Orthopedic surgeons who invent and improve medical devices often generate substantial royalties in addition to their practice income. While this can be rewarding financially and positively impact patient outcomes, many surgeons discover the tax implications of receiving royalty income are complex.
Questions arise about whether royalty income is considered ordinary income or subject to self-employment taxes or if it might qualify for favorable long-term capital gain rates. The structure of the royalty agreement can further complicate the tax classification.
The benefit to surgeons whose patent income qualifies for long-term capital gain treatment is significant. Still, the question of managing and potentially reducing the tax burden remains.
In recent years, advanced investment strategies have emerged to address some of these challenges. One example is AQR Flex Separately Managed Accounts (SMAs), which create opportunities for more tax-efficient investment strategies.
AQR Flex SMAs use quantitative methods and a blend of long and short positions so that high-income and high-net-worth individuals can benefit from ongoing tax loss harvesting. For surgeons earning significant capital gains from qualified patent royalty income, ongoing loss harvesting from a stock portfolio can help offset the patent royalty capital gains, potentially lowering overall tax liabilities.
Below, we explore how orthopedic physicians can leverage these strategies. We will define the tax-related challenges, outline how AQR Flex SMAs function, discuss their application in offsetting royalty capital gain income, and highlight the broader implications for building and preserving wealth.
Defining the problem
Orthopedic surgeons already face a steep tax burden because their clinical practice income often lands them in the highest federal tax brackets. Those who reside in high-tax states experience an even higher tax burden.
Most states conform to federal tax classifications for capital gains, while others have separate rules or additional surcharges for high-income taxpayers. Because these provisions vary widely, conducting a state-specific review is crucial.
Substantial capital gains from patent royalties can dramatically increase the overall tax exposure. Even when patent income qualifies for favorable long-term capital gain rates of 15% or 20%, the total tax liability can still be meaningful. The 3.8% Net Investment Income Tax adds to the tax bill. Recent tax proposals have sought to increase the tax rate on long-term capital gains for high-income households.
Another issue is timing.
Although some gains—like stock appreciation—can be deferred by simply not selling the underlying asset, a medical device patent typically generates royalties based on actual product sales. Each device sold or procedure performed becomes a taxable event, and you have no control over when the tax liability accrues. Many high-income households benefit from strategies that delay the time required to recognize taxable gains.
Real estate investors enjoy depreciation benefits and can use Internal Revenue Code (IRC) Section 1031 tax-deferred exchanges to defer gain from one property into another. Technology founders often hold large amounts of stock and only realize capital gains when they choose to sell their shares. If they have a liquidity need, they can use the stock as collateral and borrow against it without triggering gain recognition.
Suppose you hold a patent that yields ongoing royalties. In that case, you might feel you have less room to maneuver and manage the capital gain timing, resulting in an inability to compound earnings on a pre-tax basis.
If you don’t need the royalty income for current expenses, wouldn’t it be preferable to delay recognizing that gain until you need the liquidity or when your tax rate is lower?
A possible solution
AQR Flex SMAs are customized, highly tax-aware portfolios run by AQR Capital Management.
“AQR Flex” is a term describing a customizable, tax-aware strategy. AQR Capital Management offers different versions of tax-managed or factor-based SMAs, each with minimum investment, fee structure, and performance goals. Before committing funds, ensure you understand which AQR program you’re enrolling in and review the investment minimums, costs, and potential risks with an advisor.
These strategies go beyond traditional buy-and-hold by incorporating both long and short positions. The aim is to generate market returns while systematically harvesting capital losses that can be used to offset other capital gains, including those from royalties paid to holders of a patent taxed under IRC Section 1235.
Long-short investment approaches were once the domain of hedge funds and massive institutional portfolios. Thanks to advancements in technology and lower transaction costs, these techniques have become more accessible.
Blending a long-short strategy within a stock portfolio expands the number of holdings, which presents more opportunities to defer gains and realize capital losses, regardless of the stock market’s direction.
AQR Flex SMAs can constantly identify which positions hold unrealized gains and which have unrealized losses. The goal is to keep appreciated positions while realizing losses from the others, thereby creating a steady pool of tax losses available to offset capital gains outside the portfolio.
How it works
The investment strategy involves using borrowed funds (leverage) to purchase stock positions you expect to outperform while shorting the corresponding competitors’ stock positions you expect to underperform.
Harvested tax losses in a Flex SMA portfolio can only offset other capital gains incurred in the same tax year or carried forward to future years if an excess of tax losses are generated. Capital losses cannot be carried back to the previous year’s gains.
