James C. Cooper & Lorelei M. Cooper v. Commissioner , 143 T.C. No. 10 ( 2014 )

143 T.C. No. 10
UNITED STATES TAX COURT
JAMES C. COOPER AND LORELEI M. COOPER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17284-12. Filed September 23, 2014.
In 1997 P-H, an inventor, transferred several patents to T, a
corporation. Ps own 24% of the outstanding stock of T. P-W’s sister
and Ps’ friend own the remaining stock. P-H controlled T through its
officers, directors, and shareholders. Ps reported royalty income that
P-H received from T in exchange for the transfer of the patents as
capital gain under I.R.C. sec. 1235(a) for 2006, 2007, and 2008.
In 2006 P-H paid the engineering expenses of a related
corporation. Ps deducted these expenses as professional fees on a
Schedule C, Profit or Loss From Business, attached to their 2006
Federal income tax return.
Between 2005 and 2008 Ps advanced $2,046,901 to X, a
corporation, under the terms of a working capital promissory note.
P-H owned 24% of the outstanding stock of X during the years at
issue. X contracted with an Indian company to develop a new
product, and it used Ps’ loans in part to fund the development of the
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new product. In 2008 the Indian company abandoned its
development of the new product. Ps claimed that X was insolvent
and claimed a bad debt deduction under I.R.C. sec. 166 of $2,046,570
for 2008.
R determined that (1) the royalty payments P-H received from
T did not qualify for capital gain treatment; (2) the engineering
expenses were the ordinary and necessary expenses of a related
corporation and Ps were not entitled to deduct those expenses; (3) Ps
were not entitled to a bad debt deduction for 2008; and (4) Ps were
liable for an accuracy-related penalty under I.R.C. sec. 6662(a) for
each of the years at issue.
Held: P-H did not transfer all substantial rights in the subject
patents to T within the meaning of I.R.C. sec. 1235(a) because P-H
controlled T during the years at issue. See Charlson v. United States,
525 F.2d 1046, 1053 (Ct. Cl. 1975). Ps are therefore not entitled to
capital gain treatment under I.R.C. sec. 1235(a) for the royalties P-H
received from T in exchange for the subject patents.
Held, further, Ps are entitled to deduct the engineering
expenses for 2006. Under Lohrke v. Commissioner, 48 T.C. 679, 688
(1967), P-H’s primary motive in paying the expenses was to protect
or promote his business as an inventor, and the expenditures
constituted ordinary and necessary expenses in the furtherance or
promotion of P-H’s business.
Held, further, Ps are not entitled to a bad debt deduction under
I.R.C. sec. 166 because Ps have failed to prove that the promissory
note became worthless in 2008.
Held, further, Ps are liable for an accuracy-related penalty
under I.R.C. sec. 6662(a) for each of the years at issue.
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Lawrence T. Ullmann, for petitioners.
Nhi T. Luu and Christian A. Speck, for respondent.
MARVEL, Judge: Respondent determined deficiencies in petitioners’
Federal income tax of $580,961, $384,705, and $496,236 for 2006, 2007, and
2008, respectively, and accuracy-related penalties under section 6662(a)1 of
$116,192, $76,941, and $99,247 for 2006, 2007, and 2008, respectively. After
concessions,2 the issues for decision are: (1) whether royalties petitioner James
Cooper received during 2006, 2007, and 2008 qualified for capital gain treatment
pursuant to section 1235; (2) whether petitioners may deduct professional fees
paid during 2006 that were attributable to expenses charged by Holmes
Development for work performed with respect to U.S. Patent #5,157,489 (489
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. Some monetary amounts have
been rounded to the nearest dollar.
2
The parties stipulated or conceded that petitioners are entitled to deduct on
Schedule C, Profit or Loss From Business: (1) travel expenses of $30,072,
$18,432, and $21,444 for 2006, 2007, and 2008, respectively; and (2) professional
fees of $82,585, $241,153, and $109,007 for 2006, 2007, and 2008, respectively.
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patent);3 (3) whether petitioners’ advance of $2,046,5704 to Pixel Instruments
Corp. (Pixel) is deductible as a nonbusiness bad debt for 2008 pursuant to section
166; and (4) whether petitioners are liable for section 6662(a) accuracy-related
penalties for the years at issue.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of
facts are incorporated herein by this reference. Petitioners resided in Nevada
when they petitioned this Court.
I. Patent Royalties
Mr. Cooper is an engineer and inventor. He has an undergraduate degree in
electrical engineering from Oklahoma State University and is the named inventor
on more than 75 patents in the United States.5 His patents are primarily for
products and components used in the transmission of audio and video signals.
3
The 489 patent was titled “Apparatus and Method for Reducing Quantizing
Distortion”.
4
The parties stipulated that on December 31, 2008, the outstanding balance
on the promissory note was $2,046,901. However, petitioners claimed a
nonbusiness bad debt deduction for the outstanding balance on the promissory
note of $2,046,570 for 2008.
5
Mr. Cooper is also a patent agent entitled to represent third parties before
the U.S. Patent and Trademark Office.
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Petitioner Lorelei Cooper has an undergraduate degree in communications from
Kent State University. She is not the named inventor on any patents.
In 1988 Mr. Cooper consulted Daniel Leckrone, an attorney specializing in
patent law and patent licensing, regarding Mr. Cooper’s portfolio of intellectual
property. These consultations led to an agreement (commercialization agreement)6
among Mr. Leckrone, Mr. Cooper, and Pixel wherein Mr. Cooper and Pixel
assigned their portfolio of audio and video patents to VidPro,7 a licensing
company formed by Mr. Leckrone.
