The basic reason for excluding royalties from the definition of unrelated busi. ness taxable income was: Because your committee believes that they are "passive" in character and they are not likely to result in serious competition for taxable businesses having similar income. Moreover, investment producing incomes of these types [interest, dividends, some rents and royalties] have long been recognized as a proper source of revenue for educational and charitable organizations and trusts.22

Since the characterization of income as a "royalty" depends upon the facts and circumstances, the principal issue which usually arises is derived from the committee report's reference to "passive." The statement in the legislative history of Congress belief that investment in patents and the receipt of royalties therefrom are 'passive' in character and they are not likely to result in serious competition for taxable businesses having similar income" should give universities flexibility because it recognizes that, even though the university may be expending funds of its own to develop and stimulate the use of its patents by licensees, such expenses do not change the character of the royalties into something else. These expenditures would be the typical expenses ordinarly undertaken by businesses exploiting similar property. Thus, the mere fact that a university expends money for research, to obtain patents and to seek out suitable licensees should not alter the treatment of income it receives as royalties.

Rev. Rul. 69-430 23 illustrates the concept of the royalty exclusion. In that ruling, the exempt organization owned publication rights to a book which did not contribute in any manner to the accomplishment of its exempt purposes. The organization itself undertook to exploit the book in a commercial manner by arranging for the printing, distribution, and retail sale of the book. It also arranged for publicity and advertising in connection with the distribution and sale of the book. While the ruling held that the activities of the organization constituted the conduct of an unrelated trade or busness, it concluded with the following paragraph:

However, had the organization transferred the publication rights to a commercial publisher in return for royalties, the royalty income derived would have been excluded from the computation of unrelated business taxable income under § 512(b) (2) of the Code."

Rev. Rul 69-430 points up an important factor which distinguishes royalties from income from an unrelated trade or business. In that ruling, the exempt organization itself engaged in the conduct of activities in connection with the distribution and sale of a book which was unrelated to its exempt purposes. It derived the income from its own commercial exploitation of the publication rights rather than, as in the usual case with royalties, from third persons who in turn carried on the actual commercial exploitation.

The activities performed by the organization in Rev. Rul. 69-430 were not the activities normally undertaken by the owner of important rights in a book and cannot be analogized to the expense undertaken by a university in developing and exploring the various uses of its patents prior to actual licensing. This ruling indicates that, once a right is in such a stage of development that it can be commercially licensed for manufacture or exploitation by third parties, the fact that the organization itself undertakes to manufacture or exploit will be the active conduct of a trade or business which may be unrelated to the organization's exempt purposes.

This brings us to problems with the licensing agreement itself. The licensing agreement may or may not contain a provision with respect to the performance of engineering or other personal services for the licensee by the university or its staff. If no provision is made in the agreement, the initial question is whether, in spite of the lack of an agreement with respect to such services, the Internal Revenue Service can challenge the characterization of the payments and allocate at least a portion of the payments to such services.

Few inventions in and of themselves are so great that they require no supporting technology or stand by themselves. Thus, it is unusual that the patent transfer will include the patent itself and no "know-how." The know-how transferred with a patent may take many forms, which may include engineering data, blueprints, various plans and patterns, formulae, and expertise of employees. The problem that arises is whether the amounts received by the university are in fact royalties or are more properly classified as amounts received for services rendered. Neither the regulations nor rulings under I.R.C. section 512 deal with this question. Thus, areas of analogous law must be considered, with the recogniFootnotes at end of article.

tion that the distinction is most difficult to darw and that many factors are involved.

If technical assistance is provided, the Internal Revenue Service will more likely characterize the payments as being for services. If, however, the university simply lends its know-how to the licensee to assist it in the initial designing and building of the product under the patent this alone should be insufficient to warrant the recharacterization of part of the royalty payment as being for services, even if the services by the university are provided as part of an effort to increase and/or continue the income from its patent licensee. If at the time the licenses are granted, it is not anticipated that engineering or other services will be needed, the royalty payment cannot be recast into compensation for services." On the other hand, a more difficult problem is presented when the license agreement is entered into and either the university agrees with the licensee (verbally or otherwise) to furnish it with engineering services which the parties anticipate will be and which are substantial or the requirement to provide such services is implicit because the stage of the development of the patent is such that services by university personnel will be needed. In this type of case, the Internal Revenue Service would probably look outside the contract itself to discover the true nature of the payments in question. For example, if it is ascertained that when the license agreement was entered into the payments were fixed at a much higher percentage of production or selling price than would have been the case had the payments been for the use and manufacture of the patented invention or process alone, the university may be subject to tax and should be prepared to show that at the time the contract was entered into it did not anticipate nor did it verbally agree to provide such services.

