Figurehead Shareholders Can't Shield Patent Owner from Ordinary Income on Royalties.
(Parker Tax Publishing October 15, 2014)

Code Sec. 1235 allows payments received by a patent owner on the transfer of a patent to be characterized as long-term capital gains rather than ordinary income if certain conditions are met. This rule does not apply to any transfer, directly or indirectly, between related persons. However, neither the Code nor the regulations specifically address whether the patent characterization rule of Code Sec. 1235 applies to transfers of a patent to a corporation that is not related to a patent holder but is indirectly controlled by the holder.

This issue of first impression in the Tax Court was addressed in Cooper v. Comm'r, 143 T.C. No. 10 (9/23/14). In Cooper, a patent inventor transferred his patents to, and received royalty payments from, a corporation in which he owned a 25 percent interest. The remainder of the corporation was owned by friends. The Tax Court was asked to determine whether the patent inventor's control over an unrelated corporate transferee defeats capital gain treatment. The court concluded that the substance of the transaction rather than its form controlled and, thus, the taxpayer's control over the unrelated corporate transferee defeated capital gain treatment. As a result, the income the inventor received was all ordinary income.

OBSERVATION: The story in Cooper is a cautionary tale for taxpayers. While a taxpayer can meet all the criteria laid out by the Code to obtain favorable tax treatment, the IRS and courts can look beyond the formalities to the substance of the transaction. In this case, the substance of the transactions was that the owner of many patents transferred the patents to a corporation that he indirectly controlled through friends in an effort to have ordinary income from his patents recharacterized as capital gain. The outcome in this case could have broad implications for other situations where taxpayers try to get around related-party rules by using friends or acquaintances.

Facts

James Cooper is an engineer and the inventor of numerous patents. His patents are primarily for products and components used in the transmission of audio and video signals. In 1983, James and his wife, Lorelei, incorporated Pixel Corporation for the purpose of designing and manufacturing audio and video signal processing products. James and Lorelei also incorporated Technology Licensing Corp. (TLC) with Lois Walters, Lorelei's sister, and Janet Coulter, a long-time friend of Lorelei and her sister. TLC was incorporated by the Coopers to engage in patent licensing and patent commercialization.

The Coopers chose Lois and Janet as additional shareholders in TLC because they wanted TLC to have the "aura" of a fully operating licensing corporation but also wanted people James could trust to be the shareholders, officers, and directors of TLC. The Coopers had hired an attorney to provide advice on forming TLC. Among other things, the attorney advised the Coopers on the requirements of Code Sec. 1235 and how to qualify the royalty payments to James from TLC as capital gain. The attorney advised the Coopers that (1) they could not control TLC directly or indirectly and (2) their stock ownership in TLC had to be less than 25 percent of the total outstanding stock. The Coopers owned 24 percent of the TLC stock and Lois and Janet each contributed $3,800 for a 38 percent ownership of TLC. Lois and Janet also acted as officers and directors of TLC.

In 1997, James and Pixel entered into agreements with TLC purportedly transferring all of James and Pixel's rights in the patents (subject patents) to TLC. Under each TLC agreement, the licensor (i.e., James or Pixel) would receive 40 percent of all gross proceeds received by TLC for any sublicense and 40 percent of all damages received in litigation or settlement of litigation. The licensor then would receive 90 percent of all remaining net proceeds as defined in the TLC agreements.

The amount of the royalties paid each year to James was determined under the TLC agreements by accountants hired by TLC. Neither Lois nor Janet, who were the majority shareholders as well as officers and directors, reviewed and verified the amount of royalties paid to James each year. Similarly, neither Lois nor Janet negotiated the terms of TLC's agreements to license the patents to other companies. Instead, they relied on TLC's attorneys and James' technical expertise with regard to TLC's licensing activities. For 2006 2008, Lois and Janet's duties as directors and officers consisted largely of signing checks and transferring funds as directed by TLC's accountants and signing agreements as directed by TLC's attorneys. The only compensation Lois and Janet received from TLC were director's fees paid during some years and long-term care insurance policies purchased by TLC. TLC had no employees and paid no compensation to anyone.

The Coopers jointly filed Forms 1040 for years 2006 through 2008 and reported the royalty payments James received from TLC as capital gain on Schedules D, Capital Gains and Losses, attached to their Forms 1040. The amounts of royalty payments that the Coopers reported for 2006, 2007, and 2008 were $3,248,886, $1,933,010, and $1,597,450, respectively. The IRS issued a notice of deficiency determining that the royalties James received from TLC did not qualify for capital gain treatment under Code Sec. 1235 because James controlled TLC. The Coopers took their case to the Tax Court.

Recharacterizing Ordinary Income as Capital Gain under Code Section 1235

Code Sec. 1235(a) provides that a transfer (other than by gift, inheritance, or devise) of all substantial rights to a patent by any holder is treated as the sale or exchange of a capital asset held for more than one year, regardless of whether the payments are contingent on the productivity, use, or disposition of the property transferred. Thus, for the transfer of a patent to qualify as a sale or exchange, the owner must transfer "all substantial rights" to the property.

Generally, the term "all substantial rights" means all rights that are of value at the time the rights are transferred. The retention of the right to terminate the transfer at will is the retention of a substantial right.Under Code Sec. 1235(d), transfers between related persons, as defined in Code Sec. 267(b), are not eligible for capital gain treatment. Under Code Sec. 1235(d), a corporation and an individual owning 25 percent or more of the stock of such corporation directly or indirectly are related persons. Under Reg. Sec. 1.1235-2(b)(4), the retention of a right to terminate the transfer at will is the retention of a substantial right for the purposes of Code Sec. 1235.

