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Deferring Payment Of Estate Tax
On Intellectual Property
The estates of composers, authors and
others who create copyrightable works and other forms of intellectual
property may qualify for two of the Internal Revenue Code’s (“Code”)
sections authorizing deferral of payment of estate tax. Because the estate
of a composer, author or other creative person may consist largely of
copyrights, contract rights or other forms of intellectual property, the
estate may lack the money necessary to pay estate taxes imposed when the
creator dies. Relief from the immediate necessity of raising funds to pay
estate taxes on intellectual property rights can be based on: (a)
§6161(a)(2) of the Code providing for deferral of payment of estate tax
based on reasonable cause, or (b) §6166 of the Code, providing for
deferral of payment of estate tax on an “interest in a closely held
business.”
For purposes of computing estate tax, the
fair market value of intellectual property rights on the date of the
creator’s death is included in the taxable estate. The fair market value
of copyrights, for example, is their income producing potential,
discounted to present worth. A general rule of thumb used for computing
the fair market value of a copyright is to figure the average annual
earnings of the copyright over a 5 year period and multiply that amount by
a number varying between 3 and 7.
For example, if a copyright earned an
average of $1,000 in each year during the 5 years prior to the person’s
demise, the fair market value of that copyright for estate tax purposes
would range between $3,000 and $7,000 depending on factors such as the
length of the remaining copyright term, the prior uses to which the
copyright was put, and the likelihood that those uses would either
increase or decrease in the future.
The estate tax on an estate compromised
largely of valuable copyrights or contract rights can be substantial.
Although in 2003 the first $1,000,000 of any person’s estate is exempt
from Federal estate tax, the Federal estate tax rate on amounts of taxable
estate over $1,000,000 begins at 41% and increases to 50% for amounts of
taxable estate exceeding $2.5 million. For example, the Federal estate tax
on a taxable estate of $2,000,000 is $435,000. In addition, although there
is a credit against Federal estate tax for state inheritance taxes, the
state inheritance tax credit is being phased out and will not apply at all
to estates of persons dying after 2004.
For a married person who dies before
his/her spouse, the estate tax can be postponed to the spouse’s estate
through use of the marital deduction. In addition, in 2003 the exemption
from estate tax of married persons can be increased from $1,000,000 to
$2,000,000 if a trust for the surviving spouse is created.
Because the fair market value of a
copyright is a tax concept rather than readily accessible cash, unless the
creator has other money available to pay the estate taxes, it might be
necessary for the estate to sell some of those copyrights, or sell assets
such as real estate or securities, to pay the estate tax with a consequent
loss of those assets’ earning potential to provide future support for the
survivors.
The Code recognizes the problem of lack of
liquidity of estates that are comprised of illiquid assets such as
copyrights and has dealt with this problem in two ways:
- Payment of estate taxes may be
extended for up to 10 years based upon a showing of reasonable cause,
including an estate’s being substantially comprised of copyrights
(Code §6161(a)(2));
- Payment of estate taxes may be
deferred for up to 14 years if the copyrights constitute an “interest
in a closely held business”, and if that business equals 35% or more
of the taxable estate (Code §6166). The tax is deferred only on that
portion of the estate that is deemed to be an interest in a closely
held business. For example, if the estate consists partly of cash and
marketable securities, on the one hand, and partly of copyrights on
the other hand, the tax on the copyright portion can be deferred for
up to 14 years but the tax on the cash and securities portion cannot
be deferred.
Although an estate must pay interest on
estate tax deferred under either one of the cited Code provisions, the
rates of interest are different:
- In the case of deferral of payment for
reasonable cause, the rate of interest applied to the deferred tax is
the short-term federal rate plus 3% (Code §6621(a)(2));
- The rate of interest applied to
defered payment of estate taxes on a closely held business is fixed at
2% on the amount of tax computed on the first $1 million of taxable
estate (Code §6601(j)). The rate of interest on deferred estate tax
computed on amounts of taxable estate exceeding $1,000,000 is 45% of
the amount in 1, above. The tax may be deferred for up to 14 years,
with no payment of estate taxes during the first 4 years. Thereafter,
the estate tax can be deferred for up to an additional 10 years,
payable in equal annual installments based on the number of years of
postponement, with interest on any unpaid portion of tax.
The balance of this article will discuss
the factors used in determining whether intellectual property can be
considered an “interest in a closely held business” in order to qualify
for the 14 year deferral of estate tax.
Code §6166 defines “interest in a closely
held business” as including:
- an interest as a proprietor in a trade
or business carried on as a proprietorship;
- an interest in a partnership carrying
on a trade or business if 20% or more of it is owned by the decedent
and there are 15 or fewer partners; and
- stock in a corporation carrying on a
trade or business if the decedent owned 20% or more of the voting
stock and there are 15 or fewer shareholders.
Hence, even if a creative person has not
incorporated his business but instead operates as a sole proprietorship
and reports business income and loss on Schedule C of his personal income
tax return, his estate should qualify for deferral of tax payments if the
other tests of a closely held business are met.
The problem in proving the existence of a
business qualifying for tax deferment where the decedent created rights
that generate royalties or continuing income is that the “business” of
exploiting copyrights and other intellectual property rights may entail
little more than the collection of income generated by them. If the
creator’s only business activity in later life was confined to the
collection of royalty income, then the “closely held business” test might
not be satisfied. The Internal Revenue Service has ruled that the estate
of a person who owned and operated rental real estate where the business
consisted of merely collecting rental payments and maintaining the
properties, did not qualify for the installment payment of estate tax.
