JAMES C. COOPER; LORELEI M. COOPER v. COMMISSIONER OF INTERNAL REVENUE
No. 15-70863
United States Court of Appeals, Ninth Circuit
December 15, 2017
Tax Ct. No. 17284-12
OPINION
Appeal from a Decision of the United States Tax Court
Argued and Submitted October 4, 2017 Pasadena, California
Filed December 15, 2017
Before: Andrew J. Kleinfeld, Susan P. Graber, and Morgan Christen, Circuit Judges.
Opinion by Judge Graber; Partial Concurrence and Partial Dissent by Judge Kleinfeld
SUMMARY*
Tax
The panel affirmed the Tax Court‘s decision, after a bench trial, on a petition for redetermination of federal income tax deficiencies in which taxpayers sought capital gains treatment of patent-generated royalties pursuant to
Taxpayer James Cooper is an engineer and inventor whose patents generated significant royalties. He and his wife incorporated and transferred their rights to the patents to Technology Licensing Corporation (TLC), which was formed by taxpayers and two other individuals, Walters and Coulter.
If a patent holder, through effective control of the corporation, retains the right to retrieve ownership of the patent at will, then there has not been a transfer of all substantial rights to the patent so as to warrant capital gains treatment of the royalties under
Taxpayers claimed a deduction for a nonbusiness “bad debt” pursuant to
Finally, the panel upheld the Tax Court‘s determination that taxpayers failed to meet their burden of showing that they actually relied in good faith on their advisers’ judgment so as to avoid accuracy-related penalties under
Judge Kleinfeld dissented as to Section A of the majority opinion regarding the royalty payments as capital gains, joined in Section B as to the bad debt deduction, and observed that the accuracy penalties discussed under Section C would need to be revisited if his view on the royalties were to be accepted. Judge Kleinfeld opined that the better approach to distinguishing “control” from “mere influence” over a corporation is the approach set forth in Charlson v. United States, 525 F.2d 1046 (Ct. Cl. 1975) (per curiam), and Lee v. United States, 302 F. Supp. 945 (E.D. Wis. 1969): that “control” means the ability to compel what the transferee corporation does.
COUNSEL
Richard G. Stack (argued) and Dennis N. Brager, Brager Tax Law Group P.C., Los Angeles, California, for Petitioners-Appellants.
Clint A. Carpenter (argued) and Richard Farber, Attorneys, Tax Division; Caroline D. Ciraolo, Principal Deputy Assistant Attorney General; United States Department of Justice, Washington, D.C.; for Respondent-Appellee.
GRABER, Circuit Judge:
Petitioners James and Lorelei Cooper are married taxpayers who challenge the Commissioner of Internal Revenue‘s notice of deficiency for tax years 2006, 2007, and 2008. Mr. Cooper‘s patents generated significant royalties during those years. Petitioners sought capital gains treatment of those royalties pursuant to
FACTUAL AND PROCEDURAL HISTORY
Mr. Cooper is an engineer and inventor. He is the named inventor on more than 75 patents in the United States. His patents are primarily for products and components used in the transmission of audio and video signals. Petitioners are co-trustees of a family trust, referred to as the “Cooper Trust.” In 1983, Petitioners incorporated Pixel Instruments Corporation (“Pixel“). Mr. Cooper was president, and Ms. Cooper held various positions, including vice president. Petitioners wholly owned Pixel until 2006. In 1988, Mr. Cooper and Pixel entered into a commercialization agreement with Daniel Leckrone. Mr. Cooper and Pixel assigned their patents to a licensing company formed by Leckrone, in exchange for royalty payments arising from the commercialization of the patents. The arrangement brought significant tax benefits to Petitioners. Because Petitioners had transferred
Understandably, Petitioners sought to retain the tax benefits afforded by
Petitioners, joined by Lois Walters and Janet Coulter, incorporated Technology Licensing Corporation (“TLC“).2 Walters is Ms. Cooper‘s sister, and Coulter is a long-time friend of Ms. Cooper and Walters. During all relevant times, Coulter and Walters lived in Ohio, and both held full-time jobs unrelated to TLC. Neither Coulter nor Walters had any experience in patent licensing or patent commercialization before their involvement with TLC.
