Taxation of Self-Created Intellectual Property

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Costs incurred by a taxpayer in creating intellectual property may be (1) deductible as ordinary and necessary business expenses, (2) deductible as research and experimentation expenses, or (3) capitalized and amortized over a period of time (the costs may also qualify for the research and experimentation income tax credit).

Ordinary and necessary business expense

Costs incurred by a taxpayer in creating intellectual property may be deductible as an ordinary and necessary business expense. Internal Revenue Code (“Code”) § 162 provides that taxpayers can deduct ordinary and necessary expenses paid or incurred in carrying on any trade or business, including salaries and compensation for personal services, traveling expenses while away from home, and payments for the use of certain property. Code § 162 specifically excludes several types of property, including charitable donations and gifts; illegal bribes, kickbacks and other payments; lobbying and political expenses; and payments for fines and penalties.

To be deductible pursuant to Code § 162, the expenses must be ordinary and necessary business expenses. The term “ordinary” refers to an expense that is customary or expected in the life of the business. The term “necessary” refers to an expense that is appropriate and helpful.

To be deductible pursuant to Code § 162, the expenses must be paid or incurred in carrying on a trade or business. The term “carrying on a trade or business” generally means that the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging the activity was to produce income or a profit.

Expenses that are incurred prior the time when the taxpayer is carrying on a trade or business are generally considered non-deductible start up expenses (as explained below). Where the taxpayer incurs a taxable loss, the activities may be deemed to be a “hobby” and the expenses with the hobby may not be deductible. In addition, personal, living, and family expenses are generally non-deductible.

Even if these rules are satisfied, other Code sections may prevent he taxpayer from deducting otherwise deductible expenses. For example, Code § 263(a) specifies that expenses to create or enhance certain intangible assets are not immediately deductible. These assets are usually referred to as “capital” assets. There are a number of exceptions, but these capital asset expenses are generally added to the tax basis of the asset and the tax savings are recoverable bit-by-bit over time.