Patent Owner Not Entitled to Capital Gains on Royalty Income

(Parker Tax Publishing January 2018)

The Ninth Circuit Court upheld a Tax Court ruling that a taxpayer who transferred patents to a corporation in exchange for royalty payments was not entitled to capital gains treatment on the royalty income because he effectively controlled the corporation after the transfer. The Ninth Circuit found that the taxpayer failed to transfer substantially all interests in the patents as required under Code Sec. 1235 because (1) the other shareholders of the corporation exercised no independent judgment, (2) substantially all of the decisions were made either by the taxpayer or at his direction, and (3) the taxpayer could retrieve ownership of the patents at will. Cooper v. Comm'r, 2017 PTC 553 (9th Cir. 2017).

Background

James Cooper is the named inventor on more than 75 patents. His patents are primarily for products and components used in the transmission of audio and video signals. He and his wife are cotrustees of the Cooper Trust, a family trust. In 1983, the Coopers formed Pixel Instruments Corp. In 1988, Cooper and Pixel assigned their patents to an unrelated licensing company in exchange for royalty payments. The arrangement gave Cooper significant tax benefits under Code Sec. 1235, which allowed him to treat the royalty payments as capital gains as the result of transferring all substantial rights to the patents to the licensing company. Cooper terminated that agreement in 1997 after disputes with the licensing company, and all of his patent rights reverted to his assignee pursuant to a settlement.

Cooper wanted to retain the tax benefits afforded by Code Sec. 1235 so he sought legal advice from Gordon Baker, who advised him to form a licensing company to which to transfer the patents. Baker explained that the licensing company would have to comply with two requirements under Code Sec. 1235. First, Cooper could not own 25 percent or more of the company. Second, under Charlson v. U.S., 525 F.2d 1046 (Ct. Cl. 1975), regardless of formal ownership, Cooper could not effectively control the company.

The Coopers, joined by Lois Walters and Janet Coulter, incorporated Technology Licensing Corp. (TLC). Walters is Ms. Cooper's sister and Coulter is their longtime friend. The Coopers owned 24 percent of TLC and Walters and Coulter each owned 38 percent. Walters was president and chief financial officer, Ms. Cooper was vice president, and Coulter was secretary. Coulter and Walters lived in another state and held full time jobs unrelated to TLC. Neither had any prior experience in patent licensing or commercialization.

Cooper and Pixel transferred to TLC all rights to certain patents in exchange for an agreement by TLC to make royalty payments. In 2006, upon request, TLC returned patent rights to Mr. Cooper for no consideration, and Cooper commercialized the patents through a separate entity. The Coopers reported the royalty payments on their returns for 2006 through 2008 as capital gains.

For 2008, the Coopers also claimed a deduction under Code Sec. 166(d)(1)(B) for a debt that they claimed became worthless that year. The debt arose from a working capital promissory note that the Coopers made to Pixel. At the end of 2008, the balance on the note was around $2 million and Mr. Cooper concluded that Pixel could not pay the outstanding balance.

The IRS issued a notice of deficiency to the Coopers for 2006 through 2008. The IRS determined that the royalty payments did not qualify for capital gains treatment and that the note did not qualify for a bad debt deduction. Accuracy related penalties were also assessed. The Coopers petitioned the Tax Court, which upheld all of the IRS's determinations and ordered the Coopers to pay deficiencies and penalties totaling approximately $1.5 million. The Coopers appealed to the Ninth Circuit. On appeal, the Coopers argued that the issue of whether there was a transfer of all substantial rights in the patents should be determined by looking solely at the formal documents and without regard to the practical realities of the transaction.

Analysis

The Ninth Circuit upheld the Tax Court's rulings on the Coopers' royalty income and bad debt deduction as well as the IRS's assessment of penalties. First, the court rejected the Coopers' argument that only the formal documents should be considered in determining whether there has been a transfer of all substantial rights in a patent. It cited Reg. Sec. 1.1235-2(b)(1), which provides that the circumstances of the whole transaction, rather than the terminology used in the instrument of transfer, must be considered in determining whether all substantial rights to a patent have been transferred.

The Ninth Circuit found that the Tax Court did not err in finding that Cooper failed to transfer all substantial interests in the patents because he effectively controlled TLC. The Tax Court reasoned that Walters and Coulter exercised no independent judgment and acted at Cooper's direction; it also found that Walters' and Coulter's duties as directors and officers consisted largely of signing checks and agreements and transferring funds as directed by TLC's accountants and attorneys. Substantially all decisions regarding licensing, patent infringement, and patent transfers were made either by Cooper or at his direction, the Tax Court found. Based on these findings, the Tax Court concluded that Walters and Coulter did not make independent decisions in accordance with their fiduciary duties to TLC or act in their best interests as shareholders.

The Ninth Circuit further found that TLC's return of valuable rights in the patents to Cooper in 2006 showed that TLC would take practically any action requested by Cooper without regard to the interests of the shareholders or the personal interests of Walters and Coulter. The Ninth Circuit found that Walters and Coulter acquiesced in the return of the patent rights without question or explanation, and there was therefore no reason to think they would have objected to the rescission of any other transfer. Because the right to retrieve ownership of the patent is a substantial right under Reg. Sec. 1.1235-2(b)(4), the Tax Court did not clearly err in ruling that Cooper did not transfer all substantial rights to the patents, according to the Ninth Circuit.

The Ninth Circuit also held that the Tax Court made no error in finding that the Coopers' note to Pixel did not become worthless in 2008. The Tax Court found that, in 2008, Pixel had a small but steady income stream as well as hundreds of thousands of dollars' worth of assets. The Ninth Circuit reasoned that the Coopers almost certainly could not have recovered the full $2 million amount of the note, but considering that they were the only creditors, they likely could have made a partial recovery.

Finally, the Ninth Circuit held that accuracy related penalties were correctly applied and that the Coopers did not qualify for the reasonable cause exception because they failed to show they actually relied in good faith on an adviser's judgment. Although Baker advised the Coopers of the requirements under Code Sec. 1235 at the time they formed TLC, the Tax Court found that neither Baker nor anyone else ever advised that TLC was being operated in accordance with the Code Sec. 1235 requirements. Further, with respect to the bad debt deduction, there was no evidence that the Coopers received or relied on any professional advice regarding the deduction.

Observation: In a dissenting opinion, one judge would have held that Cooper had influence over TLC but did not control it for purposes of Code Sec 1235. The dissenting judge pointed out that Cooper did not set up TLC to retain control over it because he did not implement any of the measures available to minority shareholders to control a corporation. The dissenting judge also reasoned that Walters and Coulter were accommodating to Cooper because his inventions generated TLC's revenue.

For a discussion of capital gains treatment for royalty income on a transferred patent, 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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