Majority of Professor's Stock Sale Does Not Qualify for Preferential Tax Treatment

(Parker Tax Publishing April 2024)

The Court of Federal Claims held that a large portion of proceeds received from the sale of stock by a university professor and his wife did not qualify for favorable tax treatment under Code Sec. 1202 because the stock was transferred to the taxpayer within five years of when it was sold. However, the court concluded that some of the shares might be eligible for such treatment, depending on facts yet to be introduced. Ju v. U.S., 2024 PTC 81 (Fed. Cl. 2024).

Background

Dr. Tongzhong Ju, a former employee of the University of Oklahoma (the university), is a named inventor on two patents. The university's policy is that all patents on inventions that were made or conceived by university employees are the property of the university and that employees must assign their rights in those patents to the university. Dr. Ju assigned his rights in both patents to the university before November 2003. In November 2003, the university licensed the two patents to Selexys Pharmaceuticals Corporation in return for cash and shares of Selexys stock.

The university licensing policy states that the university will give an inventor 35 percent of the gross revenues, including equity, that it receives under a patent license. While the university will give the inventor cash revenue when the university receives it, stock issued to the university "shall be held by the Controller's Office" until the employee leaves the university.

In 2015, Dr. Ju had a dispute with the university about the revenue from his patents, and he and the university entered into a settlement agreement. The agreement stated that Selexys had previously issued 583,921 shares of common stock to the university, and 18,017 shares to Dr. Ju. Selexys was directed to reissue 53,441 shares of common stock to Dr. Ju less the 18,017 previously issued to him. In addition to Selexys stock, the agreement included terms regarding the stock of another entity named Tetherex. The settlement terms also included a payment of $33,500 from the university to Dr. Ju, who reported that payment as royalty income on his 2015 tax return. In 2016, Dr. Ju sold his Selexys stock and reported it as long-term capital gain on his tax return.

In 2019, Dr. Ju filed amended tax returns for 2015 and 2016. The amended 2015 tax return sought to treat the $33,500 payment from the university as long-term capital gain income under Code Sec. 1235(a) rather than royalty income because, Dr. Ju said, the university paid him that money in exchange for patent rights. The amended 2016 tax return sought to treat the proceeds from the stock sale as proceeds from the sale of "qualified small business stock." Under Code Sec.1202, taxpayers can exclude half the gain from the sale or exchange of qualified small business stock if (1) the taxpayer acquired the stock at original issue and held it for more than five years, and (2) the small business meets the definition of a "qualified small business" in Code Sec. 1202(d)(1).

The IRS rejected the refunds claimed on both amended returns and Dr. Ju took his case to the Court of Federal Claims. With respect to the sale of the stock, the government argued that Dr. Ju did not receive his shares of Selexys stock until 2015, when the university gave them to him and thus, he did not hold the stock for the requisite five-year period. Dr. Ju, however, contended that the university received and held 612,500 shares of Selexys stock pursuant to the 2003 license agreement, of which 71,458 belonged to him and should have been issued in his name, but only 18,017 of those shares were licensed in his name.

With respect to the $33,500 payment, the government argued that the payment was not clearly tied to a transfer of patent rights to Selexys because the part of the agreement that references the payment mentions two companies - Selexys and Tetherex and the payment could be tied to either company, but Dr. Ju licensed his patents only to Selexys. The government also argued that the sale of the patent rights concluded with the transfer of stock and was unrelated to the cash payment. Thus, the government argued that the payment must have been for Dr. Ju waiving his claims against the university, or for something else.

Analysis

The Court of Federal Claims held that a large portion of Dr. Ju's stock was not eligible for treatment as qualified small business stock under Code Sec. 1202 because it was transferred to Dr. Ju within five years of when he sold it. The court noted that both the settlement agreement and the stock certificate indicate that 53,441 shares of stock were issued to Dr. Ju in 2015, not at the time of original issuance and that Dr. Ju sold those shares in 2016, less than five years later.

However, the court said, there was a genuine dispute as to whether the 18,017 shares were held by Dr. Ju since original issuance and, the court indicated, those shares might be eligible for Code Sec. 1202 treatment depending on whether Dr. Ju could provide additional information showing that those shares meet the requisite Code Sec. 1202 criteria. This would require a showing of the original stock certificate from 2003 and documentation proving that Selexys was a qualified small business for the years at issue.

With respect to the $33,500 payment, the court denied summary judgment to both parties after concluding there is a genuine dispute over whether the cash payment was a royalty in exchange for a transfer of patent rights licensed to Selexys or for another transaction related to another company called Tetherex. The court noted that while both parties agreed that Dr. Ju entered into a settlement agreement with the university and that the settlement agreement required the university to pay Dr. Ju $33,500, they disagreed over why the university agreed to that amount. The question of why the university agreed to pay that amount, the court stated, controlled the tax treatment. If the amount was paid for a patent royalty, the court observed, Dr. Ju was entitled to favorable tax treatment but if it was for something else, he was not entitled to favorable tax treatment. Thus, the court concluded, there is (1) a genuine issue of material fact over whether the total payment equaled the amount Dr. Ju was owed for the patent license, and (2) a genuine issue of material fact over whether the cash payment covered Selexys, Tetherex, or both. Dr. Ju, the court noted, did not offer proof that the payment was all for the Selexys license, which was the only patent license Dr. Ju showed he gave to the university. On the other hand, the court said, the government did not show anything else that the payment was for.

For a discussion of the exclusion of gain from the sale of small business stock, see Parker Tax ¶116,165. For a discussion of the character of gain or loss from the transfer of patents, see Parker Tax ¶117,110.

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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