A number of disputes arose between Mr. Cooper and Mr. Leckrone under
the commercialization agreement. In 1997 Mr. Cooper sent Mr. Leckrone notice
that he was terminating the commercialization agreement. Mr. Cooper contended
that under the terms of the commercialization agreement the patent rights held by
VidPro automatically reverted to him as a result of the termination notice. Mr.
Leckrone disagreed. Ultimately, this dispute led to litigation between Mr. Cooper
6
The commercialization of a patent generally includes finding companies to
manufacture products using the patent as well as finding and suing patent
infringers for damages.
7
At the time the commercialization agreement was signed VidPro was
known as VideoTech.
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and Mr. Leckrone, VidPro, and an attorney on VidPro’s board of directors
(Cooper-Leckrone litigation).8
Subsequently, petitioners, believing that all rights in VidPro’s audio and
video patents reverted to Mr. Cooper, incorporated Technology Licensing Corp., a
California corporation (TLC),9 with Lois Walters and Janet Coulter. Ms. Walters
is petitioner Lorelei Cooper’s sister and Ms. Coulter is a long-time friend of Ms.
Cooper and Ms. Walters. Ms. Coulter and Ms. Walters resided in Ohio from 1997
through 2013, and both worked full time with companies other than TLC during
8
The Cooper-Leckrone litigation ended in 2004 when a final arbitration
award was entered determining, among other things, that the commercialization
agreement was properly terminated as of January 21, 1997, and all rights, title, and
interest that VidPro claimed in the patents were returned to Mr. Cooper or his
assignee.
9
Petitioners moved their principal residence from California to Nevada in
November 2003. Petitioners, Ms. Walters, and Ms. Coulter then formed a second
Technology Licensing Corp. with the Nevada secretary of state (TLC Nevada).
Petitioners as cotrustees of the Cooper Trust U.D.T. December 11, 1991 (Cooper
Trust), contributed $240 to TLC Nevada in exchange for 240 shares in TLC
Nevada, and Ms. Walters and Ms. Coulter each contributed $380 to TLC Nevada
in exchange for 380 shares in TLC Nevada (38%). Ms. Walters, Ms. Cooper, and
Ms. Coulter were the president and chief financial officer, vice president, and
secretary of TLC, respectively. On February 24, 2004, TLC merged into TLC-
Nevada with TLC-Nevada as the surviving corporation. We refer to TLC Nevada
as TLC unless otherwise indicated.
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the years at issue.10 Neither Ms. Coulter nor Ms. Walters had any experience in
patent licensing or patent commercialization before their involvement with TLC.
Petitioners incorporated TLC to engage in patent licensing and patent
commercialization. They wanted TLC to have the “aura” of a fully operating
licensing corporation but also wanted people Mr. Cooper could trust--such as their
close friend Ms. Coulter and their relative Ms. Walters--to be the shareholders,
officers, and directors of TLC.11
Petitioners engaged Attorney R. Gordon Baker, Jr., to provide advice on
forming TLC. Among other things, Mr. Baker advised petitioners on the
requirements of section 1235 and qualifying the royalty payments Mr. Cooper
would receive from TLC as capital gain under that section. Mr. Baker advised
petitioners that (1) they could not control TLC directly or indirectly and (2) their
stock ownership in TLC had to be less than 25% of the total outstanding stock.
10
Ms. Walters has a B.A. degree in finance from Cleveland State University.
During the years at issue she was an employee of the National Multiple Sclerosis
Society in Independence, Ohio. Ms. Coulter has a B.S. degree in animal science
from Ohio State University and an M.S. in agricultural economics from the
University of Wyoming. She owns her own construction company, Multi-
Maintenance, Inc., in Ohio and was an employee of Multi-Maintenance during the
years at issue.
11
TLC did not have an office or other formal business location.
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Consistent with Mr. Baker’s advice, the outstanding stock of TLC at
formation was as follows: petitioners as cotrustees of the Cooper Trust owned 240
shares (24%); (2) Lois Walters owned 380 shares (38%); and (3) Janet Coulter
owned 380 shares (38%). Ms. Walters and Ms. Coulter each made an initial
contribution of $3,800 to TLC in exchange for their shares while petitioners as
cotrustees of the Cooper Trust contributed $2,400 for the trust’s shares. Ms.
Walters, Ms. Cooper, and Ms. Coulter were the president and chief financial
officer, vice president, and secretary of TLC, respectively.12 Mr. Cooper was the
general manager of TLC.
On March 15, 1997, Mr. Cooper and Pixel entered into agreements
(collectively, TLC agreements) with TLC purportedly transferring all of Mr.
Cooper’s and Pixel’s rights in the patents (subject patents) giving rise to the
royalties at issue in this case to TLC. Under each TLC agreement, the licensor
(i.e., Mr. Cooper or Pixel) receives 40% of all gross proceeds received by TLC for
any sublicense and 40% of all damages received in litigation or settlement of
12
Beginning in 2004 or 2005 and continuing through the years at issue, Ms.
Coulter performed most of Ms. Walters’ duties at TLC. At that time, Ms. Walters
was working more than 50 hours per week for the National Multiple Sclerosis
Society and spending substantial time caring for her ill father.
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litigation. The licensor then receives 90% of all remaining net proceeds as defined
in the TLC agreements.
By 1999 TLC had begun experiencing financial difficulty. It could not
effectively license its patents because the patents were the subject of the Cooper-
Leckrone litigation and potential licensees were wary of TLC’s authority to
license the patents. Furthermore, TLC needed legal representation to pursue
patent infringement cases.
In an effort to solve TLC’s financial difficulties, Mr. Cooper contacted
Anthony Brown, who was in the business of helping inventors protect and enforce
their patents. Mr. Brown owned IP Innovation, LLC (IP Innovation).
