Capital Gains Treatment for Patent Royalties Denied

Gains & Losses

The Tax Court held that a taxpayer had not transferred all substantial rights in patents to an unrelated corporation because he was in control of the corporation; therefore, he was not entitled to capital gain treatment under Sec. 1235 for royalties on the patents that the corporation paid to him.

Background

James Cooper is an engineer and inventor; he is the named inventor on more than 75 patents in the United States, primarily for products and components used in the transmission of audio and video signals. Cooper and Pixel, a corporation he formed in 1983, owned these patents. In 1988, Cooper entered into a commercialization agreement with Daniel Leckrone, a patent attorney, under which he and Pixel assigned their portfolio of audio and video patents to VidPro, a licensing company formed by Leckrone. Disputes arose between Cooper and Leckrone, and Cooper attempted to terminate the commercialization agreement in 1997, resulting in prolonged litigation between Cooper and Leckrone. In 2004, an arbitration agreement held that Cooper had properly terminated the agreement and that all rights, title, and interest in the patents had reverted to Cooper and Pixel.

Later in 1997, Cooper and his wife, Lorelei, believing that all rights in VidPro’s audio and video patents had at that time reverted to Cooper and Pixel, incorporated Technology Licensing Corp. (TLC), a California corporation, with Lois Walters (Lorelei Cooper’s sister) and Janet Coulter, a longtime friend of Mrs. Cooper and Walters. Coulter and Walters resided in Ohio from 1997 through 2013, and both worked full time with companies other than TLC during the years at issue. Although the Coopers formed TLC to engage in patent licensing and commercialization, neither Coulter nor Walters had any experience in patent licensing or patent commercialization before their involvement with TLC and were apparently chosen to participate in the venture because they were trusted friends of the Coopers.

The Coopers, on the advice of a tax attorney, formed TLC with an eye toward meeting the requirements to qualify the royalty payments Cooper anticipated receiving from the company as capital gain under Sec. 1235. The Coopers, as co-trustees of the Cooper Trust, received 24% of the shares in the company, and Walters and Coulter each received 38%. Walters was president and CFO, Mrs. Cooper was vice president, and Coulter was secretary of TLC. Cooper was the company’s general manager.

Cooper and Pixel entered into agreements transferring their rights in the patents to TLC. In the years in question in the case (2006 through 2008), Cooper received royalty payments from TLC related to the patents. The amount of the royalties paid each year to Cooper under the agreements was determined by accountants hired by TLC. Neither Walters nor Coulter, who were the majority shareholders as well as officers and directors, reviewed and verified the amount of royalties paid to Cooper each year or negotiated the terms of TLC’s agreements to license the subject patents to other companies. Instead, Walters and Coulter relied on TLC’s attorneys and Cooper’s technical expertise with regard to TLC’s licensing activities. During the years at issue, Walters’s and Coulter’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 Coopers reported the royalty payments they received from TLC (over $6 million for the years 2006 through 2008) as capital gains on their income tax returns pursuant to Sec. 1235. In a notice of deficiency to the Coopers for those years, the IRS claimed that the Coopers were not entitled to capital gain treatment on the royalties under Sec. 1235 because they controlled TLC through Cooper. The Coopers challenged the IRS’s determination in Tax Court.

Sec. 1235

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 in consideration of the transfer are contingent on the productivity, use, or disposition of the property transferred. Consequently, for the transfer of a patent to qualify as a sale or exchange, the owner must transfer “all substantial rights” to the property. Regs. Sec. 1.1235-2(b) provides that for purposes of Sec. 1235, the term “all substantial rights” means all rights that are of value at the time the rights are transferred and that the retention of the right to terminate the transfer at will is the retention of a substantial right. Finally, under Sec. 1235(d), transfers between related persons, as defined in Sec. 267(b), are not eligible for capital gain treatment, and, for purposes of Sec. 1235, a corporation and an individual owning 25% or more of the stock of the corporation directly or indirectly are related persons.

