Taxpayer's Sale of Intellectual Property Results in Capital Gain

(Parker Tax Publishing February 2019)

The Tax Court held that a taxpayer properly reported payments as long-term capital gains under Code Sec. 1235 because they were consideration for intellectual property he developed. The Tax Court found that the agreement under which the payments were made was ambiguous but concluded that the parties' intention was that the payments were in exchange for the transfer of the property, not as a makeshift noncompete agreement or as commission payments. Meggs v. Comm'r, T.C. Memo. 2019-5.

Background

Anthony Meggs began his career in business working for American Express, starting in its account services department and eventually being promoted to senior project manager. During this time, he focused on process improvement and automation. After seven years, he left American Express and worked in supply-chain management. In 2001, he joined Hancock Information Group (HIG) as vice president of business development.

HIG provided business-to-business lead generation services for its clients. Lori Sprague was HIG's executive vice president. Sprague hired Meggs and they developed a friendly working relationship. Precision Response Corp. (PRC) acquired HIG in 2001 or 2002.

HIG paid Meggs both a salary and a 3 percent commission. His salary started at $120,000 and was set to decrease by $20,000 each year so that commissions would gradually make up a greater portion of his pay. Commissions from each client's billings also decreased over six years, creating an incentive for Meggs to sign new clients. In 2002, Meggs and HIG agreed to modify his compensation structure, forgoing any salary in favor of straight 4 percent commission payments.

In 2002, Meggs began to design a method by which a business allocates leads to its sales pipelines on the basis of each pipeline's capacity to develop leads. That year, Meggs filed a provisional patent application for his method, referred to as Pipeline IP. In 2003, HIG waived any rights it had in Pipeline IP and Meggs filed a regular, nonprovisional, patent application for it.

Meggs' decision to patent Pipeline IP stemmed from discussions with representatives of American Express Corporate Services (USCC) regarding the possibility of contracting with HIG for lead generation services. Meggs successfully secured the USCC account for HIG in October 2002. He also secured two other American Express accounts for HIG referred to as OBSN and Travel One. Pipeline IP was an important aspect of Meggs' efforts to secure these accounts for HIG. He was not involved in managing the accounts after securing them.

In 2004, Meggs and HIG executed a brokerage agreement (2004 broker agreement) under which Meggs was no longer an employee but instead a broker on HIG's behalf through his wholly owned S corporation, Caleb, Inc. Meggs continued to receive a 4 percent commission from new account billings. However, these commissions terminated three years from the date on which HIG's work on the account began (the origination date).

PRC's parent company began to consider a sale of PRC in late 2005. PRC was using Pipeline IP with Meggs' permission and, in preparation for its sale, PRC tasked Sprague with obtaining the rights to Pipeline IP. Meggs needed cash to support another venture and, in early 2006, he proposed two options: (1) he would license Pipeline IP to PRC and receive royalties, which would increase once the patent was awarded or (2) he would assign all rights in Pipeline IP to PRC in exchange for an extension of the termination dates for his commissions from the American Express accounts. In February 2006, Meggs executed an assignment of Pipeline IP to PRC. He later abandoned the patent application.

Meggs and PRC executed a written addendum to his commission structure in early 2006 (2006 addendum). The 2006 addendum extended the period during which Meggs would receive commissions from the American Express accounts to 3.5 years from their origination dates. The addendum stated that the extended commissions were made "due to the circumstances surrounding AMEX USCC and AMEX [OBSN]." Meggs' commissions remained at 4 percent under the 2006 addendum. The 2006 addendum also provided that if PRC terminated its relationship with Meggs, it would pay the equivalent of one month's commission for each year of service provided. Neither Meggs nor Sprague consulted a lawyer in connection with the transfer of Pipeline IP or the 2006 addendum. HIG issued a Form 1099-MISC, Miscellaneous Income, to Caleb, Inc. reporting a payment from PRC of approximately $1.3 million in nonemployee compensation for 2006.

Meggs initially reported the $1.3 million as income on Caleb's Form 1120S. He and Caleb later filed amended returns for 2006 and 2007 reporting the payments attributable to the 2006 addendum as long term capital gains attributable to a "patent." In 2012, the IRS issued a notice of deficiency determining that the payments were not properly classified as capital gains. Meggs took his case to the Tax Court.

Analysis

Code Sec. 1235 provides that the transfer of property consisting of all substantial rights to a patent is considered the sale or exchange of a capital asset held for more than one year. This treatment applies regardless of whether payments in consideration for the transfer are made periodically or are contingent on the productivity, use, or disposition of the property. Reg. Sec. 1.1235-2(a) provides that the patent need not be in existence at the time of the transfer.

The IRS did not dispute that Pipeline IP was transferred or that the transfer met the requirements of Code Sec. 1235. Rather, it contended that the payments attributable to the 2006 addendum were not made in consideration for Pipeline IP and, therefore, should not be treated as long-term capital gains. The IRS pointed out that there was no reference in the 2006 addendum to the transfer, Meggs did not retain a security interest, and the addendum included several provisions standard in a commission agreement. The IRS argued that the 2006 addendum was executed in January 2006, before Meggs and Sprague had discussed transferring Pipeline IP, and asserted that both parties would have obtained legal assistance with the transfer. Finally, the IRS argued that the form of the transaction did not support Meggs' claim because both PRC (on a Form 1099-MISC) and Meggs initially reported the 2006 payments as nonemployee compensation to Caleb rather than as consideration for Pipeline IP. The IRS argued that the 2006 addendum was a makeshift noncompete agreement rather than consideration for the rights to Pipeline IP and claimed that Pipeline IP had only nominal value to PRC.

The Tax Court held that the payments attributable to the 2006 addendum were consideration to Meggs for the rights to Pipeline IP and were therefore properly treated as long-term capital gains under Code Sec. 1235. The court found that the 2006 addendum was susceptible of more than one interpretation, so it considered extrinsic evidence of Meggs' and Sprague's intent. The court found that Meggs and Sprague conceived of the 2006 addendum as consideration for the rights to Pipeline IP. In the court's view, the January 2006 date of the addendum did not foreclose the conclusion that PRC agreed to pay the additional amounts to Meggs in exchange for Pipeline IP.

The Tax Court rejected the IRS's theory that the 2006 addendum was a makeshift noncompete agreement; the court found that Meggs had no involvement with the American Express accounts after securing them for HIG and found no evidence that Meggs had the desire or capacity to manage the accounts himself. The court concluded that PRC wanted to acquire Pipeline IP from Meggs, not a noncompete agreement. For that reason the court also rejected the IRS's other theory that Pipeline IP was of nominal value to PRC.

The Tax Court found that Meggs' and Sprague's failure to obtain legal advice, or Meggs' failure to retain a security interest, was a reflection of the parties' circumstances as they were discussing the transfer rather than evidence that the 2006 addendum constituted an ordinary commission or noncompete agreement. In the court's view, both Meggs and Sprague were focused on transferring Pipeline IP as soon as possible - Meggs wanted cash to invest in a new venture, and Sprague wanted to obtain the rights before PRC was sold. The court also noted that the two had worked together since 2001 and found it plausible that they would have a level of trust.

The court also was not convinced that PRC's reporting of the 2006 payments indicated that the 2006 addendum did not relate to Pipeline IP. The court reasoned that, because those payments mirrored Meggs' commissions, it was reasonable for both PRC and Meggs to continue reporting commission payments as they always had in the absence of any tax or legal advice.

For a discussion of the gain or loss from the transfer of patents under Code Sec. 1235, 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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