Subsequently, TLC, Mr. Cooper, and Pixel entered into an agreement (IP
Innovation assignment agreement) with IP Innovation assigning an undivided
interest in Patent #5,424,780 (780 patent) to IP Innovation.13 Then, IP Innovation,
Mr. Cooper, Pixel, and TLC engaged the patent law firm of Niro, Scavone, Haller
& Niro (Niro firm) to represent their interests with respect to the 780 patent. Mr.
13
On August 12, 2002, TLC, Pixel, Mr. Cooper, and IP Innovation executed
an agreement (exclusive license agreement) expanding IP Innovation’s license
beyond the 780 patent by providing an exclusive, perpetual, and irrevocable
license to several additional patents. TLC, Pixel, Mr. Cooper, and IP Innovation
amended the exclusive license agreement on October 31, 2002, and on November
12, 2004, the exclusive license agreement was terminated.
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Cooper agreed to provide technical assistance to the Niro firm as necessary to
assist the firm in interpreting the patents, technology, and devices that would be
the subject of the licensing and infringement matters the firm was pursuing. Mr.
Cooper was not compensated for providing technical assistance to the Niro firm.
On February 28, 2003, TLC and its shareholders adopted a stock restriction
agreement providing in relevant part that TLC’s shares could not be sold,
assigned, or transferred except according to the terms of the stock restriction
agreement. Under the agreement petitioners were permitted to transfer shares of
TLC stock to their issue or any trust for the benefit of their issue. No other TLC
shareholder (i.e., Ms. Coulter or Ms. Walters) was permitted to transfer shares of
TLC stock to her issue or any party other than a shareholder. Mr. Baker drafted
the stock restriction agreement in his role as petitioners’ estate planning attorney.
Despite owning a majority of TLC’s outstanding stock and being on the board of
directors, neither Ms. Coulter nor Ms. Walters negotiated the terms of the stock
restriction agreement.14
14
Neither Ms. Coulter nor Ms. Walters consulted an attorney before signing
the stock restriction agreement, and neither could recall the circumstances of her
signing the agreement. They did not receive any consideration for giving up their
right to transfer their shares in TLC. Mr. Baker testified that the restrictions on
Ms. Walters’ and Ms. Coulter’s ability to transfer shares in TLC were inadvertent
and done in error. We find Mr. Baker’s testimony unconvincing in the light of our
(continued...)
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In 2004 Anthony Brown formed New Medium, LLC (New Medium), and
AV Technologies, LLC (AV Technologies), to pursue patent commercialization.
TLC, Pixel, and Mr. Cooper subsequently entered into licensing agreements for
certain patents with both New Medium and AV Technologies (collectively, New
Medium and AV Technologies agreements). In or about 2004 Acacia
Technologies Group (Acacia) purchased IP Innovation and IP Innovation became
a subsidiary of Acacia. On March 23, 2005, the parties to the New Medium and
AV Technologies agreements and the IP Innovation assignment agreement
clarified by agreement (letter agreement) that all material decisions (i.e., licensing,
litigation, and prosecution) with respect to the New Medium and AV Technologies
agreements and the IP Innovation assignment agreement were to be made
according to a majority vote of Mr. Cooper, Acacia,15 and Anthony Brown. Under
the letter agreement TLC did not have a vote with respect to the material decisions
14
(...continued)
finding that Mr. Cooper indirectly controlled TLC. See infra p. 31. Mr. Cooper
had ample motivation to ensure that the stock of TLC was not transferred to
parties he could not control.
15
Under the letter agreement Acacia was defined as IP Innovation, New
Medium, and AV Technologies.
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under either the IP Innovation assignment agreement or the New Medium and AV
Technologies agreements.16
Among the patents transferred by Mr. Cooper to TLC under the terms of the
TLC agreements were three patents known as the “Lowe patents”. The Lowe
patents included the 489 patent. On January 18, 2006, TLC transferred the Lowe
patents back to Mr. Cooper. He did not pay any money or transfer any other
consideration to TLC for the return of the Lowe patents. The agreement
transferring the Lowe patents from TLC to Mr. Cooper simply states that the
16
The letter agreement provides that “all material decisions with respect to
the * * * [IP Innovation assignment agreement and the New Medium and AV
Technologies agreements] will be made by a majority of Cooper, the Acacia
Companies, and Anthony Brown, including without limitation, all licensing,
litigation, and prosecution decisions.” Petitioners contend that the above-
referenced provision in the letter agreement mistakenly uses the term Cooper
instead of “Cooper Parties”. “Cooper Parties” was defined in the letter agreement
to include TLC, while “Cooper” was defined as J. Carl Cooper (petitioner James
C. Cooper).
Generally, where the terms of a contract are unambiguous, we presume that
the contracting parties intended what they stated and will interpret the contract as
written. See, e.g., Peco Foods, Inc. v. Commissioner, T.C. Memo. 2012-18, aff’d,
522 Fed. Appx. 840 (11th Cir. 2013); see also Canfora v. Coast Hotels & Casinos,
Inc., 121 P.3d 599, 603 (Nev. 2005) (holding that when a contract is clear on its
face it will be enforced as written). As a result, we presume the parties intended
what they stated in the letter agreement and infer that Mr. Cooper (and not TLC)
was entitled to vote on material decisions regarding the IP Innovation assignment
agreement and the New Medium and AV Technologies agreements.
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parties completed the transfer because TLC had not licensed the Lowe patents and
TLC and Mr. Cooper desired to return the Lowe patents to Mr. Cooper.
On January 23, 2006, Mr. Cooper transferred the Lowe patents to Watonga
Technology, Inc. (Watonga). The shareholders of Watonga were as follows: the
Cooper Trust (1%); petitioners’ son (11.5%); petitioners’ daughter (11.5%); Ms.
