I’m Darrin Mish. Tampa tax attorney, 32 years in, more than $100 million in IRS debt resolved. What follows isn’t theory – it’s what I’ve actually watched work.
You spent years building it. Maybe it is proprietary software. Maybe it is a patented invention, a trademark, a secret formula, or a creative work. You pour your time, expertise, and money into creating something valuable. Then you sell it, expecting to pay the favorable capital gains rate on your profit.
And that is when the tax surprise hits. Under current tax law, the gain on the sale of many self-created intangible assets is taxed as ordinary income – up to 37% – not the 20% long-term capital gains rate you were counting on.
The difference on a $1 million gain? $170,000 in additional federal taxes. That is not a rounding error. That is a life-changing amount of money that most people do not know about until it is too late to do anything about it.
What Changed and Why It Matters
Before the Tax Cuts and Jobs Act of 2017, self-created patents, copyrights, and similar intangible assets could qualify for long-term capital gains treatment when sold. Inventors, software developers, authors, and creators could sell their work and pay the preferential 20% rate. It was a known, planned-for tax benefit that influenced how people structured their transactions and planned their exits.
The TCJA changed that. Section 13314 of the TCJA modified IRC Section 1221(a)(3) to explicitly exclude self-created intangible assets from the definition of a “capital asset.” Effective for dispositions after December 31, 2017, gains on the sale of these assets are now ordinary income – taxed at rates up to 37%.
This was not a heavily publicized change. It was buried deep in a 1,097-page tax bill. Many business owners, inventors, and creators still do not know about it eight years later. And they find out at the worst possible time – after the sale has closed, the money has been spent or allocated, and the tax bill arrives with a number they never expected.
Which Assets Are Affected?
Under IRC Section 1221(a)(3) as amended by the TCJA, the following self-created assets are excluded from capital asset treatment:
Patents, inventions, models, or designs (whether or not patented). Secret formulas or processes. Copyrights, literary compositions, musical compositions, or artistic compositions. Letters, memoranda, or similar property. Any lease or improvement to property created by the taxpayer’s personal efforts.
The key phrase is “created by the taxpayer’s personal efforts.” If you created the intangible asset – or directed its creation as part of your business activities – the gain on selling it is ordinary income. Period. No exceptions based on holding period, no phase-in based on how long you held it, no de minimis threshold. If you created it, ordinary income treatment applies.
This catches a lot of people off guard. A software developer who writes code over several years and then sells the application to a competitor? Ordinary income. An inventor who develops a new manufacturing process and licenses it for a lump sum? Ordinary income on the proceeds. A musician who sells their catalog of original compositions? Ordinary income. A small business owner who developed a proprietary training methodology and sells the business including that IP? The portion allocated to the self-created intangible is ordinary income.
The 17% Tax Rate Difference in Real Dollars
Let me put concrete numbers on this so you can see exactly why it matters.
A software developer creates a SaaS application over five years. A larger company acquires the software for $2 million. The developer’s cost basis is $200,000 in development expenses that were previously capitalized, resulting in a $1.8 million gain.
Under the old rules (pre-TCJA): $1.8 million taxed at 20% capital gains rate equals $360,000 in federal tax. Plus the 3.8% Net Investment Income Tax brings the total federal tax to approximately $428,400.
Under current rules: $1.8 million taxed at 37% ordinary income rate equals $666,000 in federal tax. Plus applicable Additional Medicare taxes of 0.9% on earned income above the threshold.
The difference is roughly $237,600 in additional federal taxes on the exact same transaction. Add state income taxes (which in many states tax ordinary income at higher rates than capital gains) and the gap widens even further. In a state like California, the total difference could exceed $300,000.
The Patent Exception Under Section 1235
There is one significant exception to the ordinary income treatment, and it applies only to patents. Under IRC Section 1235, the transfer of all substantial rights to a patent by the individual who created it (or by an investor who acquired the interest before the invention was reduced to practice) is treated as a sale of a long-term capital asset, regardless of the holding period.
This means patent creators can still get capital gains treatment – but only if they meet all of the following requirements.
The transfer must include all substantial rights to the patent. You cannot retain significant control over the patent and claim Section 1235 treatment. If you keep the right to manufacture, use, or sublicense the patented technology in certain fields or territories, the exception may not apply. The transfer must be comprehensive.
The transferor must be the individual creator or a qualifying investor. Corporations, partnerships, and other entities generally cannot use Section 1235 (with very limited exceptions). This is an individual-level provision.
The transaction cannot involve related parties. Sales to related parties as defined in IRC Sections 267(c) and 707(b) are disqualified. If you sell a patent to a company you control, your spouse’s company, or certain family members’ entities, Section 1235 does not apply.
When all requirements are met, Section 1235 overrides Section 1221(a)(3) and provides capital gains treatment for the patent sale. This is a powerful exception, but it is narrow. It does not help software developers, trademark owners, copyright holders, trade secret sellers, or anyone whose intangible is not a patent. The distinction between a “patent” and a “trade secret” or “proprietary process” can literally be worth hundreds of thousands of dollars in taxes.
