Eureka! Your company has created a new gizmo that's a vast improvement on the competition's product. Once you work out the bugs, you expect to patent the invention to protect your interests. Then, you hope it will start selling faster than hot cakes.
Strategy: Start reaping tax rewards right now. Even before your new product or design has been patented, you can write off research and experimentation (R&E) costs under Section 174 of the tax code.
Don't confuse the Section 174 deduction with the tax credit for research and development (R&D) costs. The R&D credit is available only for incremental increases in qualified research activities.
Here's how it works: Section 174 allows you to treat R&E expenditures as business expenses and deduct them. You can amortize those costs over five years or "expense" (i.e., currently deduct) them in the year in which they're incurred. The deduction covers all "reasonable" expenses, including experimental or pilot models, plant process, a product, formula, invention or some other similar property.
If you pay attorneys' fees to obtain patents (domestic or foreign), you can also deduct those fees as Section 174 expenses.
Suppose you acquire a patent separately or as part of a business acquisition. In that case, several other tax-code provisions come into play. Generally speaking, you must depreciate a patent that's acquired separately over its useful life using the straight-line method.
But if a patent is included in a business acquisition, you must amortize it under Section 197. This tax-code section lets you amortize certain intangibles, such as patents, over a 15-year period, beginning in the month of the acquisition.
On the other hand, if you decide to sell the patent, treat the income from the sale as low-taxed capital gain (except for gain from amortization deductions, which counts as high-taxed ordinary income).
In a new private ruling, three inventors transferred patents to a limited liability company (LLC) set up to market the product. The Tax Court said the gain from the subsequent sales of the patents still qualifies for favorable tax treatment, since the income will flow through to three owners. (IRS LR 200506008)
Tip: Lots of interplay exists between the tax-code provisions for research activities and patents. Keep detailed expense and income records, and then leave it to your tax pro to sort out the details.
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