In defending against such an attack, various provisions in the agreement itself may indicate that no agreement was made for the payments for personal services. If the agreement is not subject to cancellation, except with a substantial penalty to the licensee, this would indicate that the services are incidental to the contract because the licensees could not be protected in their right to any services that are not specifically set forth in the agreement. The provision for a penalty would indicate that the licensee did not anticipate the need for services from the university or its staff. On the other hand, if the license is cancellable at the option of the licensee without a substantial penalty, this fact together with the fact that payments are based on sales or production would lend support to the argument that part of the payments are for services since it would be in the universitylicensor's self interest to furnish the services which might enlarge the market for the product.

To reduce the risk that the Internal Revenue Service might attempt to recast the royalty payments as being in part for services, the licensing agreement should specifically recite that it contains the entire understanding and agreement between the parties, that the licensees do not desire the university to furnish them any services, that there are no oral agreements or understandings between the university and the licensee that the university or its employees should furnish them any services, and that there is no agreement that a portion of the payments to be made by the licensee should constitute payment for services of for anything else except payment for the use of the patent. However, if, despite such provisions or in the case of contracts which do not contain such provisions, payments are determined in fact not to be exclusively in the nature of royalties, the university should be prepared to offer a reasonable basis for the allocation of the aggregate amount received to payments for royalties and to payments for other purposes.

25

20

Provision for engineering and development work which the university anticipates at the time it enters into the license to be necessary to further commercial development of the patented process or machine should be made the subject of a separate agreement. The agreement should call for the employment of the university or members of its staff to provide such services and to work in cooperation with the licensee in developing and exploiting the patent. Alternatively, the university should consider the possibility of granting a leave of absence for a period of time or permitting particular faculty or staff members to undertake the additional work as independent contractors. Whichever course is taken, however, these understandings should be the subject of a separate employment agreement and no provision should be included in the licensing agreement itself which conditions the right to payment of royalties on the satisfaction of the terms of the employment contract. A service agreement should not, however, be utilized in Footnotes at end of article.

those situations where the services would be incidental to the overall patent licensing or would be unnecessary or not contemplated at the time the license agreement is entered into.27

The university may become involved in assisting its faculty members to exploit their patented or patentable inventions. This involvement may be in the form of assisting the inventor in getting needed financing to promote the invention or may be more extensive in that the university or affiliate may itself evaluate, process, develop and manage the inventions. The university may also be empowered to sell or grant licenses in its name (if the patent is assigned to it ") or in the name of the inventor to licensees to exploit the patent. In exchange for these services, the university usually receives a portion of royalties and pay the balance to the owner of the patent.

In Rev. Rul. 73-193," the Internal Revenue Service dealt with one aspect of this type of situation. In that ruling, the organization entered into agreements with educational and scientific institutions under which it evaluated, processed, promoted, developed and managed the inventions of faculty members, associates and staff members of educational and scientific institutions. Pursuant to the agreement, the staff members would assign title to their inventions to the organization which in turn negotiated licenses to third parties. The organization collected the royalty income from the licensees, retained a portion thereof as compensation for patent development and management services rendered, and distributed the remainder of the amounts collected to the institutions and inventors in the proportions specified. In addition to paying all the normal expenses involved in the patent management operations, the organization maintained all the books and records relating to the activities thereunder. In holding that the royalties did not retain the character of royalties in the organization's hands for purposes of I.R.C. section 512(b) (2), the Internal Revenue Service observed that the organization held legal title to the invention "only for the purpose of performing the agreed patent development and management services for the account of the beneficial owners. . . ."

This ruling points to the need to determine, in analyzing the character of the payments received by the university, even though denominated royalties, whether the university has an interest in the patent other than mere legal title. In Rev. Rul. 73-193, the agreement and facts show that the licensor had no beneficial interest in the property except the legal title. This ruling should have application only to those situations in which the university is not an owner of the patents, having at least a portion of the beneficial interest. As noted in the ruling, title alone is insufficient and the university should receive a portion of the payments in excess of the amount required to reasonably compensate it for the services performed in connection therewith. However, even if the university merely holds legal title to the patent, its situation is still distinguishable from Rev. Rul 73–193 if it limits its activities to managing patents derived from university-related research.

