Payments under broker agreement characterized as long-term capital gains

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that payments made to a taxpayer under an addendum to a broker agreement were payments for the rights to a patent owned by the taxpayer that were properly classified as long-term capital gains under Sec. 1235.

Background

Anthony Meggs was hired in December 2001 as the vice president of business development for Hancock Information Group (HIG), a company that provides business-to-business lead generation services for its clients, contacting potential customers for clients and arranging appointments with them with its clients' sales teams. Meggs originally was paid a salary and commission by HIG, but within a year his compensation structure was changed so that he received only commission payments on client billings and no salary.

In 2002, Meggs designed a method by which a business allocates leads and marketing efforts to its sales pipelines based on each pipeline's capacity to develop leads effectively. On Sept. 17, 2002, Meggs filed a provisional patent application for his method, calling it "Method and Apparatus for Managing Resources Within an Organization and in the Sales and Marketing Pipeline" (Pipeline IP). Shortly after he developed Pipeline IP, Meggs secured three lucrative lead generation service accounts for HIG with American Express (USCC, OBSN, and Travel One). Pipeline IP was an important element in Meggs' efforts to secure these accounts.

In 2004, Meggs discontinued his employment with HIG and became a broker on behalf of the company through his wholly owned S corporation, Caleb Inc. Under his broker agreement with HIG, Meggs continued to receive a 4% commission from new account billings, but only for three years from the date that HIG's work on an account originated.

Toward the end of December 2005, PRC's parent company became interested in selling PRC. Because PRC used Pipeline IP, the parent company wished to obtain the rights to Pipeline IP from Meggs before the sale. To this end, the parent company had Meggs' boss, Lori Sprague, approach Meggs about acquiring the rights to Pipeline IP. Meggs was receptive to the idea of transferring the rights to Pipeline IP to obtain cash for a new venture.

On Jan. 2, 2006, Meggs and PRC executed an addendum to his 2004 commission structure agreement, extending the period in which he would receive commissions from each of the three American Express accounts to June 30, 2007. The 2006 addendum explained that these changes were made "due to the circumstances surrounding AMEX USCC and AMEX [OBSN]." It did not specifically mention a transfer of Pipeline IP.

In February 2006, Meggs sent Sprague an email outlining two alternative options for PRC to purchase Pipeline IP. Under one of the options, Meggs would assign the rights to Pipeline IP in exchange for an extension of the time that he received commissions from the American Express accounts. PRC chose this option, and on Feb. 14, Meggs assigned his rights in Pipeline IP to PRC.

Under the 2006 addendum, Meggs received commissions of $1,265,043 in 2006 and $552,738 in 2007. PRC reported the amount it paid Meggs in 2006 on a Form 1099-MISC, Miscellaneous Income, as nonemployee compensation. On his original personal return for 2006, Meggs reported the income as ordinary commission income.

On an amended return for 2006, however, Meggs reported $813,978 of the amount he received under the 2006 addendum as long-term capital gains under Sec. 1235 from the sale of Pipeline IP. Similarly, on his 2007 return, he reported $549,597 of the amount he received as long-term capital gains. Under Sec. 1235, if a taxpayer transfers property consisting of all substantial rights to a patent, and the requirements of the section are met, the transfer is treated as a sale or exchange of a capital asset held for more than one year. The treatment applies regardless of whether payments in consideration of the transfer are payable periodically or are contingent on the productivity, use, or disposition of the property.

On audit, the IRS determined that, while Meggs transferred Pipeline IP and the transfer met the requirements of Sec. 1235, the payments he received under the 2006 addendum to the commission agreement with PRC were not made in consideration for the transfer of Pipeline IP. Consequently, the payments should not be treated as long-term capital gains under Sec. 1235.

The Tax Court's decision

The Tax Court held that the commission payments from the American Express accounts that were paid under the 2006 addendum were paid as consideration for Pipeline IP. Because they met the requirements of Sec. 1235, as the IRS had conceded, they were long-term capital gains under Sec. 1235.

