Tax Law and Trade Secrets
Do “trade secrets” or “know-how” constitute “property” under the tax laws? Why does it matter?
It matters because property is treated differently for tax purposes than non property.
One of the more challenging aspects of trade secret taxation is the threshold issue of defining “trade secrets” or “know-how” for tax purposes. Neither term is defined in either the Internal Revenue Code (Title 26, USC) or the Treasury Regulations (Title 26, CFR). In general, favorable tax treatment depends on a determination that the particular “trade secret” or “know-how” constitutes “property” within the meaning of various tax provisions, including, e.g., the provisions that provide nonrecognition treatment on the transfer of “property” to a corporation or partnership in exchange for stock or an interest in the partnership under certain conditions (see IRC §§351, 721).
If not “property,” then “services.” Because a taxpayer’s services are often instrumental in creating a particular process, invention, technique, or trade secret, a determination that the item in question does not rise to the level of “property” for tax purposes will often mean that any consideration received by a taxpayer with respect to that item will be characterized as payments for services.
IRS definitions of “trade secrets” and “know-how.” In a series of pronouncements, the IRS has enunciated a position with respect to the definitions of “trade secrets” and “know-how” for tax purposes. First, the terms “trade secrets” and “know-how” are essentially identical for tax purposes. Second, to be considered a trade secret or know-how for tax purposes, the information in question must be secret and must be afforded substantial legal protection against unauthorized disclosure and use under applicable state or federal law. See Rev Rul 55–17, 1955–1 Cum Bull 388; Rev Rul 64–56, 1964–1 Cum Bull 133; Rev Proc 69–19, 1969–2 Cum Bull 301; Rev Rul 71–564, 1971–2 Cum Bull 179.
Case law consistent with IRS. Case law is generally consistent with the IRS definitions. The Court of Claims established the following definition in E.I. Du Pont de Nemours & Co. v U.S. (Ct Cl 1961) 288 F2d 904, 911:
A trade secret is any information not generally known in a trade. It may be an unpatented invention, a formula, pattern, machine, process, customer list, customer credit list, or even news.… It is truly valuable only so long as it is a secret, for only so long does it provide an advantage over competitors. It follows that the essential element of a trade secret which permits ownership and which distinguishes it from other forms of ideas is the right in the discoverer to prevent unauthorized disclosure of the secret.
Trade secrets under California law should qualify as “property.” In general, it would appear that any information that qualifies as a trade secret under the California Uniform Trade Secrets Act (UTSA) (CC §§3426–3426.11) should satisfy the foregoing requirements of the IRS and case law and will therefore be considered “property” for income tax purposes.
TIP: Although the law appears to be largely settled with regard to the nature of trade secrets as “property” for income tax purposes, there is a dearth of case law and agency rulings that deal specifically with the tax treatment of trade secrets beyond this threshold determination. Accordingly, the tax practitioner must often apply other law developed for similar types of property, such as patents, or law applicable to categories of property that may include trade secrets. See, e.g., Pickren v U.S. (5th Cir 1967) 378 F2d 595 (trade secrets sufficiently similar to patents to apply decisions on patents in cases involving trade secret transfers). In advising a client who uses or owns trade secrets, the practitioner must have a general understanding of the framework of tax law relevant to a particular situation and evaluate the various possible sources of law that may apply. Many laws that apply to classes of property not defined as “trade