Consistent with Baker‘s advice, Petitioners, as co-trustees of the Cooper Trust, owned only 24% of the TLC stock; Walters owned 38%; and Coulter owned 38%. Walters was president and chief financial officer, Ms. Cooper was vice president, and Coulter was secretary.
In 1997, Mr. Cooper and Pixel entered into agreements with TLC. Under the TLC agreements, Mr. Cooper and Pixel transferred to TLC all rights to certain patents, and TLC agreed to pay Mr. Cooper and Pixel royalty payments using a formula that relied on percentages of gross and net proceeds received from licensing the patents. During 2006, 2007, and 2008—the years at issue here—Mr. Cooper received royalty payments pursuant to the TLC agreements, and Petitioners treated those payments as capital gains.
During 2008, Petitioners also claimed a deduction on their 2008 tax return for a nonbusiness “bad debt” pursuant to
The Commissioner issued a notice of deficiency to Petitioners. Relevant here, the Commissioner disagreed that the royalty payments from TLC qualified as capital gains; he disagreed that the Pixel
STANDARDS OF REVIEW
“We review decisions of the Tax Court under the same standards as civil bench trials in the district court. Therefore, conclusions of law are reviewed de novo, and questions of fact are reviewed for clear error.” Johanson v. Comm‘r, 541 F.3d 973, 976 (9th Cir. 2008) (internal quotation marks omitted).
DISCUSSION
“Determinations made by the Commissioner in a notice of deficiency normally are presumed to be correct, and the taxpayer bears the burden of proving that those determinations are erroneous.” Merkel v. Comm‘r, 192 F.3d 844, 852 (9th Cir. 1999). The burden shifts back to the Commissioner in certain circumstances,
Petitioners challenge the Tax Court‘s rulings on (A) the treatment of royalty payments as capital gains; (B) the treatment of the Pixel loan as a bad debt; and (C) the imposition of penalties.
A. Royalty Payments as Capital Gains
The Tax Code generally treats income derived from a capital asset as ordinary income. By contrast, the Tax Code generally treats the proceeds from the sale of a capital asset more favorably, as capital gains. Real property provides a good example: If a homeowner rents a house, the rents are ordinary income; but if the homeowner sells the house, the proceeds from the sale are capital gains. Patents do not fit neatly within that dichotomy, because patent holders often sell all substantial rights to a patent in exchange for periodic payments contingent on the patent‘s productivity. But because that payment arrangement appears so similar to rent, the Commissioner originally treated the proceeds from such exchanges as ordinary income—even though the patent holder had divested all meaningful property rights in the patent. See Fawick v. Comm‘r, 436 F.2d 655, 659–61 (6th Cir. 1971) (describing this history).
In 1954, Congress responded by enacting
A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent . . . by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are–
(1) payable periodically over a period generally coterminous with the transferee‘s use of the patent, or
(2) contingent on the productivity, use, or disposition of the property transferred.
Petitioners urge us, for the first time on appeal, to determine whether there has been a transfer of all substantial rights by looking solely to the formal documents, without regard to the practical realities of the transaction.4 We decline the invitation. A bedrock principle of tax law—now and in 1954—is that substance controls over form. See, e.g., United States v. Eurodif S.A., 555 U.S. 305, 317–18 (2009) (“[I]t is well settled that in reading regulatory and taxation statutes, form should be disregarded for substance and the emphasis should be on economic reality.” (internal quotation marks omitted)); Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 255 (1939) (“In the field of taxation, administrators of the laws and the courts are concerned with substance and realities, and formal written documents are not rigidly binding.“). Nothing in
Acting pursuant to an express statutory delegation,
It is the intention of your committee to continue this realistic test, [developed under prior case law,] whereby the entire transaction, regardless of formalities, should be examined in its factual context to determine whether or not substantially all rights of the owner in the patent property have been released to the transferee . . . .
