part to not having to pay self-employment taxes on it.
This is why in many instances I advise inventors to license their patents for a royalty, rather than sell them outright for a large lump sum. If you sell a patent, you can only deduct your costs for a single year, and that lump sum of revenue will be taxed at a rather unforgiving rate. But licensing allows for taking the amortization route along with having a smaller revenue stream over time and thus significantly reducing the amount of revenue lost to taxes. (If you’re particularly deft with business structures, you can even license your patent to yourself with the use of another business entity, and realize the same tax benefits.)
Determining When Amortization is the Right Choice
However, there may be times when taking an upfront tax deduction is the better option. When is better? This depends on a large number of factors, such as the amount of revenue involves, the size of your business, if you have employees, and so on.
There is no one-size-fits-all tax solution for inventors. That’s why it’s wise to work with a patent attorney to find the solution that’s most appropriate for your specific situation.
If you’re trying to find a way to protect the revenue generated by your patent, Patent Attorney Michael O’Brien can help. We’ll work alongside you to develop and implement a sound financial strategy that’s customized just for you. To schedule a consultation, you can call 916-760-8265, or use our contact form to leave us a message.