IRS Arguments

Arguing before the Tax Court, the IRS did not dispute that (1) the transfer of the patents to TLC under the TLC agreements was other than by gift, inheritance, or devise; (2) James qualified as a holder of the subject patents; and (3) the Coopers owned less than 25 percent of TLC for purposes of Code Sec. 1235(d). However, the IRS argued that, under Reg. Sec. 1.1235-2(b)(4), James effectively retained a right to terminate the transfers under the TLC agreements because he indirectly controlled TLC through its directors, officers, and shareholders. Therefore, the IRS contended that James did not transfer all substantial rights in the subject patents and was not entitled to capital gain treatment.

Taxpayer Arguments

The Coopers argued that James did not control TLC and that the directors, officers, and shareholders of TLC acted independently of James in their corporate decision making. The Coopers relied on the facts regarding control in Lee v. U.S., 302 F. Supp. 945 (E.D. Wis. 1969), and Charlson to support their contention that the directors, officers, and shareholders of TLC acted independently of James in their corporate decision making and that they are entitled to capital gain treatment under Code Sec. 1235.

In Lee, the taxpayer transferred patents to a closely held corporation. The three shareholders of the corporation were unrelated but were all friends. The taxpayer owned 24 percent of the outstanding stock of the corporation. The IRS argued that the taxpayer had not transferred all substantial rights in his patents because he controlled the corporation the exclusive licensee of the patents and thus the taxpayer did not effectively transfer his patents under Code Sec. 1235. The district court rejected the IRS's contentions stating, among other things, that there was no evidence presented suggesting the taxpayer was able to force the other shareholders or directors to do his bidding.

In Charlson, the taxpayer transferred an exclusive license to a corporation to use, manufacture, and sell items incorporating his patents in exchange for 80 percent of the royalties that the corporation received from licensing the patents to others. The corporation was formed for the specific purpose of purchasing and licensing the taxpayer's patents, and the shareholders and directors of the corporation were all trusted business associates, friends, and employees of the taxpayer. The taxpayer treated the royalties he received from the corporation as capital gain under Code Sec. 1235. The IRS argued that the taxpayer had not transferred all substantial rights in the patents to the corporation because he controlled the corporation.

The Court of Claims in Charlson examined the legislative history of Code Sec. 1235 and found it was clear that the retention of control by a holder over an unrelated corporation can defeat capital gains treatment if the retention prevents the transfer of all substantial rights. The court supported its conclusion by reasoning that the holder's control over the unrelated corporation "places him in essentially the same position as if all substantial rights had not been transferred." The court found further support for its reasoning in the legislative history of Code Sec. 1235, advising that a court should closely examine all of the facts and circumstances of transactions under Code Sec. 1235 and not rely solely on the terms of the transfer agreement to determine whether a patent owner transferred substantially all rights in a patent to a transferee.

The court in Charlson found that although the relationships among the taxpayer, the corporation, and the shareholders made more probable the existence of prohibited retained control, the evidence did not establish that the taxpayer was able to exercise such control over the corporation. Instead, the court found that corporation exercised its rights in the patents according to its own discretion even though it frequently sought, received, and followed the taxpayer's advice.

Tax Court's Analysis

The Tax Court began it analysis by noting that the issue of whether Code Sec. 1235 applies to transfers to a corporation not related to the holder but indirectly controlled by the holder is not addressed in either the Code or regulations. Thus, the issue was one of first impression for the Tax Court. The court did observe, however, that the question had arisen in the Charlson case and, although the court ultimately sided with the taxpayers, the court had concluded that such control could prohibit the transfer of substantially all rights in a patent and therefore preclude capital gain treatment under Code Sec. 1235.

The Tax Court agreed with the Charlson court that retention of control places the holder in essentially the same position as if the patent had not been transferred, thereby precluding the application of Code Sec. 1235. The court further agreed that Congress intended for a transferor's acts to speak louder than his words in establishing whether a sale of a patent has occurred. Accordingly, the Tax Court held that retention of control by a holder over an unrelated corporation can defeat capital gain treatment under Code Sec. 1235 because the retention prevents the transfer of all substantial rights in the patent.

In support of its conclusion that James retained control, the Tax Court noted that, as officers and directors of TLC, Lori and Janet took numerous actions that were inconsistent with acting independently and in the best interest of the corporation. Among other things, they approved TLC's transfer of potentially valuable patents to James for no consideration. At least in one instance, James almost immediately licensed one of these patents to another corporation related to James for which that corporation received a royalty of $120,000. As shareholders, Lori and Janet signed a stock restriction agreement placing restrictions on their ability to transfer shares of stock in TLC to anyone other than the Coopers, without receiving any consideration in exchange. The stock restriction agreement did not place similar restrictions on the Coopers. Indeed, the court said, it was unclear what material decisions, if any, the officers and directors of TLC made independent of James. Accordingly, the Tax Court concluded that such control by James existed and, thus, James was not entitled to capital gain treatment on his royalty income.

Practice Tip: Thus, for individual contemplating transferring patents to a corporation in which friends and acquaintances are shareholders and officers, there must be documentation that those shareholders and officers are able to act independently, have a say in the business, and are appropriately compensated. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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