30

The Internal Revenue Service may raise some questions as to the possible application of this ruling in those cases where the payment is based in part on the performance of management services described in the ruling. However, most of the activities mentioned in the ruling are merely incidental to the performance of services that would ordinarily be undertaken by any owner of a patent engaged in licensing and incidental to the receipt of royalties. I.R.C. section 512 (b) (2) indicates that Congress did not intend to prohibit the owner of a patent from making the necessary expenditures to make it productive of income." Indeed, the statute provides that expenses related to the royalty income are deducted from it. That the royalty itself may or may not be passive is not really the issue in this ruling. Rather, the issue is whether the organization doing the licensing has something more than just bare legal title, that is, whether it is a joint owner of the patent, in which case the expenses and activities would be appropriate for an exempt organization. Thus, Rev. Rul. 73-193 should have no application to those situations in which the university does in fact own a beneficial interest in the patent.

Another means by which the university may derive income from a patent is to enter into an agreement with another party who has the manufacturing or technical wherewithal to commercially exploit a patent owned by the university. The Internal Revenue Service, in this situation, may attempt to characterize the relationship between the university and the "licensee" as being in reality a joint venture. Whether or not the university and the licensee have created the relationFootnotes at end of article.

ship of a joint venture" as between themselves will depend upon their intention to be gathered from the agreement and their conduct in carrying out its provisions.

32

The university may be called upon to share part of development costs incurred by the licensee in preparing and adapting the patent to commercial usage. In such a case, the fact that there is no provision for sharing losses is not controlling and the element of profit sharing would appear to be the important factor in determining whether a joint venture exists. Although the payments under the agreement may be characterized as royalties, such a characterization would not be conclusive if from the surrounding facts it is clear that they are, in fact, profits from operations. However, the risks of this type of characterization should be relatively small if the allocation of payments to the university is based on a share of production regardless of the realization of profits by the licensee.” Other factors bearing on the lack of intention to operate as a joint venture would be the maintenance of the separate interests of the university and the licensee and of separate books and records for accounting.

There may be situations, however, in which, for example, the university is called upon to share in a venture and its payments will be proportionate to the share of capital it invests in developing, promoting and exploiting a patent. In this situation, the Internal Revenue Service could strongly argue that the payments received are in fact profits from a joint venture as opposed to "royalties."

CONCLUSION

In this article, the authors have considered the various federal tax aspects of a university patent program. The basic point is that a university should be cautious in the degree of patent exploitation activities in which it engages. We have set forth certain guidelines which are recommended where the university operates its own patent program and grants licenses. These guidelines, while designed to minimize the financial involvement of the university in development and promotion, nevertheless require careful attention to operations and expenditures in administering the university's patent program. If attention to these guidelines and operations are burdensome, then the university has the alternative of contracting with an independent organization for patent management, such as that described in Rev. Rul. 73-193, in which case the university's position in receiving tax-exempt royalties should be assured under the rules of I.R.C. section 512(b) (2).

FOOTNOTES

1 See generally, A. Palmer, University Research and Patent Policies, Practices and Procdeures (1962).

See generally, Stedman, The Employed Inventor, The Public Interest, and Horse and Buggy Law in the Space Age, 45 N.Y.U. Rev. 1 (1970)

* Id. at 10–11. Sponsors of research, whether governmental, universities or industry, may reserve patent rights or otherwise specify the terms or conditions for patent ownership or licensing created by individuals either hired to invent or hired to perform certain types of services under the overall restriction that all inventions be disclosed and assigned to the employer.

Rev. Rul. 58-260, 1958-1 C.B. 126.

& A. Palmer, University Research and Patent Policies, Practices and Procedures 10 (1962).

Except as otherwise indicated, all statutory reference are to the Internal Revenue Code of 1954, as amended (hereinafter "I.R.C.").

7 See Treas. Reg. (hereinafter "Reg.") § 1.501(a)-1 (c).

8 Compare Edward Orton, Jr. Ceramic Fdn., 9 T.C. 533 (1947), aff'd 173 F.2d 483 (6th Cir. 1949), nonacq., 1947–2 C.B. 6.

9

Reg. § 1.50 (c) (3)−1(c) (1). This limitation does not, however, preclude a university from operating an unrelated trade or business as an insubstantial part of its activities. Reg. § 1.50 (c) (3)−1(e) (1) recognizes that exempt organizations may operate a trade or business in furtherance of exempt purposes, as long as the organization does not operate in an unrelated trade or business, as defined in I.R.C. section 513, as its primary purpose. See also Reg. § 1.501 (c) (3)−1(d) (5) (v).