S. Rep. No. 83-1622, at 440 (1954), as reprinted in 1954 U.S.C.C.A.N. 4621, 5083. Not surprisingly, then, we previously have described the inquiry in practical terms: “What did the taxpayer actually give up by the transfer; that is, was there an actual transfer of the monopoly rights in a
In Charlson, 525 F.2d 1046, the United States Court of Claims described how the principle applies in a case involving a transfer of patent rights to a corporation. In that case, the inventor formally transferred all substantial rights to certain patents to a corporation that was owned by the inventor‘s close friends and associates. Id. at 1048–49.
Section 1235(c) provides that royalties from a patent transfer are not taxable as capital gains if the recipient is a “related” person or entity. The court held that § 1235(c)‘s requirements concerning formal ownership had been met, but the court “stressed that § 1235[(c)] was not intended to be an exclusive or exhaustive statement of the impact of control over a § 1235(a) transaction.” Id. at 1053. It is “clear,” the court held, “that retention of control by a holder over an unrelated corporation can defeat capital gains treatment, if the retention prevents the transfer of ‘all substantial rights.‘” Id. “This is because the holder‘s control over the unrelated transferee . . . places him in essentially the same position as if all substantial rights had not been transferred.” Id.; see also id. (describing Congress’ “obvious intent of having a transferor‘s acts speak louder than his words in establishing whether a sale of a patent has occurred“).
We agree: If a patent holder exercises control over the recipient corporation such that, in effect, there has not been a transfer of all substantial rights in the subject patent(s), then the requirements of
Importantly, “[t]he retention of a right to terminate the transfer at will is the retention of a substantial right for the purposes of section 1235.”
Here, the Tax Court found, and we agree, that Petitioners complied with the formal requirements of
The Tax Court found that Walters and Coulter—the two shareholders other than the Cooper Trust—exercised no independent judgment and acted at Mr. Cooper‘s direction. “During the years at issue, [Walters’ and Coulter‘s] duties as directors and officers consisted largely of signing checks and transferring funds as directed by
Those findings strongly suggest that TLC would take practically any action requested by Mr. Cooper—including the return of patent rights—without regard to the interests of TLC‘s shareholders and without regard to the personal interests of Walters and Coulter. But the Tax Court was not required to speculate as to whether, upon Mr. Cooper‘s request, TLC would return valuable patent rights to Mr. Cooper; that event in fact occurred. In 2006, upon request, TLC returned valuable patent rights to Mr. Cooper for no consideration. Mr. Cooper quickly commercialized the patents through a separate entity, which received $120,000 in revenue.
In sum, the Tax Court permissibly concluded that Walters and Coulter acted at Mr. Cooper‘s direction; did not exercise independent judgment; and, when requested, returned patents to Mr. Cooper for no consideration. Given that Walters and Coulter acquiesced, without question or explanation, in the rescission of the transfer of certain patents, there is no reason to think that they would have objected to the rescission of any other transfer of patents. Because the right to retrieve ownership of the patent is a substantial right, the Tax Court did not clearly err in ruling that Mr. Cooper did not transfer “all substantial rights” to the patents.
We respectfully part ways from the dissent‘s thoughtful analysis of this issue and offer the following observations in response.
For all the reasons described above, the inquiry into whether there was a transfer of all substantial rights is a practical one, not merely a formalistic or legalistic one. We therefore reject the dissent‘s suggestion that we must ask whether, in theory, TLC could have declined to transfer the patents back to Mr. Cooper; instead, we must ask whether, as a practical matter, Mr. Cooper retained the ability to retrieve the patents at will. Similarly, whether Mr. Cooper hypothetically could have forced TLC to comply with his wishes on other matters is beside the point.