Coulter and Ms. Walters (76% combined). Ms. Coulter was the president of
Watonga.17 Under the agreement transferring the Lowe patents to Watonga, Mr.
Cooper received 55% of all net revenue (as defined in the agreement), and
Watonga retained 20% of all net revenue.18 Watonga received $120,000 in gross
receipts from the license of the 489 patent in 2007.19
17
Although she was Watonga’s president, Ms. Coulter testified that she did
not know whether Watonga licensed any patents during 2006.
18
The remaining 25% of net revenue was payable to Virgil Lowe or his
nominee. Mr. Lowe was the original owner of the Lowe patents. He sold the
Lowe patents to Mr. Cooper in 1995 for $40,000 and 25% of all net revenue
received from any third party in connection with the license of the patents.
19
Watonga purportedly paid TLC $72,000 in 2007 with respect to the 489
patent. It is unclear from the record whether such a payment was made and, if so,
pursuant to what agreement the payment was made. Mr. Cooper testified at trial
that he could not recall the details of the payment and was not sure whether
Watonga had a licensing agreement with TLC. He further testified that the
document notating the payment could be in error or that the payment could be the
result of a prior agreement that was not in the record. In the light of Mr. Cooper’s
testimony and our review of the record, we do not find credible the contention that
(continued...)
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The amount of the royalties paid each year to Mr. Cooper was determined
under the TLC agreements by accountants hired by TLC. Neither Ms. Walters nor
Ms. Coulter, who were the majority shareholders as well as officers and directors,
reviewed and verified the amount of royalties paid to Mr. Cooper each year.20
Similarly, neither Ms. Walters nor Ms. Coulter negotiated the terms of TLC’s
agreements to licence the subject patents to other companies. Instead, Ms. Walters
and Ms. Coulter relied on TLC’s attorneys and the technical expertise of Mr.
Cooper with regard to TLC’s licensing activities. During the years at issue, Ms.
Walters and Ms. Coulter’s duties as directors and officers consisted largely of
signing checks and transferring funds as directed by TLC’s accountants and
signing agreements as directed by TLC’s attorneys. The only compensation Ms.
Walters and Ms. Coulter received from TLC was director’s fees paid during some
years and long-term care insurance policies purchased by TLC in 2003. TLC had
no employees and paid no compensation to any party.
19
(...continued)
Watonga paid TLC anything of value with respect to the 489 patent in 2007.
20
Ms. Coulter testified that her review of the royalties paid annually to Mr.
Cooper consisted solely of reviewing the statement provided by the accountants
regarding the amount of royalties to be paid and agreeing with it.
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We infer from the record and find that substantially all of TLC’s decisions
regarding licensing, patent infringement, and patent transfers were made either by
Mr. Cooper or at his direction. We further find that Mr. Cooper controlled TLC in
all material respects. Ms. Coulter and Ms. Walters acted in their capacities as
directors and officers of TLC at the direction of Mr. Cooper. They did not make
independent decisions in accordance with their fiduciary duties to TLC or act in
their best interests as shareholders.
II. Professional Fees
During late 2005 and 2006 Mr. Cooper engaged Mike Holmes of Holmes
Development to complete reverse engineering and related services with respect to
the 489 patent (reverse engineering services). The reverse engineering services
included disassembling televisions and DVD recorders to determine how the
products were designed and manufactured and whether any of the products were
infringing on Mr. Cooper’s patents.
The invoices for the reverse engineering services were addressed to Mr.
Cooper individually and not to TLC or Watonga.21 Yet TLC and Watonga were
the principal owners of the 489 patent during the period when Mr. Holmes
21
Mr. Cooper transferred the 489 patent to TLC in 1997. TLC returned the
489 patent to Mr. Cooper on January 18, 2006, and Mr. Cooper transferred the 489
patent to Watonga on January 23, 2006. See supra pp. 12-13.
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completed the reverse engineering services. Mr. Cooper owned the 489 patent for
only a few days in 2006. He paid Holmes Development $108,519 in 2006 for the
reverse engineering services.
III. Pixel Instruments/Bad Debt
Petitioners incorporated Pixel in 1983 for the purpose of designing and
manufacturing audio and video signal processing products. Specifically, Pixel
designed products to measure and correct errors in the synchronization of sound
and video images. Mr. Cooper was the president of Pixel at all relevant times.
Ms. Cooper held various positions with Pixel from 1983 to 2004, including the
position of vice president.
In September 1995 Pixel executed a working capital promissory note
(promissory note) wherein it promised to pay to the Cooper Trust all sums
advanced to Pixel by the Cooper Trust up to $1.5 million. On May 14, 2004, Pixel
and the Cooper Trust amended the promissory note to increase the maximum loan
amount to $2.5 million.
Until some point in 2006 petitioners wholly owned Pixel. In 2006
petitioners transferred 76% of their shares in Pixel to Mirko Vojnovic and
Christopher Smith. Mr. Smith was a longtime consultant to Pixel. He and Mr.
Vojnovic owned 22% and 54% of Pixel’s shares, respectively, during the years at
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issue.22 They paid nothing or a de minimis amount for their shares. However, in
conjunction with the Cooper Trust’s transfer of shares to Mr. Smith and Mr.
Vojnovic, Pixel transferred certain intellectual properties--including its rights to
royalties from the patents Pixel previously licensed to TLC--to Mr. Cooper.
When televisions changed from standard definition to high definition in the
mid-to-late-2000s, many of Pixel’s products became obsolete. In an effort to
better compete in the marketplace, Pixel began developing a product known as
Liptracker to correct lip synchronization errors in high definition televisions.