Tax Court’s Decision

The Tax Court held that the Coopers were not entitled to capital gain treatment for the royalties from TLC under Sec. 1235 because Cooper was in control of TLC. The court found that a taxpayer’s retention of control over an unrelated corporation to which the taxpayer transferred a patent could prevent the transfer of all substantial rights in the patent, thereby making the transfer ineligible for Sec. 1235 capital gain treatment.

The IRS did not dispute that, as required by Sec. 1235, (1) the transfer of the patents to TLC was other than by gift, inheritance, or devise; (2) Cooper qualified as a holder of the subject patents; and (3) the Coopers owned less than 25% of TLC. However, it contended that Cooper effectively retained a right to terminate the transfers under the TLC agreements because he indirectly controlled TLC through its directors, officers, and shareholders. Therefore, Cooper did not transfer all substantial rights in the subject patents and was not entitled to capital gain treatment. The Coopers countered that Cooper did not control TLC and that the directors, officers, and shareholders of TLC acted independently of Cooper in their corporate decision-making.

The Tax Court first considered whether a taxpayer’s control of a corporation unrelated to the taxpayer under Sec. 1235(d) would preclude Sec. 1235 treatment for a transfer of a patent by the taxpayer to that corporation. The Tax Court determined, as had the Court of Claims in Charlson, 525 F.2d 1046 (Ct. Cl. 1975), that in this situation Sec. 1235 would not apply because a patent holder’s retention of control over an unrelated corporation to which the patent holder transfers a patent places the holder in essentially the same position as if all substantial rights in the patent had not been transferred. The court found further support for its position in the legislative history of Sec. 1235, which states that a court should examine the facts and circumstances of transactions and not rely solely on the terms of a transfer agreement in determining whether a taxpayer had transferred all substantial rights in a patent.

The Tax Court then considered whether Cooper had control of TLC. Despite the fact that Walters and Coulter together owned a majority interest in TLC and were officers in the company, the Tax Court agreed with the IRS that Cooper was in control of the company. The court found that the Coopers, troubled by the results of the VidPro venture, had chosen Walters and Coulter to be the other shareholders and directors of TLC because they were individuals Mr. Cooper could trust and control. The court noted that Walters and Coulter did not have the patent, engineering, or other such skills to make them particularly valuable to a small patent licensing company. In addition, they took numerous actions that benefited the Coopers and were inconsistent with acting independently and in the best interest of the corporation. The court further observed that Cooper made all the important decisions regarding the operations of TLC and stated, “[I]t is unclear what material decisions, if any, the officers and directors of TLC made independent of Mr. Cooper.”

In support of its argument that the directors, officers, and shareholders of TLC acted independently of Cooper in their corporate decision-making, the Coopers pointed to the similarity of the facts in their case and the facts in Lee, 302 F. Supp. 945 (E.D. Wis. 1969), and Charlson for support. The Tax Court found, however, that both those cases were easily distinguishable. In both cases, although the other shareholders or directors of the transferee corporations were friends, trusted business associates, or employees of the taxpayer who transferred the patents, there was no evidence in either case that the taxpayer actually was able to control the transferee corporation, whereas the evidence regarding TLC indicated that Cooper had full control of the company.

Reflections

In this case of first impression for the Tax Court, the facts and circumstances of how TLC actually operated led the court to conclude that it should disregard the fact that, on the surface, the arrangement complied with the Sec. 1235 related-party rules. Practitioners must be aware that the phrase “retention of a right to terminate the transfer at will” in Regs. Sec. 1.1235-2(b)(4) has been given a very expansive meaning by the courts to this point, and clients they advise must be warned that a transfer of a patent to a directly or indirectly controlled corporation will likely be held to not qualify for Sec. 1235 capital gain treatment, even if the written patent transfer agreement does not include a right to terminate the transfer.

Cooper, 143 T.C. No. 10 (2014)