We recognize that there is a difference between mere influence and control sufficient to defeat
Finally, we emphasize that our analysis is limited solely to the tax consequences of Petitioners’ business arrangements. Allowing an inventor to have effective control of the recipient corporation very well may be a smart business practice in some circumstances. We hold only that, if the patent holder effectively controls the corporation such that he or she did not transfer all substantial rights to the patents, then the tax treatment allowed by
We review for clear error the Tax Court‘s finding of the worthlessness of a debt. L.A. Shipbuilding & Drydock Corp. v. United States, 289 F.2d 222, 228–29 (9th Cir. 1961); accord Cox v. Comm‘r, 68 F.3d 128, 131 (5th Cir. 1995). The taxpayer bears the burden of proving “that the debt became worthless within the tax year.” Andrew v. Comm‘r, 54 T.C. 239, 244–45 (1970). “The year a debt becomes worthless is fixed by identifiable events that form the basis of reasonable grounds for abandoning any hope of recovery. Petitioner must establish sufficient objective facts from which worthlessness could be concluded; mere belief of worthlessness is insufficient.” Aston v. Comm‘r, 109 T.C. 400, 415 (1997) (citation omitted). The debt must “become totally worthless, and no deduction shall be allowed for a nonbusiness debt which is recoverable in part during the taxable year.”
The Tax Court found that, contrary to Petitioner‘s assertion, the debt on Pixel‘s promissory note did not become “worthless” in July 2008.
Pixel had total yearend assets each year from 2008 through 2012 in excess of $172,000, including more than $319,000 in assets in 2011 and 2012. It appears to us that Pixel remained a going concern well past 2008. . . . Pixel experienced a decline in its business in 2008, but its gross receipts increased in 2009. Petitioners as cotrustees of the Cooper Trust continued to advance funds to Pixel under the terms of the promissory note throughout 2008. Indeed, petitioners advanced $148,255 to Pixel under the terms of the promissory note between July and December 2008. We do not find it credible that petitioners would have advanced nearly $150,000 to Pixel after July 2008 if they believed the promissory note had been rendered worthless in July 2008 . . . . The evidence shows that Pixel had substantial assets at the end of the 2008 tax year and that its gross receipts increased in 2009. Moreover, at the very least, Pixel was entitled to an indefinitely continuing annual royalty of $22,500 and owned rights in several other patents. . . . Pixel‘s liabilities to petitioners under the terms of the promissory note comprised substantially all of Pixel‘s liabilities in 2008.
Those findings are not clearly erroneous.
In short, Pixel had a steady, if small, income stream, and it had hundreds of thousands of dollars worth of assets. Petitioners almost certainly could not have recovered the full $2 million and change but, considering that they were essentially the only creditors, they likely could have made a partial recovery. The Tax Court permissibly concluded that the debt had not become “totally worthless.”
C. Accuracy Penalties
Title
Reliance on professional advice may establish reasonable cause and good faith.
1. Royalty Penalty
With respect to the royalty penalty, Petitioners contended that they relied on the advice of Baker. The Tax Court found:
Mr. Baker testified with respect to the royalty payments and petitioners’ compliance with section 1235 that he advised petitioners that Mr. Cooper could not indirectly control TLC. Moreover, Mr. Baker did not provide advice to petitioners before they filed their Forms 1040 for the years at issue, nor did he provide advice to petitioners regarding whether Mr. Cooper controlled TLC following TLC‘s incorporation. Petitioners did not follow Mr. Baker‘s advice to ensure that Mr. Cooper did not indirectly control TLC. Consequently, petitioners cannot claim reliance on the professional advice of Mr. Baker to negate the section 6662(a) penalty with respect to their erroneous capital gain treatment of the royalty payments Mr. Cooper received during the years at issue.