Between 2005 and 2008 petitioners as cotrustees of the Cooper Trust advanced
funds to Pixel under the terms of the promissory note. These funds were used in
part to fund the Liptracker program.
Pixel contracted with an Indian company to complete the software
development necessary for Liptracker. Pixel’s goal was to have a working and
salable Liptracker product for presentation at the National Association of
Broadcasters convention in April 2008. Unfortunately, the Indian company could
not fulfill its promise to develop the Liptracker software, and Pixel was unable to
proceed with the development on its own. Pixel met with representatives from the
22
Mr. Vojnovic sold all of his Pixel shares to Mr. Smith in April 2011 for
$1.
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Indian company in July 2008 who confirmed the company was abandoning its
development of the Liptracker software.
In 2008 Pixel faced financial difficulty. It had no new products in
development--aside from the stalled Liptracker product--and few older products
that were still marketable. Its gross receipts were in excess of $525,000 in both
2005 and 2006 but decreased significantly in 2007 and 2008.
However, Pixel continued business operations through at least 2012. It was
the assignee of many patents in 2008 and thereafter and had an active licensing
agreement with TLC.23 Pixel’s gross receipts were $92,603, $148,968, $26,912,
$22,500, and $22,50024 for 2008, 2009, 2010, 2011, and 2012, respectively. Pixel
had total yearend assets each year from 2008 through 2012 in excess of $172,000,
including more than $319,000 in both 2011 and 2012.
Mr. Cooper continued to advance funds to Pixel under the terms of the
promissory note throughout 2008. On December 31, 2008, the outstanding
23
Pixel was the assignee or assignor on a number of filings with the U.S.
Patent and Trademark Office from 2010 through 2012. Mr. Cooper testified that
these assignments were confirming assignments that had occurred many years
before and did not transfer anything new of value to Pixel. According to Mr.
Cooper, these confirmatory assignments were necessary to show proper chain of
title.
24
The gross receipts of $22,500 in 2011 and 2012 consisted of a single
annual trademark royalty that will continue for the foreseeable future.
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balance on the promissory note was $2,046,901. Mr. Cooper concluded at that
time that Pixel could not pay the outstanding balance on the Pixel note, and
petitioners treated the balance as a nonbusiness bad debt on petitioners’ 2008
Federal income tax return. Petitioners did not initiate any type of litigation25 to
recover the amounts they lent Pixel under the terms of the promissory note and it
is unclear from the record what demands, if any, they made for payment of the
outstanding balance.
IV. Petitioners’ Tax Reporting and Notice of Deficiency
Petitioners jointly filed Forms 1040, U.S. Individual Income Tax Return, for
each of the years at issue. They reported the royalty payments Mr. Cooper
received from TLC as capital gain on Schedules D, Capital Gains and Losses,
attached to their Forms 1040. The amounts of royalty payments petitioners
reported for 2006, 2007, and 2008 were $3,248,886, $1,933,010, and $1,597,450,
respectively. Petitioners also reported income and expenses from Mr. Cooper’s
patent licensing business on Schedules C attached to their Form 1040 for each of
the years at issue. Among the deductions claimed for 2006 was $108,519 for
25
Mr. Cooper testified that he consulted attorney Mitch Mitchell, who had
previously represented Mr. Cooper in the Cooper-Leckrone litigation, regarding
pursuing litigation against Pixel for the balance due on the promissory note. Mr.
Cooper claimed that he subsequently determined that litigation against Pixel
would be futile.
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professional fees paid to Holmes Development during 2006. Finally, for 2008,
petitioners claimed a bad debt deduction of $2,046,570 on a Schedule D attached
to their Form 1040. This deduction was for the purportedly uncollectible loan to
Pixel under the terms of the promissory note.
On April 4, 2012, respondent issued the notice of deficiency to petitioners.
Respondent determined that (1) the royalties Mr. Cooper received from TLC did
not qualify for capital gain treatment under section 1235 because Mr. Cooper
controlled TLC; (2) petitioners could not deduct certain expenses for the years at
issue; and (3) petitioners were not entitled to a bad debt deduction under section
166 for the promissory note because petitioners had not shown that the promissory
note became worthless in 2008.
OPINION
I. Burden of Proof
Ordinarily, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving that the
determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933). The burden of proof shifts to the Commissioner, however, if the
taxpayer produces credible evidence to support the deduction or position, the
taxpayer complied with any substantiation requirements, and the taxpayer
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cooperated with the Secretary26 with regard to all reasonable requests for
information. Sec. 7491(a); see also Higbee v. Commissioner, 116 T.C. 438, 440-
441 (2001).
Petitioners do not assert nor have they proven that they are entitled to a shift
in the burden of proof under section 7491(a)(1). Accordingly, petitioners bear the
burden of proof with respect to respondent’s deficiency determinations.
II. Section 1235 Gain
A. Whether a Holder’s Control Over an Unrelated Corporate Transferee
Defeats Capital Gain Treatment Under Section 1235
Section 1235(a) provides that a transfer (other than by gift, inheritance, or
devise) of all substantial rights to a patent by any holder27 shall be treated as the
sale or exchange of a capital asset held for more than 1 year, regardless of whether
the payments in consideration of such transfer are contingent on the productivity,
use, or disposition of the property transferred. Thus, in order for the transfer of a
patent to qualify as a sale or exchange, the owner must transfer “all substantial
26
The term “Secretary” means the Secretary of the Treasury or his delegate.
Sec. 7701(a)(11)(B).
27
The term “holder” includes any individual whose efforts created such
property. Sec. 1235(b)(1).
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rights”28 to the property. See sec. 1235(a); see also Juda v. Commissioner, 90 T.C.
