Overview
I have been a major fan of Afro-Cuban (Salsa) and Brazilian Bossa Nova music since high school. Most of you know by now that I grew up in the Panama Canal Zone. By the time I got to West Point in the summer of 1978, it was “sink or swim” in every facet of my life. It was only then that I realized Latin was a dead language but for a few Catholic churches that still have Mass read in Latin. Oh, and I am Protestant and not Catholic! I was above average, but not a great math student. I was surprised to discover that West Point was the oldest engineering school in the country. What a dirty trick!
As an academic balance to my four years of suffering, I took my ten electives over four years in foreign language. I took them all in Spanish and Portuguese (Brazilian). I went to sleep on a Sunday night and woke up on Monday speaking both languages. It did not hurt that my mother and brother spoke Spanish well. Growing up in the Canal Zone, I had no interest in learning. It is true in my life at least that necessity is the mother of invention.
While I am not a great dancer, I have strong salsa credentials in that I met the great Cuban singer Celia Cruz while living in Miami and had a picture with her. I also saw her perform in the Bronx with Tito Puente and Johnny Pacheco and his black flute. While living in Miami, we regularly ate at various Cuban restaurants, so I know Cuban sandwiches well – Elena Ruiz, and Media Noche to name a few.
This article focuses on the use of intellectual property in the personal and business tax planning for closely held businesses. Intellectual property (“IP”) has played a significant role in the tax planning of multi-national corporations. Strategies such as the Double Irish with Dutch Sandwich are used routinely to shift income in high tax jurisdictions to lower tax jurisdictions through the transfer and licensing of IP. This is the connection to Elena Ruiz and the Cuban Sandwich. If multi-national corporations can have a Double Irish with Dutch Sandwich, why can’t small business owners have a Cuban sandwich?
The operating company in the high tax jurisdiction takes a deduction of its royalty income while the owner of the IP in a lower tax jurisdiction is taxed at a lower rate pursuant to a tax treaty. In the multi-national context, the legal and tax complexities primarily deal with tax treaties and transfer pricing.
As best as I can tell, very few closely held businesses engage in tax planning using IP. Nevertheless, every successful business (or not!) has intellectual property, intangible property such as patents, trademarks, copyrights, digital assets, and trade secrets.
Intellectual Property Considerations
Intellectual property (IP) are creations of the mind that have value. IP includes inventions; literary and artistic works; designs; and symbols, names and images used in commerce. IP is protected in law by patents, copyrights, and trademarks. A patent is an exclusive right granted for an invention. A patent provides the patent owner with the right to decide how - or whether - the invention can be used by others. In exchange for this right, the patent owner makes technical information about the invention publicly available in the published patent document.
Copyright is a legal term used to describe the rights that creators have over their literary and artistic works. A trademark is a sign capable of distinguishing the goods or services of one enterprise from those of other enterprises. Trade secrets are IP rights on confidential information which may be sold or licensed. The unauthorized acquisition, use or disclosure of such secret information in a manner contrary to honest commercial practices by others is regarded as an unfair practice and a violation of the trade secret protection.
Tax Planning Structures
I have written extensively on private planning life insurance (PPLI) and more recently on 501(c)(4) tax exempt organizations. PPLI benefits from the favorable tax treatment afforded life insurance policies. The cash value increases of the policy are not taxable to the policyowner.
Additionally, the policyowner can take very low-cost tax-free policy loans from the policy. The policy death benefit also receives income tax-free treatment. PPLI is an institutionally priced variable universal life insurance policy that provides the opportunity to customize the policy’s investments. With careful planning and tax structuring, IP may be one of the policy’s investments where royalty income would receive tax-free treatment.
A 501(c)(4) or C4 is a tax-exempt organization. The C4 organization can accomplish everything that a public charity plus engage in political lobbying and political activity. The taxpayer can exercise more control over the C4’s charitable activities than other types of charitable organizations. The tax tradeoff for this control is donations that are non-deductible for income tax purposes. Absent a relinquishment of the donor’s control at the time of donor’s death, the value of the C4 organization will be included in the donor’s estate. C4s are not taxable on their investment income unless it is Unrelated Business Taxable Income (“UBTI”). Fortunately, IP royalties are not considered UBTI.
These two structures provide the mechanism for business owners to accomplish results like multi-national corporations without having to trip over the complexities of tax treaties, and transfer pricing. The IP planning considered provides the opportunity for tax optimization through the transfer of IP and licensing of the transferred IP back to the operating company. The operating company (taxpayer’s business) may deduct the full amount of the royalty payment. The royalty payment received within the C4 or PPLI policy is tax-free. The business owner may borrow funds from the C4 on an arms-length basis or take low-cost policy loans from a PPLI policy. Below is an example to outline the concept.
Planning Example
Pedro Navaja is the one hundred percent shareholder of Acme, Inc., an S corporation. Acme was recently valued by a business valuation specialist for $8.5 million with annual revenues of $25 million. Acme has a trademark which is valued at $1 million. Navaja enters into a purchase agreement with Acme to transfer the business trademark to Navaja. Navaja assigns the IP to a new LLC called Acme IP, LLC.
Solution #1 – IP Planning Using a 501(c)(4)
Navaja forms For Love or Charity, a 501(c)(4) (“C4”) organization to benefit disabled veterans and political lobbying on behalf of veterans with disabilities. He also creates Acme IP, LLC (“Acme IP”). He assigns the Acme trademark to Acme IP, LLC and makes a non-deductible donation of 99.9% interest in Acme IP to the new C4. Acme IP enters into a licensing agreement with Acme Inc. for the use of the trademark. The licensing agreement provides for a royalty payment equal to ten percent of Acme’s gross revenue. The royalty payment of $2.5 million is a deductible expense to Acme Inc. As manager of Acme IP, Navaja has the management control to reinvest and make distributions to the C4. Importantly, he can take a management fee on a taxable basis or enter an arms-length loan arrangement with Acme IP on a tax-free basis.
Importantly, the K-1 income allocated to the C$ is non-UBTI income. The royalty payment by Acme is fully deductible.
Summary
Every successful business has intellectual property of some sort. Business owners can restructure the ownership of the IP and license the use of the IP back to the operating business. When the ownership of the IP is principally owned by a non-taxable entity the result is powerful. The operating business can deduct the royalty payment for the use of the IP as a trade or business expense. The royalty payment is non-UBTI to the C4. The retention of management and control of the IP, LLC provides the business owner with control of distributions and the ability to borrow some of the IP royalty income, tax-free on an arms-length basis.
Tax optimization using IP is a mainstay for large multi-national corporations. It is time for closely held business owners to avail themselves of the same planning opportunity.