Those findings are not clearly erroneous, and the Tax Court‘s reasoning is sound. Baker advised Petitioners at the time they formed TLC that, in order to receive capital gains treatment, Mr. Cooper could not control TLC indirectly. Baker also testified specifically that he had no recollection that he ever advised Petitioners that the way in which they were operating TLC actually conformed to his advice. Indeed, there is no evidence that Petitioners ever sought post-formation advice from anyone about whether their conduct actually complied with Baker‘s advice.
Nor was the penalty inappropriate because of the allegedly uncertain state of the law. “[A]n honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances” can excuse an understatement of tax.
2. Bad Debt Penalty
With respect to the bad debt penalty, Petitioners contended that they relied on the advice of Mitch Mitchell and Baker. The Tax Court found:
With regard to the bad debt deduction, petitioners have failed to introduce evidence regarding what information they provided to Mr. Baker and Mr. Mitchell to enable them to determine whether the promissory note was worthless within the meaning of section 166 in 2008. Petitioners did not call Mr. Mitchell to testify or otherwise introduce any evidence regarding Mr. Mitchell‘s advice. Similarly, Mr. Baker did not testify regarding any advice he may have given to petitioners that would indicate that it was his opinion that the promissory note became worthless in 2008. In short, petitioners have failed to prove that they received or relied on the professional advice of Mr. Baker and Mr. Mitchell with respect to their erroneous section 166 bad debt deduction in 2008.
Again, there is no clear error. Petitioners have not rebutted the Tax Court‘s finding that Petitioners failed to prove that “the taxpayer provided necessary and accurate information to the adviser.” DJB Holding Corp., 803 F.3d at 1030. Mitchell did not testify, and neither Petitioners nor the Commissioner asked Baker any questions about the bad debt or about any advice he may have given Petitioners on that topic.
AFFIRMED.
JAMES C. COOPER; LORELEI M. COOPER v. COMMISSIONER OF INTERNAL REVENUE
No. 15-70863
United States Court of Appeals, Ninth Circuit
KLEINFELD, Senior Circuit Judge, concurring in part and dissenting in part:
I respectfully dissent. My dissent is directed only to Section A, “Royalty Payments as Capital Gains.” I join in Section B, “Bad Debt Deduction.” As for Section C, “Accuracy Penalties,” whether and how the penalties would apply would need to be revisited if my view on royalties were to be accepted.
The majority errs because it dilutes the meaning of “control” from the ability to compel a result to something less and indeterminate. This puts us at odds with our only sister circuit to rule on the matter, the Court of Claims in Charlson v. United States.1 Both Charlson and the Commissioner‘s own regulations show the error of the majority‘s approach.
The majority opinion accurately notes that in Charlson, the corporation to which inventor Lynn Charlson transferred his patent was owned by his “close friends and associates.” Actually, they were more than close friends and associates: three of the shareholders and directors were his employees, and the fourth was his personal attorney.2 As such, Charlson could fire each of them if he disliked how they voted. The corporation also “frequently sought, received, and followed the recommendations
Yet Charlson won his case. The Commissioner lost.6 Despite the evidence that the corporation did what Charlson wanted, the Court of Claims concluded that he did not “control” the corporation such that the transfer of patent rights was not genuine. Today‘s majority opinion quotes Charlson‘s statement that the “retention of control by a holder over an unrelated corporation can defeat capital gains treatment, if the retention prevents the transfer of all substantial rights.”7 That language marks the boundary of capital gains treatment, but Charlson held that the boundary was not crossed. Charlson had power over the corporate directors—far more power than Cooper had over TLC‘s directors—but Charlson did not “control” the directors for the purposes of
The regulations make it clear that even though the directors in this case are Cooper‘s friends and relatives, that does not amount to control or make TLC a “related” entity. The regulations are at pains to say that even transferring patent rights to a corporation controlled by one‘s own brother “is not considered as transferring such rights to a related person.”8 Since a brother is not a “related person” for
The majority correctly concedes that “[m]ere influence by the patent holder is insufficient to defeat
Walters and Coulter, like the directors in Charlson, were solicitous of Cooper‘s and each other‘s personal interests. They did transfer a few patents to Cooper for no consideration so that he could in turn transfer them to a corporation in which his children had an interest. But Walters and Coulter still owned 76% of the new corporation. (Instead of Cooper and his wife owning 24%, Cooper and his wife owned 1% and their children owned 23%.) And Cooper was not the only one who benefitted from TLC. Walters and Coulter each received $40,000 in director‘s fees, and
Although the Commissioner argues that the patent transfer benefitting Cooper‘s children somehow breached a fiduciary duty to TLC‘s shareholders, that argument would apply equally to the payments made to Walters and Coulter. And it would be equally irrelevant. All that a breach of fiduciary duty means is that Walters and Coulter, acting in their capacity as shareholders, could theoretically sue themselves in their capacity as directors. That unlikely possibility does not show control. The core of the Commissioner‘s argument—that the directors knew nothing about Cooper‘s sophisticated inventions and simply followed his instructions—does not show control. If anything, it shows that there was no good reason for them to reject Cooper‘s recommendations, because it was his knowledge and skill that generated millions in revenue, so he did not need control.