The Tax Court's first step in determining the characterization of the payments under the 2006 addendum was to review the applicable Florida contract law to ascertain the rules for interpreting the terms of a contract in that state. The court explained that under Florida law, the determination of the parties' intent in a contract is generally limited to the four corners of the document if the contract's terms are clear and unambiguous. However, if the contract's terms are ambiguous (susceptible to more than one interpretation) and the ambiguity is a latent ambiguity (the contract fails to specify the rights or duties of the parties in certain situations), extrinsic evidence, such as the testimony of the parties to the contract, can be considered in interpreting the ambiguous language. If the ambiguity is a patent ambiguity (the uncertainty is on the face of the document arising from defective, obscure, or insensible language), extrinsic evidence is not allowed.

The Tax Court found that the clause "the circumstances surrounding AMEX USCC and AMEX [OBSN]" in the 2006 addendum involved both patent and latent ambiguities because "it is not clear to what, if anything, within the document it refers, and more than one 'circumstance' may have surrounded the American Express accounts." Under Florida law, if both patent and latent ambiguities in the language of a contract exist, extrinsic evidence can be considered to clarify the parties' intentions. Therefore, the court concluded that it could look at the extrinsic evidence before it to interpret the 2006 addendum.

The IRS argued that both the terms of the 2006 addendum and the extrinsic evidence indicated that the payments under the addendum were not payments for Pipeline IP, which the IRS said had little value. It claimed this view was supported by the fact that the 2006 addendum did not mention the transfer, Meggs did not retain a security interest in Pipeline IP, and the addendum had several provisions that are standard in commission agreements. Also, according to the IRS, the circumstances surrounding the 2006 addendum that it was signed before Meggs and Sprague substantively discussed the transfer and no legal advice was sought as part of these discussions did not support the claim that the 2006 addendum covered the transfer. In addition, the IRS claimed that the form of the transaction could not be a transfer of Pipeline IP because both PRC (on the Form 1099-MISC it issued in 2006) and Meggs (on his original 2006 individual return) initially reported the payments as nonemployee compensation rather than as consideration for Pipeline IP, and Meggs was bound by the form he and PRC had chosen.

The Tax Court agreed with the IRS that the lack of a reference to the transfer in the 2006 addendum and the fact that the addendum was executed before Meggs assigned Pipeline IP to PRC supported the idea that the addendum was independent of the transfer. However, the court found that these points were outweighed by the credible testimony of Meggs, Sprague, and other PRC executives, who testified that the language "the circumstances surrounding AMEX USCC and AMEX [OBSN]" in the addendum referred to the transfer of Pipeline IP, and that both Meggs and PRC believed that the additional payments provided under the addendum were for the rights to Pipeline IP.

The court concluded that the parties' failure to obtain legal advice in setting up the transfer and Meggs' failure to retain a security interest in Pipeline IP reflected the time pressures that the parties were under when discussing the transfer and were not evidence that the addendum was an ordinary commission agreement. The court observed that both parties were motivated to get the deal done quickly: Meggs needed cash for the new venture he wished to pursue, and PRC needed the rights in Pipeline IP before its sale. In addition, Sprague and Meggs had had a good working relationship over several years, so it was plausible they had a level of trust when they undertook the transfer.

Finally, the Tax Court found that the tax reporting of the 2006 payments was not evidence that the 2006 addendum was not related to Pipeline IP. The payments mirrored Meggs' commissions, so the court concluded it was reasonable for both PRC and Meggs to continue reporting the commission payments as they had in the past in the absence of any tax or legal advice. Thus, the court refused to bind Meggs to the reporting by PRC, which was contrary to the other evidence the court had before it.

Reflections

Meggs is fortunate that the court accepted his testimony and that of the others involved because the IRS was right that the language in the addendum itself did not support his argument that the Pipeline IP rights were being transferred. The subsequent reporting by PRC and Meggs' treatment of the income as commission income on his tax returns further bolstered the IRS's position. Clear drafting and legal advice during the negotiation of the 2006 addendum could have saved the parties a trip to Tax Court.

Meggs, T.C. Memo. 2019-5

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