Cooper v. Comm'r of Internal Revenue

• Decision Date: 15 December 2017
• Docket Number: No. 15-70863,15-70863
• Citation: 877 F.3d 1086
• Parties: James C. COOPER ; Lorelei M. Cooper, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

877 F.3d 1086

James C. COOPER ; Lorelei M. Cooper, Petitioners-Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 15-70863

United States Court of Appeals, Ninth Circuit.

Argued and Submitted October 4, 2017 Pasadena—California

Filed December 15, 2017

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.

Before: Andrew J. Kleinfeld, Susan P. Graber, and Morgan Christen, Circuit Judges.

Partial Concurrence and Partial Dissent by Judge Kleinfeld

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 26 U.S.C. § 1235(a) on the theory that Mr. Cooper had transferred to a corporation "all substantial rights" to the patents. After a bench trial, the Tax Court disagreed, finding that Mr. Cooper effectively controlled the recipient corporation such that he had not transferred all substantial rights to the patents. The Tax Court also found that Petitioners could not take a bad debt tax deduction in 2008 because the debt at issue had not become worthless during that year, and that Petitioners had not established reasonable cause to avoid accuracy penalties arising from their underpayment. Because the Tax Court accurately applied the law and did not clearly err in its factual findings, we affirm.

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 cotrustees 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 "all substantial rights" to the patents to the licensing company, 26 U.S.C. § 1235(a) permitted Petitioners to treat the payments from the licensing company as capital gains. But in 1997, after disputes with Leckrone, Mr. Cooper terminated the commercialization agreement. All of Mr. Cooper's patent rights reverted to his assignee pursuant to a settlement and arbitration.

Understandably, Petitioners sought to retain the tax benefits afforded by § 1235 and, to that end, they sought legal advice from Gordon Baker. Baker advised them that they could set up a licensing company to which to transfer the patents, so long as they complied with two requirements that are relevant here. First, he advised them that, pursuant to § 1235(c),¹ they could not own 25 percent or more of the company. Second, he advised them that, regardless of formal ownership, they could not effectively control the new company. The prohibition on effective control had been discussed at length in Charlson v. United States , 525 F.2d 1046, 1053 (Ct. Cl. 1975) (per curiam).

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 26 U.S.C. § 166(d)(1)(B), which allows short-term capital-loss treatment of a loss "where any nonbusiness debt becomes worthless within the taxable year." The debt arose from a working capital promissory note from the Cooper Trust to Pixel. At the end of 2008, the outstanding balance on the promissory note was a little more than $2 million, and Mr. Cooper concluded that Pixel could not pay the outstanding balance.

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 promissory note debt qualified as a bad debt deduction; and he assessed penalties for those errors. Petitioners sought review by the Tax Court. After a trial, the Tax Court agreed with the Commissioner on all three points, and the court ordered Petitioners to pay deficiencies and penalties totaling approximately $1.5 million. Petitioners timely appeal.³ See 26 U.S.C. § 7482(a)(1) (permitting appeals from the Tax Court to the applicable circuit court).

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, 26 U.S.C. § 7491(a), but the Tax Court held that Petitioners have neither asserted nor proved that they have met those requirements. On appeal, Petitioners do not challenge the Tax Court's conclusion that they bear the burden of proof.

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 26 U.S.C. § 1235. Subsection 1235(a) provides:

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.

Accordingly, if a patent holder transfers "all substantial rights to a patent," then the resulting royalty payments are treated as capital gains, because the patent has been "sold." By contrast, if a patent holder retains substantial rights to a patent and merely licenses the patent, then the resulting payments are not treated as capital gains, because the patent has not been "sold." The key consideration is whether the patent holder "transfer[red] ... all substantial rights" to the patent. Id.

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, 129 S.Ct. 878, 172 L.Ed.2d 679 (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, 60 S.Ct. 209, 84 L.Ed. 226 (1939) ("In the field of...