Although the person had maintained a fully equipped office to collect the
payments and direct the maintenance of the rental properties and had
maintained regular office hours, the IRS determined that the activities
did not justify the use of the installment method of estate tax payment.
The rationale of the IRS’s determination is found in the following
sections from the ruling (Revenue Ruling 75-365):
“This section [Internal Revenue Code
§6166] was not intended to protect continued management of income
producing properties or to permit deferral of the tax merely because the
payment of the tax might make necessary the sale of income-producing
assets, except where they formed a part of an active enterprise
producing business income rather than income solely from the ownership
of property. The disposition of one or more of the income producing
properties would involve no hardship since it would not affect the
management of, or threaten the income from, the properties
remaining...Section 6166 was intended to apply only with regard to a
business such as a manufacturing, mercantile, or service enterprise, as
distinguished from management of investment assets.
* * * * *
It follows that the mere grouping
together of income-producing assets from which a decedent obtained
income only through ownership of the property rather than from the
conduct of the business, in and of itself, does not amount to an
interest in a closely held business within the intent of the statute.
In this case the decedent’s relationship
to the various assets described was merely that of an owner managing
investment assets to obtain the income ordinarily expected from them.”
In an earlier revenue ruling (61-55), the
IRS determined that the “working interests” in oil and gas properties
constituted a trade or business under Internal Revenue Code §6166, but the
“royalty interests” did not qualify. The ruling states:
“It is held that the ownership,
exploration, development, and operation of oil and gas properties by the
decedent constituted a single trade or business within the meaning of
§6166 of the Code. Therefore, the Federal estate tax attributable
thereto may be paid in installments if the estate otherwise qualifies
under §6166.
However, the mere ownership of royalty
interests in oil properties does not constitute a single trade or
business within the meaning of that section. Consequently, the deferred
payment right provided for in §6166 of the Code is not applicable to the
portion of the decedent’s estate which consists of such royalty
interest.”
The estate of an author, composer or other
creative person may be able to demonstrate enough differences between his
business activities and those involved in the cited revenue rulings to
make the estate eligible for the §6166 installment payment provisions.
Thus, for example, while a composer may be collecting income from his
royalties, he may also be composing new works, making efforts to find new
uses of existing works, or engaging in other business activities (such as
directing or producing) in addition to creating copyrightable
compositions. Copyrights are not analogous to real estate, which was the
business of the taxpayer referred to in Revenue Ruling 75-365, where it
was said that the disposal of one or more of the rental properties would
create no hardship for the estate. It may not be practical to “chip off”
one or two copyrights in order to raise money to pay the estate tax. In
the first place, it may be necessary to sell the most valuable copyrights
in order to raise the necessary money, thus leaving the less valuable
copyrights for the composer’s heirs. In addition, part of the catalog may
not be saleable without the rest of it, with the result that the sale of
one copyright would require the sale of all of the copyrights.
Furthermore, if only the most valuable copyrights are sold, the remainder
may suffer a disproportionate loss in value as a result of the sale of
some of them than they would if the entire catalog remained available as a
whole.
The emphasis of Revenue Ruling 75-365 on
“manufacturing, mercantile or service enterprises, as distinguished from
management of investment assets”, does not account for the reality of the
business life of a creative person, which does not seem, on the face of
it, to fit into any of the manufacturing, mercantile or service enterprise
categories. Yet, given enough indicia of an active business enterprise,
the estate ought to qualify for deferred payment.
Where a creative person has incorporated
his business, the corporation’s income tax returns, and the facts they
demonstrate concerning the conduct of the business, will be some evidence
that the person operated a “closely held business” entitled to the benefit
of §6166 of the Code. If the creative person, on the other hand, never
incorporated, then the following factors would be important in qualifying
for §6166 treatment:
- The filing of Federal Schedule C
(Profit or Loss From Business) for several years prior to the person’s
death. Reporting royalty income on Federal Schedule E (Supplemental
Income and Loss) should be avoided because it is more consistent with
the mere collection of income from income—producing assets than it is
with the conduct of an active business.
- Documented efforts to create new uses
of existing copyrights (e.g., correspondence and contracts).
- Creation of new compositions or works.
- Maintenance of an actual place of
business, the payment of rent, secretarial and other salaries, the
employment of an agent to actively pursue new uses, and incurring
travel, entertainment and other costs of doing business.
CONCLUSION
The copyrights and other intellectual
property of the estates of authors, composers and other creative people is
subject to estate taxes like other estate assets at their fair market
value as of the date of death. Estates of creative people may lack enough
cash, securities or other “liquid” assets to pay the estate taxes on the
intellectual property portion of the estate without causing hardship. If
the estate can establish either that there is reasonable cause to defer
payment, or if the intellectual property portion of the estate equals 35%
or more of the taxable estate and the person operated a “closely held
business” involving the intellectual property, then the estate taxes
attributable to the intellectual property portion of the estate can be
deferred for up to up to 10 years if reasonable cause exists, or up to 14
years if the deceased person operated a “closely held business”. A pattern
of business activities and regular filing of a Schedule C with each income
tax return will enhance the chances that the IRS will accept the existence
of a “closely held business” on which to base an extension of time to pay
estate taxes under Code §6166.
© 2003 by Richard A. Whitney
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