Intangible assets play a major role in today’s business world. From goodwill and trademarks to customer lists, these assets often come into focus when a company is sold, ownership changes, or intellectual property is transferred. However, the IRS doesn’t treat all intangibles equally, and tax implications can vary significantly.
Capital Gains vs. Ordinary Income
Most intangible assets qualify as capital assets, meaning their sale generates capital gains or losses. This is advantageous because long-term capital gains tax rates (15%–20%) are typically lower than ordinary income tax rates (up to 37%). But not all intangibles enjoy this treatment — especially those considered “self-created.”
Understanding Self-Created Intangibles
A self-created intangible is one developed through the personal efforts of the taxpayer. This includes situations where:
- The taxpayer directly contributed to the creation of the asset, or
- The taxpayer directed others in creating the asset.
This definition applies not only to individuals but also to corporations, partnerships, and LLCs that receive contributions of intangible assets from their creators.
Self-Created Noncapital Intangibles
Certain self-created intangibles are treated as noncapital assets, meaning their sale produces ordinary income or loss. Examples include:
- Patents
- Inventions, models, or designs
- Proprietary formulas or processes
- Copyrights
- Literary, musical, or artistic works
Even letters, memorandums, or similar property prepared for you may fall under this category.
The Substituted Basis Principle
When self-created noncapital intangibles are contributed to another entity, the unfavorable tax treatment often continues. If the new owner’s tax basis is tied to the creator’s basis, the asset remains a noncapital asset. For example, when a creator contributes such an asset to a partnership in a tax-free transaction, the partnership inherits the same tax basis and treatment.
Self-Created Capital Intangibles
Not all self-created intangibles face ordinary income treatment. The following are considered capital assets:
- Goodwill or going concern value
- Workforce in place
- Business books and records
- Operating systems
- Customer-based intangibles (client lists, prospective customer lists)
- Supplier-based intangibles (favorable supplier contracts)
Sales of these assets generate capital gains or losses. Proper allocation of purchase price among capital and noncapital intangibles is crucial, as the IRS may scrutinize these transactions.
Non-Self-Created Intangibles
If intangible assets are created by employees and owned by the business entity, they are generally not considered self-created. For example, IRS Revenue Ruling 55-706 determined that a corporation’s intangibles created by employees were capital assets, not self-created. Similar treatment applies to partnerships, LLCs, and S corporations.
Conclusion: Proceed with Caution
The tax rules surrounding self-created intangibles are complex. While some assets are inevitably treated as noncapital, many others qualify as capital assets with favorable tax treatment. If you plan to sell or transfer intangible assets, consult a tax professional to ensure compliance and minimize risk.