The Tax Court recently upheld a ruling that patent holders must give up control of a transferred patent to treat royalty income from it as capital gains.

In a case of first impression for the Tax Court, Cooper v. Commissioner, 143 T.C. No. 10, it has agreed with a 1975 decision by the U.S. Court of Claims that “retention of control by a holder over an unrelated corporation can defeat capital gain treatment under Section 1235 [which provides capital gain treatment for patent transfers to an unrelated party] because the retention prevents the transfer of ‘all substantial rights’ in the patent.”

James Cooper and his wife, Lorelei, transferred patents to a corporation, Technology Licensing Corp., owned jointly with Lorelei’s sister and a long-time friend of the family. Their attorney advised the Coopers that they could not control TLC directly, and that their stock ownership in TLC had to be less than 25 percent of the total outstanding stock. Consistent with his advice, the Coopers as co-trustees of the Cooper Trust owned 24 percent of the shares, while the others each owned 38 percent.

The Coopers reported royalty income they received from TLC in exchange for the transfer of the patents as capital gain for the years 2006 through 2008. The IRS determined that the royalty payments did not qualify for capital gain treatment. The Tax Court agreed.

In order for the transfer of a patent to qualify as a sale or exchange, the owner must transfer “all substantial rights.” The Tax Court noted that “Neither the code nor applicable regulations specifically address whether Section 1235 applies to transfers to a corporation that is not related to the holder but is indirectly controlled by the holder. Whether a holder’s control over a corporate transferee that is unrelated within the meaning of Section 1235(d)) defeats capital gain treatment appears to be an issue of first impression for this court.”

However, the Tax Court agreed with the Court of Claims that “retention of control places the holder in essentially the same position as if the patent had not been transferred, thereby precluding the application of Section 1235.”

It was unclear to the court what material decisions, if any, the officers and directors of TLC made independent of James Cooper. “We do not find credible any testimony by petitioners that TLC was an independent corporation that Mr. Cooper did not control,” the court stated. Therefore, it found that the Coopers’ royalty income for the years in question did not qualify for capital gain treatment.

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