Royalties Are Ordinary Income Where Doctor Retained Rights in Patents

(Parker Tax Publishing September 2016)

The Tax Court determined that royalty payments a doctor received under an agreement for the use of his drug delivery technology were taxable as ordinary income, rather than as capital gain. The court held that because the doctor could choose how the technology was used, and retained the right to use the patents outside the pharmaceutical field, he did not transfer "all substantial rights" to the patents and the resulting royalties were not eligible for capital gain treatment under Code Sec. 1235. Spireas v. Comm'r, T.C. Memo. 2016-163.

Background

Spiridon Spireas immigrated to the United States from Greece in 1985 and completed a master's and doctoral studies in pharmaceutical technology and industrial pharmacy. He obtained his Ph.D. degree from St. John's University in 1993. Dr. Spireas became a renowned expert in the science of drug delivery, including "liquisolid" technologies, which created unique formulations for the delivery of a chemical in tablet form, such as a nutritional supplement or a pharmaceutical drug.

In 1997, Dr. Spireas and Dr. Bolton, a St. John's doctor that worked closely with Dr. Spireas, organized Hygrosol Pharmaceutical Corporation (Hygrosol), an S corporation, for the purpose of exploiting the liquisolid technologies they were developing. The doctors each owned 50 percent of Hygrosol and took turns serving as its president and vice president. Between 1996 and 2002, Dr. Spireas and Dr. Bolton were issued, jointly or individually, four U.S. patents related to liquisolid technology. Hygrosol received the royalties related to the patents, and those royalties flowed through to Dr. Spireas and Dr. Bolton.

In June 1998, Hygrosol, Dr. Bolton, and Dr. Spireas (collectively, licensors) entered into a license agreement with Mutual Pharmaceutical Company, Inc. (Mutual), a company whose business focused on developing and marketing generic drugs (1998 license agreement). The agreement granted to Mutual the right to use patents for the liquisolid technology, on a product-by-product basis, to develop, produce, and sell within the U.S. new and generic pharmaceutical drugs, as determined by agreement between the parties. The 1998 license agreement granted Mutual rights to use the liquisolid technology only in the pharmaceutical field. Dr. Spireas retained rights to use his technology to develop vitamins, nutritional supplements, and other health-related products not requiring FDA approval.

In early 2000, Dr. Spireas began work on a new formulation for a drug called "felodipine," used to treat high blood pressure. In March, 2000, Mutual sent Dr. Spireas an engagement letter (2000 engagement letter) addressing the development of three products, including felodipine, and enclosed a check for $30,000 in accordance with the 1998 license agreement. Dr. Spireas countersigned this letter in his capacity as vice president of Hygrosol.

On his income tax returns for 2007 and 2008, Dr. Spireas reported royalties received under the 1998 license agreement as long-term capital gain. Felodipine generated 99.64 percent of this royalty income; the remaining royalties were attributed to the drug propafenone, which was also covered in the 2000 engagement letter. The IRS examined the returns and determined that the royalties received should have been reported as ordinary income.

Analysis

Royalty payments received under a license agreement are generally taxed as ordinary income. However, Code Sec. 1235(a) provides that a transfer of property consisting of all substantial rights to a patent by any holder of that patent is treated as the sale or exchange of a capital asset held for more than one year. Under Reg. Sec. 1.1235-2(b)(1)(iii), this capital gain treatment is not available where the "instrument of transfer" grants rights to the grantee, in fields of use within trades or industries, which are less than all the rights covered by the patent and which exist and have value at the time of the grant.

The Tax Court stated that the central dispute between Spireas and the IRS regarded what the "instrument of transfer" was. The IRS argued that the instrument of transfer was the 1998 license agreement and that Dr. Spireas did not transfer all substantial rights to the liquisolid technology. Dr. Spireas argued that the key document was the 2000 engagement letter; that this letter was in substance a license agreement; and that he transferred all substantial rights to the felodipine and profafenone formulations. The court concluded that the IRS had the stronger argument.

The court stated that the 1998 license agreement was clearly the relevant "instrument of transfer" under Reg. Sec. 1.1235-2(b)(1) because it was the agreement that granted the rights for which Mutual paid. The court found the rights transferred were the rights to use the liquisolid technology and to make and sell products containing that technology. Conversely, the court said, the agreement did not transfer rights to the formulation of any specific drug because no such formulations existed in June 1998; felodipine and propafenone in particular, the court noted, were not selected for development until March 2000.

With regard to the 2000 engagement letter, the court found it was substantially similar to 20 other engagement letters the parties signed to memorialize their selection of certain drugs for further investigation. These engagement letters, the court stated, granted no rights and had no royalty payment terms. Far from constituting freestanding license agreements, the court said, they simply rendered the 1998 license agreement operative with respect to the products that they identified.

The court determined that Dr. Spireas did not transfer "all substantial rights" to the liquisolid technology in the 1998 license agreement. The court found that the rights granted to Mutual were less than all the rights in the technology because the agreement gave Dr. Spireas and his co-licensors effective veto power over the drugs as to which Mutual could exercise its rights, noting that all parties to the license had to agree on which products could be developed. In addition, the court noted that Dr. Spireas retained all rights to use the technology outside the pharmaceutical field (e.g., in developing nutritional supplements, vitamins, and other products not requiring FDA approval). The court stated that the restriction of a license to one field of use, where a reserved field of use has value at the time of the grant, fails to convey "all substantial rights."

The court held that because Dr. Spireas did not transfer "property consisting of all substantial rights to a patent" in the 1998 license agreement, Code Sec. 1235(a) did not apply and thus the royalties he received pursuant to the agreement were taxable as ordinary income.

For a discussion on the taxation of gain or loss from the transfer of patents, see Parker Tax ¶117,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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