If your Flex SMA doesn’t generate enough realized losses in a particular year, you may still owe taxes on a portion of your royalty income. Conversely, if losses exceed your total royalty capital gains, you can carry the unused losses forward and use them to offset the next year’s royalty capital gains.
To illustrate how this works, you might initially invest $100 in a diversified stock portfolio. Using the $100 diversified stock portfolio as collateral, you borrow $50 through your custodian and invest the $50 in Company Y stock (long position). Simultaneously, you borrow $50 worth of stock in Company Z and immediately sell it because you have a bearish view of Company Z and believe the stock price will fall. If Company Z’s stock price drops, you can repurchase the shares at a discount and return them to the custodian, realizing a profit on the transaction.
You now have $200 in total stock exposure—your original $100 diversified stock portfolio, plus $50 in a long position in Company Y and a $50 short position in Company Z. Assume the $100 diversified stock portfolio tracks the overall stock market closely during the time period.
If your stock predictions were correct and, Company Y’s stock appreciated, and Company Z’s stock price fell, you have a gain on both the long and the short. While this outcome is ideal because both trades were profitable, it’s more likely at least one position won’t perform as you anticipated.
Assume Company Y’s stock appreciated to $62 for a gain of $12, which is not taxable until you sell the Company Y stock. Let’s further assume Company Z’s stock didn’t fall in value and appreciated to $55. Because you sold the stock short at $50, you must now repurchase it at $55 to replace the borrowed stock you sold, realizing a $5 loss.
While the long-short net profit was $7, your taxable income is a $5 capital loss because the $12 gain in Company Y is not taxed until you sell the Company Y stock.
This strategy increases the probability that some positions will show losses, even when the broader portfolio is designed to produce returns comparable to the overall market.
By exiting or rotating out of those loss positions, the portfolio realizes capital losses for tax purposes. Stocks that have accrued gains remain in the portfolio, thereby deferring taxes on those gains.
A key aspect is understanding that royalty income from a qualified patent can be treated similarly to capital gain income under IRC Section 1235, depending on the patent’s specifics and how ownership or licensing is structured.
Under IRC Section 1235, royalty income can qualify as capital gains if you, as the inventor, transfer “all substantial rights” in the patent. Your payments may be classified as ordinary income if those substantial rights aren’t fully transferred.
If you provide consulting services or only transfer a portion of your patent rights, the income generated from those activities may be treated as ordinary income and possibly require payment of self-employment taxes.
A careful review of your licensing agreements, consulting contracts, and the extent of rights transferred is essential to ensure you correctly classify and report your income.
If the income qualifies as a capital gain income, tax-loss harvesting from a portfolio like AQR Flex can help offset it.
Application to orthopedic physicians
One of the most significant benefits of the AQR Flex SMA approach is the ability to offset royalty-based capital gains that meet the criteria for long-term treatment. Because royalty income is often unpredictable—you never know exactly how well a new device or implant will sell—consistently harvesting losses within an SMA gives you a tool to manage this unpredictability.
Consider your successful medical device patent analogous to a technology founder’s equity stake in their growing company. The founder doesn’t have to realize gains unless they sell their shares. As a patent holder, your gains occur continuously as more devices are sold.
By redirecting these royalty payments into a tax-aware SMA, you could harness realized tax losses generated within the portfolio to offset some or all of your annual capital gains.
Diversification benefit
The second significant benefit is diversification. While the patent represents a concentrated bet on one product, you don’t want all your financial hopes riding on a single invention. Diversifying into hundreds of stocks—while systematically harvesting losses—helps shield you from the risk that one product or market segment could falter.
By shifting funds into a long-short SMA, you can manage the transition gradually and reduce immediate tax implications. This allows you to retain more capital working and compounding in the market.
Enhancing after-tax wealth
Tax-aware strategies can be valuable beyond the immediate savings on royalty income. For physicians with estate-planning or philanthropic goals, deferring gains can increase their options and potential impact.
Giving your patent or royalty income stream to others is problematic. The tax code generally prevents taxpayers from assigning their income to someone else in a lower bracket. However, you can donate or gift appreciated stock with unrealized gains.
Suppose you’ve successfully offset your patent’s capital gains through AQR Flex. You can reinvest those tax-sheltered profits into stocks that can be donated to children or charities without tax liability. When your long-short portfolio continuously generates losses to offset your royalty gains, you have effectively deferred those royalty patent-based gains and transformed them into readily shareable equity positions with unrealized gains.