10 Reg. §1.501 (c(3)−1(d) (5) (iii) (a).

11 L.R.C. section 512(bX8).

"Reg. § 1.513–1(b).

13 The term "primary" has been defined in Malat v. Riddell, 383 U.S. 569 (1966), to mean of first importance or principally, which defintion has in turn been generally interpreted to mean more than 50 percent of an organization's activities.

14 Reg. § 1.513-1(c).

15 Rev. Rul. 57-313, 1957-2 C.B. 316.

18 Reg. § 1.513–1(d) (4) (ii).

Notwithstanding the statutory exclusion of capital gains and royalty income from the definition of unrelated business taxable income as subsequently de scribed in the text, such gains or income may nevertheless be subject to the tax on unrelated business income if there is "acquisition indebtedness" with respect to the patient. See I.R.C. sections 512(b) (4) and 514. Further, royalty income taxable income is treated as unrelated business taxable income. Sec. I.R.C. section 512(b) (15). Under the foregoing provisions, it is immaterial whether the university is engaged in a "trade or business."

18 Cf. Elrod Slug Casting Machine Co., 7 T.C.M. 157, 160 (1948).

19 Whether the assignment of rights in a patent constitutes a "sale" or "license" is beyond the scope of this article. However, in determining whether there is a sale resulting in capital gain, the Internal Revenue Service is likely to be guided by I.R.C. section 1235, which requires that the property transferred must consist of all substantial rights evidenced by the patent or an undivided interest in the patent which includes a part of all of the substantial rights. In any event, I.R.C. section 512(b) (5) does not apply if the patent is stock in trade or inventory or property held primarily for sale to customers in the ordinary course of business.

20 See also Rev. Rul. 73–193, 1973-1 C.B. 262.

21 Reg. $ 1.543–1(b) (3).

22

S. Rep. No. 2375, 81st Cong., 2d Sess. 30-31 (1950).

23 1969-1 C.B. 129.

24 Cf. John C. O'Connor, 16 T.C.M. 213, 221-22 (1957), aff'd, 260 F.2d 358, 58-2 U.S.T.C. § 9913 (6th Cir. 1958), cert. denied, 359 U.S. 910 (1959).

23

Such as compensation for services; but it may be argued that payments are for other purposes, such as for know-how or are charitable contributions.

26 Income from this type of activity would not necessarily be unrelated business

taxable income if the activity is not regularly carried on.

97

28

Cf. Portable Ind., Inc., 24 T.C. 571 (1955), acq., 1955-2 C.B. 8.

'It is the usual practice of universities to be assigned the patent to facilitate dealings with prospective licensees.

29 1973-1 C.B. 262.

30 The statute recognizes that the organization will have expenditures; I.R.C. section 512(b) (2) excludes royalty income and "all deductions directly connected" thereto. Further, it is implicit in the Congress's assumption that receipt of income from patents would not result in competition with taxable business that it recognizes the need for expenditures, such as for developing an invention as well as the costs of obtaining a patent, including attorneys' fees and funds expended in making and perfecting a patent application.

31

A joint venture has been defined as "a special combination of two or more persons where, in some specific venture, a profit is sought without an actual partnership or corporate designation." Thompkins v. Comm., 97 F.2d 396 (4th Cir. 1938).

32

See. Reg. § 1.512(b)-1, which states the following: "For example if a payment termed 'rent' by the parties . . . is a share of the profits retained by such organization as a partner or joint venturer, such payment is not within the modification for rents."

33

See William J. Lemp Brewing Co., 18 T.C. 586 (1952), acq., 1952-2 C.B. 2.

APPENDIX A

DISPOSITION OF INVENTIONS AND PATENTS: THE UNIVERSITY OF WISCONSIN

In an institution such as the University of Wisconsin, where creativity is a major ingredient of research, new products, devices, processes and compositions are often found. It is our purpose here to state for University faculty and staff what their responsibilities, privileges and options are when they have made an invention or discovery.

Historically, The University of Wisconsin has never claimed that it has proprietary rights in any invention generated at the University. In the absence of