In distinguishing control from influence, our focus should not be merely on whether TLC‘s directors did what Cooper wanted. There was no reason for them to do anything else. Instead we must ask whether, as a practical matter, they could have done otherwise. Cooper could have, but did not, set up the corporation to retain control.
The most obvious way to control a corporation is to own a majority of its stock. For example, owning 100% of the stock defeated the tax benefits in the classic sham case Gregory v. Helvering.11 However, Congress provided that a patent holder cannot receive capital gains treatment if he owns 25% or more of the corporation to which he transferred his patents.12 That is why Cooper and his wife owned only 24% of TLC‘s stock.
Minority shareholders may still control a corporation by controlling its directors’ votes, and there are well-established means by which Cooper might have done so. Those means are often used in close corporations to protect minority shareholders from oppression. One way to retain control is to write the articles of incorporation to require a super-majority so that no decision can be made without the minority shareholders’ consent.13 Another is to establish a voting trust so that the majority must vote their shares in line with the minority‘s preferences.14 A third means is to use classified shares with the minority shares controlling the class that chooses the directors.15 And a fourth is to contractually obligate the directors to vote consistently with the minority shareholders’ preferences.16 This list is not exhaustive, of course. But Cooper did not do any of these things. If he had, then he would have genuinely controlled TLC, not just influenced it.
Because Cooper‘s inventions generated TLC‘s revenue, Walters and Coulter no doubt thought it was in TLC‘s best interest to accommodate Cooper and keep him productive. But Cooper could not always count on Walters and Coulter to do things his way. At some point, he would age out of his peak productivity, meaning there would be less reason to listen to him. Moreover, a change in circumstances could always occur. As Professor Clark wrote in his treatise:
As time passes, the personal relationships among the major participants in a close corporation always change in important ways. One of several participants will retire or die, leaving a gap in a shareholding or managerial role that might or might not be filled. Participants who were once friendly to each other will accumulate grudges. Some participants will want to go on to other ventures. Others will want to bring in new associates, who may or may not be acceptable to the others.17
If, for example, a buyout offer could enrich Walters and Coulter but would end Cooper‘s influence over TLC, that might create conflict between the shareholders. Yet Cooper would lack any power to make Walters and Coulter reject the buyout. They would be multimillionaires and he would lose his connection to his own inventions.
Because the majority opinion makes “control” a vague and ambiguous term, it risks eviscerating
In short, the majority opinion does not say how “control” is distinct from “mere influence,” so mere influence of some vague and indeterminate kind prevents capital gains treatment. “Control” means the taxpayer can make the transferee corporation do what he wants, while “influence” means that although the corporation may defer to his judgment or be persuaded by his view, he cannot make the corporation do what he wants. The better approach is the one seen in Charlson and Lee: that “control” means the ability to compel what the transferee corporation does.