Trademark Licensing for Growing Brands: Quality Control, Naked Licensing, and How Royalties Are Taxed
Updated: 4 hours ago
By Trenton Roberts and Autumn Hartman
Circular 230 / general information notice. This article is general information only. It is not tax, legal, or accounting advice. Reading it does not create an attorney-client relationship. Tax results depend on your facts and on law that can change. Consult your own attorney and CPA before taking any action. This article was not written to be used, and cannot be used, to avoid tax penalties.
Trademark licensing is how a brand grows beyond the company that built it. A restaurant concept licenses its name to an operator in another city. A consumer products company lets a manufacturer put its mark on a new product line. A founder holds the brand in a separate entity and licenses it to the operating company. In each case, the owner is lending out the one asset that tells customers who stands behind the product. Trademark law expects the owner to keep watching how it is used, and the tax law watches the same facts for a different reason.
If you have not yet cleared and registered the mark, start with our post on trademark clearance and registration. This piece assumes the brand exists and someone else wants to use it.
Why trademark licensing is different from other IP licensing
A copyright or patent license is mostly about permission. A trademark license is about permission plus control. A trademark exists to identify a single source of goods or services. If the owner lets others use the mark without any say over what they sell under it, the mark can stop identifying a source, and the law treats that as a loss of the mark.
The Lanham Act builds licensing around this idea. Section 5, codified at 15 U.S.C. 1055, says that when a registered mark is used legitimately by related companies, that use inures to the benefit of the registrant and does not affect the validity of the mark or its registration, as long as the mark is not used to deceive the public. Section 45, at 15 U.S.C. 1127, defines a related company as a person whose use of the mark is controlled by the owner with respect to the nature and quality of the goods or services. Control is what makes a licensee's use count as the owner's use.
Naked licensing and how brands are lost
A license without meaningful control is called a naked license. Section 45 defines abandonment to include any course of conduct by the owner, including omissions, that causes the mark to lose its significance as a mark. Courts have applied that language to owners who license without control.
The cases are instructive because the owners did not set out to give anything away.
In Barcamerica International USA Trust v. Tyfield Importers, 289 F.3d 589 (9th Cir. 2002), the owner of a wine mark had licensed it without quality control provisions and without any practical oversight of the wine, and the Ninth Circuit held the mark abandoned. In FreecycleSunnyvale v. Freecycle Network, 626 F.3d 509 (9th Cir. 2010), the court found a naked license where the licensor had no contractual right to control quality, did not exercise actual control, and could not reasonably rely on the licensee's own quality controls. In Eva's Bridals Ltd. v. Halanick Enterprises, 639 F.3d 788 (7th Cir. 2011), the Seventh Circuit held that the owner of the Eva's Bridals name had abandoned the mark by letting a licensee operate a bridal shop under it with no contractual or practical control over how the shop was run, even though the licensee ran a good shop. Good quality was not enough. The owner had to be the one ensuring it.
The burden on a party claiming abandonment is heavy, and courts do not find naked licensing lightly. But the risk is real enough that we treat quality control as the core of every trademark license, not boilerplate at the end.
What quality control looks like in a license
Control has to exist on paper and in practice. A license that gives the owner sweeping inspection rights that the owner never uses is weaker than a modest set of controls the owner actually exercises. The provisions we build into a trademark license usually include:
Standards. A description of the goods or services the licensee may offer under the mark, with a reference to specifications, a brand standards manual, or approved samples.
Approval rights. The licensor's right to approve new products, packaging, advertising, and uses of the mark before they go to market, with a deadline for responding and a default if the licensor does not.
Inspection and samples. The right to inspect facilities or receive production samples on a regular schedule, and the right to request more when something looks wrong.
Usage rules. How the mark appears, including form, color, and the registration symbol, and a prohibition on combining the mark with other marks or creating variations.
Cure and termination. A process for curing quality failures, and a right to terminate the license if the licensee does not cure.
Ownership acknowledgment. The licensee's agreement that all use inures to the licensor, that the licensee will not challenge the mark, and that the licensee will not register confusingly similar marks or domain names.