1263, 1281 (1988), aff’d, 877 F.2d 1075 (1st Cir. 1989). For purposes of section
1235, the term “all substantial rights”29 means “all rights * * * which are of value
at the time the rights * * * are transferred.” Sec. 1.1235-2(b)(1), Income Tax
Regs.30 The retention of the right to terminate the transfer at will is the retention
of a substantial right under section 1235.31 Sec. 1.1235-2(b)(4), Income Tax Regs.
28
Generally, an assignment is a transfer of all substantial rights to a patent,
see Juda v. Commissioner, 877 F.2d 1075, 1078 (1st Cir. 1989), aff’g 90 T.C.
1263 (1988), while a license is a transfer of less than all substantial rights in a
patent, see Kueneman v. Commissioner, 68 T.C. 609, 613 (1977), aff’d, 628 F.2d
1196 (9th Cir. 1980).
29
We have previously stated that transactions between shareholders and their
closely held corporations should be closely scrutinized in determining whether
there has been a transfer of all substantial rights in a patent. See McDermott v.
Commissioner, 41 T.C. 50, 59 (1963).
30
Sec. 1.1235-1(b), Income Tax Regs., provides that if a transfer is not one
described in sec. 1.1235-1(a), Income Tax Regs. (transfer of all substantial rights
to a patent by a holder to a person other than a related person), then sec. 1235 does
not apply to determine whether such transfer is the sale or exchange of a capital
asset. In other words, a transfer by a person other than a holder or a transfer by a
holder to a related person is not governed by sec. 1235. Sec. 1.1235-1(b), Income
Tax Regs. Instead, the tax consequences of such transactions are determined
under other provisions of the Code. Id. Petitioners do not contend that Mr.
Cooper is entitled to capital gain treatment under any provisions of the Code (e.g.,
sec. 1221 or sec. 1231) other than sec. 1235.
31
In determining whether a transfer of all substantial rights to a patent has
occurred, the language of the transfer agreement is not controlling. Sec. 1.1235-
2(b)(1), Income Tax Regs. Instead, the entire agreement and the form of the
(continued...)
- 23 -
Finally, under section 1235(d), transfers between related persons, as defined in
section 267(b), are not eligible for capital gain treatment, and for purposes of
section 1235, a corporation and an individual owning 25% or more of the stock of
such corporation directly or indirectly are related persons. Sec. 267(b)(2), (c).
Respondent does not dispute that (1) the transfer of the patents to TLC
under the TLC agreements was other than by gift, inheritance, or devise; (2) Mr.
Cooper qualified as a holder of the subject patents; and (3) petitioners owned less
than 25% of TLC for purposes of section 1235(d). However, respondent contends
that Mr. Cooper effectively retained a right to terminate the transfers under the
TLC agreements, see sec. 1.1235-2(b)(4), Income Tax Regs., because he indirectly
controlled TLC through its directors, officers, and shareholders. Therefore,
respondent contends that Mr. Cooper did not transfer all substantial rights in the
subject patents and is not entitled to capital gain treatment. Petitioners contend
that Mr. Cooper did not control TLC and that the directors, officers, and
shareholders of TLC acted independently of Mr. Cooper in their corporate
decisionmaking.
31
(...continued)
transaction must be examined to see if all substantial rights were transferred. See
Juda v. Commissioner, 877 F.2d at 1078.
- 24 -
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 Court of Claims32 in Charlson v. United States, 525 F.2d
1046, 1053 (Ct. Cl. 1975),33 considered this issue and concluded that such control
could prohibit the transfer of substantially all rights in a patent and therefore
preclude capital gain treatment under section 1235.
The Court of Claims in Charlson examined the legislative history of section
1235 and stated that “it is * * * clear that retention of control by a holder over an
unrelated corporation can defeat capital gains treatment, if the retention prevents
32
The Federal Courts Improvement Act of 1982, Pub. L. No. 97-164, 96
Stat. 25, merged the United States Court of Claims into the newly created Court of
Appeals for the Federal Circuit and, in effect, reconstituted the trial division of the
Court of Claims into a newly created United States Claims Court, a so-called
Article I court. Subsequently, the United States Claims Court was renamed the
United States Court of Federal Claims. Federal Courts Administration Act of
1992, Pub. L. No. 102-572, sec. 902(a)(1), 106 Stat. at 4516.
33
In Charlson v. United States, 525 F.2d 1046 (Ct. Cl. 1975), the Court of
Claims found that on the facts of that case the taxpayer did not control the
transferee corporation, and thus the taxpayer was not precluded from claiming
capital gain treatment under sec. 1235. See infra pp. 27-29.
- 25 -
the transfer of ‘all substantial rights.’” Id. The court supported its conclusion by
reasoning that the holder’s control over the unrelated corporation “places him in
essentially the same position as if all substantial rights had not been transferred.”
Id. The court found further support for its reasoning in the legislative history of
section 1235, noting that a court should closely examine all of the facts and
circumstances of transactions under section 1235 and not rely solely on the terms
of the transfer agreement to determine whether the owner transferred substantially
all rights in the patent to the transferee. See id. (citing S. Rept. No. 83-1622, at
439-440 (1954), 1954 U.S.C.C.A.N. 4621, 5083).
We agree 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. See id. We further agree that Congress intended for a
“transferor’s acts to speak louder than his words in establishing whether a sale of a
patent has occurred”. Id. Accordingly, we hold that retention of control by a
holder over an unrelated corporation can defeat capital gain treatment under
section 1235 because the retention prevents the transfer of “all substantial rights”
in the patent.
- 26 -
B. Whether Mr. Cooper Retained Control Over TLC and Therefore Did
Not Transfer All Substantial Rights in the Subject Patents to TLC
Petitioners rely on the facts regarding control in Lee v. United States, 302 F.