What About Section 1231?
Some tax advisors have suggested using IRC Section 1231 as an alternative route to capital gains treatment for self-created intangibles. Section 1231 provides favorable treatment for the sale of business property held for more than one year – gains are taxed at capital gains rates while losses are deductible as ordinary losses.
Unfortunately, the TCJA also closed this door. The amendments to Section 1221(a)(3) effectively prevent self-created intangibles from qualifying for Section 1231 netting. The IRS’s position is clear: self-created intangibles are ordinary income assets, and attempting to reclassify the transaction through Section 1231 does not change the result. Trying this approach in an audit is not going to end well.
The Amortization Problem
Here is another wrinkle that makes this worse. Under IRC Section 197, purchased intangible assets can be amortized over 15 years. This gives the buyer of an intangible a tax deduction that offsets the purchase price over time.
But self-created intangible assets generally do not qualify for Section 197 amortization while you hold them. You cannot depreciate or amortize the cost of creating a patent, developing software, or building a brand against your current income in the same way (though you can often deduct the costs as they are incurred under Section 174 for research and experimental expenditures).
This creates a double disadvantage for creators. You cannot amortize the asset while you own it (limiting its ongoing tax benefit during your holding period), and when you finally sell it, the gain is taxed at ordinary income rates instead of the preferential capital gains rates. The tax code effectively penalizes creation compared to acquisition.
Planning Strategies That Still Work
The ordinary income treatment for self-created intangibles is the law, and there is no way to completely avoid it for non-patent assets. But there are legitimate strategies to manage and reduce the impact.
Installment sales under Section 453. Instead of receiving the full payment upfront, structure the sale as an installment agreement spreading payments over multiple years. This spreads the ordinary income recognition across tax years, potentially keeping you in lower brackets each year instead of spiking into the 37% bracket all at once. On a $2 million sale over five years, you might report $400,000 per year instead of $2 million in one year – a significant bracket management tool that can save tens of thousands in taxes.
Charitable contribution of the asset. If charitable giving is already part of your financial plan, donating a self-created intangible to a qualified charity can generate a fair market value deduction while avoiding the ordinary income recognition entirely. The rules for charitable contributions of intellectual property have their own complexities (including the reduced deduction rules for ordinary income property under Section 170(e)), but in the right circumstances, this can be a powerful planning move.
Entity structure planning. If you anticipate creating valuable intangible assets that you may eventually sell, the entity you operate through matters. C corporations pay a flat 21% rate on all income, including gains from intangible sales. While there are other costs to C corporation status (double taxation on distributions being the most significant), the rate differential between 21% corporate rate and 37% individual rate on a large intangible sale can be substantial enough to justify the entity choice in certain situations.
Cost segregation and basis maximization. Maximize your basis in the asset by meticulously tracking all development costs, including direct labor, materials, contractor fees, allocable overhead, and any capitalized research expenditures. A higher basis means a lower gain, which means less tax regardless of what rate applies.
Timing the sale strategically. If you know a sale is coming, consider whether accelerating or deferring to a different tax year provides a bracket advantage. Can you combine the sale year with other deductions, losses, or retirement plan contributions to offset the ordinary income impact? Strategic timing can save thousands even within the ordinary income framework.
What This Means for Business Owners Planning an Exit
If you are building a business whose value is primarily in its intellectual property – software, processes, trade secrets, brand identity, proprietary methodologies – you need to understand that the exit tax picture is fundamentally different than it was before 2018. This is not a minor technical footnote. It can dramatically change the after-tax proceeds of a business sale.
When you sell a business, the purchase price is allocated across the various asset categories. Tangible assets, goodwill, customer relationships, and other acquired intangibles may qualify for capital gains treatment. But to the extent the purchase price is allocated to self-created intangibles that you developed, you as the seller face ordinary income treatment on that portion.
This affects business valuations, deal structures, and negotiation strategies. Buyers and sellers increasingly need to consider the tax character of each asset category during the deal negotiation, not after the closing documents are signed. The allocation of purchase price between goodwill (potentially capital gains) and specific self-created intangibles (ordinary income) can shift hundreds of thousands of dollars between the IRS and your pocket.
The Bottom Line
If you created it yourself and you plan to sell it, the IRS is going to tax the gain as ordinary income at rates up to 37%. For patents, Section 1235 provides a narrow but valuable escape hatch. For everything else – software, copyrights, trademarks, trade secrets, processes, and proprietary methodologies – the gain is ordinary income.
This is not a trap. It is the law. But it is a law that many business owners, inventors, and creators still do not know about until tax time. And by then, the sale has already closed, the purchase price has been allocated, and the planning options have narrowed considerably. The time to address this is before the letter of intent is signed, not after the check clears.
Get Help Now
If you are considering selling a business, licensing intellectual property, or disposing of any self-created intangible asset, the tax implications need to be part of the conversation from the very beginning – not an afterthought that costs you six figures. Contact the Law Offices of Darrin T. Mish, P.A. at (813) 229-7100 for a free consultation.