Then the owner has to use those rights. A calendar reminder to request samples, a short file of approvals, and an occasional site visit will matter if a dispute ever turns on whether the owner exercised control.
Related-company licenses inside a corporate family
Many owners hold the brand in a holding company and license it to the operating company, sometimes for liability reasons and sometimes for tax planning. The same rules apply. If the holding company never controls quality, the arrangement may not protect the mark. Common ownership helps the factual case for control, but a written license with real quality provisions is still the better record.
This structure also needs to be reflected in the company's other documents. Lenders often take a security interest in trademarks, and a lender will want to know which entity owns the brand. Buyers in an acquisition will want the license to transfer cleanly, as we discuss in our post on IP assignment for founders and contractors.
Exclusivity, territory, and the rest of the business terms
Beyond quality control, the business terms in a trademark license are where owners give away more than they intend.
Exclusivity should be tied to performance. If a licensee gets exclusive rights in a territory or channel, the license should require minimum sales, minimum royalties, or marketing commitments, and should let the owner end exclusivity if the licensee does not perform.
The field of use should be specific. A license for apparel should say which apparel, in which channels, and whether online sales outside the territory are allowed.
Sublicensing and assignment should require consent. A licensee that sells its business or brings in a manufacturer should not be able to pass the mark along without the owner's approval.
Enforcement rights should be allocated. Most owners keep the right to decide whether to sue infringers, with the licensee required to cooperate and to report infringement it sees.
Post-termination terms should cover sell-off periods for inventory, return or destruction of materials, and a clean stop to use of the mark.
Bankruptcy of the licensor
Licensees sometimes worry about what happens if the brand owner goes into bankruptcy. In Mission Product Holdings, Inc. v. Tempnology, LLC (2019), the Supreme Court held that a debtor's rejection of a trademark license in bankruptcy operates as a breach of the contract, not a rescission, so the rejection does not by itself terminate the rights the license already granted. Licensees should still draft for the possibility, but the decision gives them a stronger starting point than they had before.
How royalties are taxed
The tax rules start from the same facts as the trademark analysis.
For the licensor, royalties from a license are ordinary income. Whether a transfer of a trademark is instead a sale that may produce capital gain is governed by Section 1253 of the Internal Revenue Code. Under Section 1253(a), a transfer of a franchise, trademark, or trade name is not treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest. Section 1253(b)(2) lists examples, including a right to disapprove assignment, a right to terminate at will, a right to prescribe the standards of quality of products or services, and a right to payments contingent on productivity, use, or disposition when those payments are a substantial element of the deal.
That creates a tension owners should understand. The quality control rights that protect the mark under the Lanham Act are, for tax purposes, the kind of continuing interest that keeps the transaction from being a sale. For an ongoing license, that is usually fine because the parties intend a license. For a deal the parties are calling a sale with continuing royalties, the tax result may not match the label.
For the licensee, Section 1253(d)(1) allows a deduction under Section 162 for amounts that are contingent on the productivity, use, or disposition of the mark and are paid as part of a series of payments that are payable at least annually throughout the term and are substantially equal in amount or payable under a fixed formula. Other amounts paid on account of the transfer, such as a large upfront fee, are chargeable to capital account under Section 1253(d)(2) and are generally recovered over time. How the payment stream is structured therefore affects when the licensee gets its deduction.
Related-party licenses raise transfer pricing questions. When a holding company licenses a brand to an affiliate, the IRS can reallocate income under Section 482 if the royalty does not reflect an arm's length arrangement. A royalty rate chosen to move income between entities without support is an audit risk, and the documentation behind the rate matters.
Cross-border licenses add withholding. Royalties for the use of a trademark in the United States are generally United States source income under Section 861(a)(4), and payments to a foreign licensor can be subject to 30 percent withholding unless a tax treaty reduces the rate and the licensor provides the required forms. A domestic licensee paying a foreign brand owner should build that into the license from the start.
How we can help
We draft and negotiate trademark licenses for owners and licensees, build quality control programs that can actually be run, and coordinate with your CPA on royalty structure and related-party pricing.
If you are licensing a brand or taking a license, email info@robertsandwillie.com or call (469) 910-4017. Sending a message does not create an attorney-client relationship.
Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.
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