October 22, 2021

Good News on Self-Created Know-How

By Kelly Yim, Director, Tax & Business Services

Good News on Self-Created Know-How Tax & Business

Extra! Extra! Read all about it! Certain self-created know-how may still qualify for favorable capital gains tax treatment! Effective 2018, the Tax Cuts and Jobs Act (“TCJA”) eliminated capital gain treatment for certain self-created intangible assets. Any gain on the sale of these assets is now taxed at the higher ordinary tax rate, as opposed to the more favorable capital gains tax rate of 20%. The effect of this provision is to treat gain or loss from the sale or disposition of these assets as ordinary income or loss. Fortunately, self-created intangible assets, such as business know-how, may still get the favorable capital gains treatment in certain situations.

Know-how is one of those self-referential terms. It’s the knowledge of how to do something and the experience in doing it. It’s generally closely held, might be reduced to written form (designs, drawings, procedures and methods) and it gives the holder a competitive advantage.

The law provides that the following are not capital assets if the taxpayer created them or acquired them as a gift from the creator:

  • Patents
  • Inventions
  • Models or designs (whether or not patented)
  • A secret formula or process
  • A copyright or literary, musical or artistic composition, letter or memorandum
  • Or “similar property”

Know-how is not one of the items expressly excluded from the capital asset category but it could be a “similar property” to a patent, copyright, invention, model or design, a secret formula or process. So, eligibility for capital gain treatment would depend upon whether the know-how was acquired by personal effort or gift from the creator. If not, then gain on the sale of know-how should qualify for capital gain treatment.

The IRS has ruled that an asset created by a group of individuals working for a corporation won’t be considered created by the “personal efforts” of any particular individual because it is created by a business enterprise. When the making of a product involved a multiplicity of skills and abilities, the combined efforts of numerous individuals of various backgrounds and trades, and the use of substantial amounts of the company’s capital, no individual can be single out as the main contributor to the production. Under this concept, the self-created know-how is created by the business enterprise. It should be a capital asset, eligible for the favorable capital gain treatment upon its sale.

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