By: Nestor Cruz
Section 1235 of the Internal Revenue Code states a patent-holder may receive long-term capital gains treatment from a patent sale, even if the holding period is less than one year. Royalties and payments which depend on whether the patent is financially successful also qualify for capital gains treatment. For Section 1235 to apply the patent-holder must transfer all substantial rights. Transfers between related persons are not eligible for capital gains treatment; and, a corporation and an individual who owns 25% or more of the stock of a corporation, directly or indirectly, are considered related persons.
For tax planning purposes, therefore, an individual who wishes to transfer a patent to a corporation must be careful about his or her share percentage if such individual wishes to receive capital gains treatment. Moreover, the individual must transfer all substantial rights. Given the large number of start-ups in the Washington area involving patents, this case is important locally as well as nationally.
In Cooper v. Commissioner, 143 T.C. No 10 (2014), the US Tax Court was faced with a Section 1235 issue. Taxpayer was an inventor with many patents to his name. He and his wife created Technology Licensing Corporation for the purpose of licensing his inventions. Taxpayer and his wife were advised by their attorney to hold only 24% of the corporation’s stock. Of the remainder, 38% of the shares were held by taxpayer’s sister-in-law and 38% by a friend of taxpayer. Neither taxpayer’s friend had any experience in patent licensing or commercialization before involvement with the corporation. For 2006, 2007 and 2008 taxpayer received about $7 million in patent royalties from the corporation, which he duly reported as capital gains, rather than ordinary income.
The Internal Revenue Service (IRS) issued a tax deficiency arguing taxpayers had retained the right to terminate the transfers to the corporation because he indirectly controlled the corporation through its directors, officers, and shareholders. The IRS sought back taxes as well as nearly $300,000 in penalties. The tax court sided with the IRS.
The court noted that by his actions, taxpayer indirectly controlled the corporation. He placed in positions of authority persons he could trust and control (sister-in-law and friends) those persons did not have the patent, engineering and business skills to make them valuable to a small patent licensing corporation. Since these other persons lacked the necessary skills, they would have to rely on tax payer for instructions. They took numerous actions inconsistent with acting independently and in the best interest of the corporation, but rather in the interest of taxpayer.
The court concluded that retention of control by taxpayer placed him in the same position as if the patent had not been transferred, precluding application of Section 1235. Congress had intended for a transferor’s act to speak louder than his words in establishing whether a sale of a patent had occurred.
This case is a classic example of the “substance over form” doctrine in which is taxpayer is too clever for his own good. Taxpayer and his wife complied with the “form” in that they only owned 24% of the corporation. They did not comply with the “substance” however since they found themselves two partners who were willing to play along so taxpayer could receive favorable capital gains treatment. Once taxpayer was audited the result was preordained. Perhaps taxpayer thought had he not been audited his arrangement would have worked-it very well may have. Nevertheless, relying on audit lottery can turn out to be expensive in terms of penalties, attorney fees and costs.