Supp. 945 (E.D. Wis. 1969), and Charlson to support their contention that the
directors, officers, and shareholders of TLC acted independently of Mr. Cooper in
their corporate decisionmaking and that they are entitled to capital gain treatment
under section 1235. We disagree because the facts regarding control in Lee and
Charlson are distinguishable from the facts regarding control in this case. Here,
the facts support our finding that Mr. Cooper indirectly controlled TLC. We
explain below.
In Lee, the taxpayer transferred patents to Lee Custom Engineering, Inc.
(Lee Engineering), a closely held corporation. The three shareholders of Lee
Engineering were unrelated but were all friends. The taxpayer owned 24% of the
outstanding stock of Lee Engineering. The Government argued that the taxpayer
had not transferred all substantial rights in his patents because he controlled Lee
Engineering--the exclusive licensee of the patents. Therefore, the Government
argued that the taxpayer did not effectively transfer his patents under section
1235.34 The District Court rejected the Government’s contentions, stating among
34
The court in Lee interpreted the Government’s argument to be that no
(continued...)
- 27 -
other things, that there was “no evidence presented which suggested * * * [the
taxpayer] was * * * able to force the other stockholders or directors to do his
bidding.” Lee, 302 F. Supp. at 950.
In Charlson, the taxpayer transferred an exclusive license to Germane Corp.
(Germane) to use, manufacture, and sell items incorporating his patents in
exchange for 80% of the royalties that Germane received from licensing the
patents to others. Germane was formed for the specific purpose of purchasing and
licensing the taxpayer’s patents, and the shareholders and directors of Germane
were all trusted business associates, friends, and employees of the taxpayer.
The taxpayer treated the royalties he received from Germane as capital gain
under section 1235. The Government argued that the taxpayer had not transferred
all substantial rights in the patents to Germane because he controlled Germane. In
effect, the Government argued that the taxpayer had a tacit understanding with
34
(...continued)
transfer had occurred under sec. 1235 because the purported transfer was between
parties within the same economic group. Lee v. United States, 302 F. Supp. 945,
950 (E.D. Wis. 1969). The court rejected the Government’s argument because it
reasoned that under sec. 1235(d) Congress considered transfers within the same
economic group to be “transfers to a corporation in which 25% or more of the
outstanding stock was owned by the transferor. Congress did not at any point in
the legislative history of this section indicate an intent to prohibit as a matter of
course transfers to a closed corporation.” Id.
- 28 -
Germane that he would have final veto over any license agreement that Germane
made with respect to his patents.
The court found that although the relationships among the taxpayer,
Germane, and the shareholders made more probable the existence of prohibited
retained control, the evidence did not establish that the taxpayer was able to
exercise such control over Germane. Charlson 525 F.2d at 1055. Instead, the
court found that Germane exercised its rights in the patents according to its own
discretion even though it frequently sought, received, and followed the taxpayer’s
advice. Id. at 1056.
The court noted, among other things, that the shareholders in Germane all
had skills valuable to a small patent licensing company. Id. at 1049. These skills
included legal, engineering, design, and business expertise. Id. Further, the court
found that although the taxpayer was present in many of Germane’s licensing
negotiations, this was mutually beneficial to both parties since it would potentially
lead to higher royalties. Moreover, there was no evidence that the taxpayer--and
not Germane--decided the terms of the licensing agreements. Finally, although the
taxpayer participated as a joint plaintiff with Germane in patent infringement
actions, there was no evidence that the taxpayer controlled or directed the details
of the litigation. Id. at 1055. In short, the court rejected the Government’s
- 29 -
position that the taxpayer controlled the operation of Germane. As a result, the
court held that the taxpayer had transferred all substantial rights in his patents to
Germane--entitling him to capital gain treatment under section 1235. Id. at 1057.
By contrast, TLC did not exercise its rights in the subject patents according
to its own discretion. Both Lee and Charlson are distinguishable because the
taxpayers in those cases did not control the transferee corporations. Here, Mr.
Cooper--troubled by his deteriorated business relationship with Mr. Leckrone--
formed TLC with individuals he could trust and ultimately control. Ms. Coulter
and Ms. Walters--the shareholders and directors of TLC (along with Ms. Cooper)
--did not have the patent, engineering, or other such skills to make them
particularly valuable to a small patent licensing company. Instead, they were
individuals whom Mr. Cooper could trust to follow his direction on patent
licensing issues. Indeed, Ms. Coulter testified that the technical negotiations
regarding licensing and patent infringement were over her head and she deferred
to Mr. Cooper on such issues. She further testified that she signed licensing and
infringement agreements when directed to do so by TLC’s attorneys and signed
checks and transferred funds when directed to do so by TLC’s accountants.
As officers and directors of TLC, Ms. Coulter and Ms. Walters took
numerous actions that are inconsistent with acting independently and in the best
- 30 -
interest of the corporation. Among other things, Ms. Coulter and Ms. Walters
approved TLC’s transfer of potentially valuable patents to Mr. Cooper for no
consideration. At least in one instance, Mr. Cooper almost immediately licensed
one of these patents to another related corporation for which that corporation
received a royalty of $120,000 in 2007. As shareholders Ms. Coulter and Ms.
Walters signed a stock restriction agreement placing restrictions on their ability to
transfer shares of stock in TLC to anyone other than petitioners, without receiving
any consideration in exchange. The stock restriction agreement did not place
similar restrictions on petitioners.