A philanthropic-minded physician might donate stock shares directly to a university, church, or donor-advised fund.
Doing so creates a trifecta of benefits: the unrealized capital gains on the shares are never taxed, you receive a charitable deduction for the fair market value of the donated stock, further reducing your tax bill, and the charity can sell the shares tax-free to fund its activities.
Gifts of appreciated stock can avoid immediate capital gains taxes, but large stock gifts may require filing a gift tax return. Significant lifetime gifts reduce your overall federal estate and gift tax exemption. For larger estates, confirm with your estate attorney how these transfers might interact with your overall wealth transfer plan. Rules differ at the state level, so state laws should also be addressed.
Tax efficiency
Many high earners underestimate how much tax drains their net worth over time. A long-short SMA can directly reduce the tax bite on external capital gains, including those from a qualified patent, by systematically realizing losses in some positions while deferring gains in others. The result can be a cumulative lift to your after-tax returns.
Professional management
AQR specializes in quantitative methods focusing on risk control, factor exposures, and systematic tax management.
While it’s possible to replicate these strategies on your own, the complexity and time commitment would be daunting. Wash sale rules are one example of the intricacies that must be handled precisely.
A professional manager has the infrastructure to execute trades, track the cost basis meticulously, and ensure compliance with all regulations. In addition, layering a long-short strategy onto a portfolio involves borrowing costs.
Working with an institutional SMA partner can provide access to cheaper lending rates because of its bargaining power.
Customization
Flex SMAs are adaptable to individual goals and constraints. An orthopedic physician nearing retirement might want a more conservative risk profile. Another, still in the early stages of their career, could prefer a more aggressive tilt.
The SMA manager can tailor the portfolio to match these preferences, especially for significant investments tied to patent-generated wealth.
Risks
While deferring capital gains taxes is a worthy goal with many benefits, implementing this strategy is not without risks. Here are some issues to consider.
Complexity
Long-short strategies are more intricate than a straightforward portfolio of stocks and bonds. They involve leverage, short selling, and ongoing monitoring to optimize tax treatment. You should work closely with trusted advisors to ensure they’re comfortable with the underlying methodology.
Long-short portfolios employ leverage and short positions, amplifying gains and losses. The losses can exceed your initial investment if the market moves against a leveraged position.
Short-selling also carries “unlimited” theoretical risk because a stock’s price can continue to rise.
Market risk
Any portfolio tied to the stock market, no matter how diversified, will experience volatility. While hedging strategies can soften the blow of market drops, they can’t eliminate all risk.
Regulatory compliance
Tax laws change, and the nuances of royalty income classification can shift over time. Maintaining good documentation of your patents, licensing agreements, and investment activities is important.
Some high-income individuals may trigger the Alternative Minimum Tax (AMT), even when much of their income is taxed at long-term capital gains rates. Certain deductions, exemptions, or credits can be limited under AMT rules, potentially increasing your tax liability. If you expect significant patent royalties or large capital gains, it’s worth evaluating whether AMT might apply to you so you can plan accordingly.
Because of these risks, for some, simply paying the tax and keeping things simple is the optimal approach. If you don’t have significant capital gain exposure (from royalty, real estate, sale of business, concentrated stock, or appreciated crypto) or a strong charitable desire, and a risk profile that makes a significant stock allocation suitable, you are not a candidate for this strategy.
Final thoughts
Orthopedic physicians who earn significant royalties from their patented devices face a multifaceted tax problem. Even when royalties qualify for long-term capital gain rates, the sheer size of the income can push overall taxes to uncomfortable levels. Strategies that manage or defer tax recognition can significantly affect how much wealth is ultimately preserved, invested, or shared with family or charitable causes.
AQR Flex SMAs serve as a specialized tool for tackling these issues. Layering long and short positions in hundreds of stocks makes it possible to harvest losses systematically, offset outside capital gains, and defer recognition of gains on appreciated positions. This strategy allows physicians to transition from concentrating most of their wealth in a single patent to a more diversified portfolio with far less tax friction.
As with any sophisticated financial strategy, consulting with knowledgeable advisors is wise. A thorough review by your CPA, estate attorney, and financial planner will confirm whether a tax-aware portfolio such as AQR Flex aligns with your circumstances.
If used properly, could allow you to transform your patent-derived capital gains into broader, sustainable, and more tax-efficient wealth, providing the flexibility to fund your lifestyle, support charitable endeavors, or grow your family legacy.