Indeed, it is unclear what material decisions, if any, the officers and
directors of TLC made independent of Mr. Cooper.35 Mr. Cooper--and not the
officers or directors of TLC--provided technical assistance to the Niro firm in
interpreting the subject patents and relevant technology and in formulating patent
enforcement strategies. Mr. Cooper conducted all technical matters for TLC--
which in substance was all or a large part of TLC’s activities. Furthermore, in his
role as general manager of TLC and under the terms of the letter agreement, Mr.
35
Ms. Coulter testified that she often followed the advice of TLC’s
attorneys, but she did not know who at TLC was directing TLC’s attorneys. We
infer from the record and find that TLC’s attorneys drafted licensing agreements
and patent infringement agreements largely at the direction of Mr. Cooper.
- 31 -
Cooper made all material decisions for TLC with respect to the IP Innovation
assignment agreement and the New Medium and AV Technologies agreements.
We do not find credible any testimony by petitioners that TLC was an
independent corporation that Mr. Cooper did not control. We conclude that
petitioners have failed to meet their burden of establishing that they transferred all
substantial rights in the subject patents to TLC pursuant to section 1235(a). See
Rule 142(a). Accordingly, we sustain respondent’s determination that petitioners’
royalty income for 2006, 2007, and 2008 did not qualify for capital gain treatment
under section 1235(a).
III. Professional Fees
Generally, a taxpayer is entitled to deduct ordinary and necessary expenses
paid or incurred in carrying on a trade or business. See sec. 162(a); Am. Stores
Co. v. Commissioner, 114 T.C. 458, 468 (2000).36 An expense is ordinary if it is
customary or usual within the particular trade, business, or industry or if it relates
to a transaction “of common or frequent occurrence in the type of business
involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense is necessary
36
Additionally, sec. 212 generally allows a taxpayer to deduct the ordinary
and necessary expenses paid or incurred during the taxable year for the production
or collection of income. Such expenses must be reasonable in amount and bear a
proximate relationship to the production or collection of taxable income. Sec.
1.212-1(d), Income Tax Regs.
- 32 -
if it is appropriate and helpful for the development of the business. See
Commissioner v. Heininger, 320 U.S. 467, 471 (1943). To be deductible, ordinary
and necessary expenses must be “directly connected with or pertaining to the
taxpayer’s trade or business”. Sec. 1.162-1(a), Income Tax Regs. Deductions are
a matter of legislative grace, and a taxpayer must prove that he is entitled to the
deductions he claims. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
Generally, a taxpayer who pays another taxpayer’s business expenses may
not treat those payments as ordinary and necessary expenses incurred in the
payor’s trade or business. See Deputy v. du Pont, 308 U.S. at 494-495; Columbian
Rope Co. v. Commissioner, 42 T.C. 800, 815 (1964). An exception exists for
cases in which the taxpayer paid another taxpayer’s ordinary and necessary
business expenses in order to “protect or promote” the taxpayer’s own business.
See, e.g., Scruggs-Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779, 787
(1946). In Lohrke v. Commissioner, 48 T.C. 679, 688 (1967), we articulated a
two-part test for determining whether a taxpayer’s payments are eligible for this
exception: (1) The taxpayer’s primary motive for paying the expenses was to
protect or promote the taxpayer’s business and (2) the expenditures constituted
ordinary and necessary expenses in the furtherance or promotion of the taxpayer’s
business.
- 33 -
Under the Lohrke test, we must first “ascertain the purpose or motive which
cause[d] the taxpayer to pay the obligations of the other person.” Id. To meet this
prong, Mr. Cooper’s purpose in paying the Holmes Development expenses must
have been for the benefit of his business as an inventor. We “must then judge
whether it is an ordinary and necessary expense of the * * * [taxpayer’s] trade or
business; that is, is it an appropriate expenditure for the furtherance or promotion
of that trade or business? If so, the expense is deductible by the individual paying
it.” Id.
Petitioners claimed a deduction of $108,519 in 2006 for professional fees
paid to Mr. Holmes for reverse engineering services. Respondent disallowed this
deduction in its entirety. Respondent contends that these expenses are properly
chargeable to Watonga or TLC and are not Mr. Cooper’s ordinary and necessary
business expenses. Petitioners contend that these expenses are the ordinary and
necessary expenses of Mr. Cooper’s business as an inventor. Alternatively,
petitioners contend that even if we find that the expenses are properly chargeable
to Watonga or TLC, petitioners are still entitled to deduct the expenses.
Mr. Holmes’ reverse engineering services included the disassembling of
televisions and DVD recorders to determine how the products were designed and
manufactured and whether any of the products infringed on Mr. Cooper’s patents.
- 34 -
The invoices for the reverse engineering expenses indicated that the services were
completed with respect to the 489 patent. However, Mr. Cooper testified that most
of these expenses were unrelated to the 489 patent. For example, according to Mr.
Cooper, the reverse engineering services included the reverse engineering of
plasma televisions that use random dithering and not coherent dithering--the
subject of the 489 patent. Regardless, petitioners stipulated that the reverse
engineering expenses were for services performed with respect to the 489 patent.37
Petitioners are bound by their stipulation. See, e.g., Dorchester Indus., Inc. v.
Commissioner, 108 T.C. 320, 330 (1997), aff’d without published opinion, 208
F.3d 205 (3d Cir. 2000); see also Rule 91(e). Because TLC and Watonga, as
applicable, owned the 489 patent during the period in which Mr. Holmes
completed his services, see supra pp. 12-13, we conclude that the reverse
engineering expenses were the ordinary and necessary business expenses of TLC
and Watonga. Nevertheless, because petitioners paid the reverse engineering
37
The parties filed a stipulation of settled issues on June 10, 2013, stating
that “[t]he legal and professional services expenses not allowed by respondent for
taxable year 2006 in the amount of $108,518.60 are attributable to expenses
charged by Holmes Development for works performed by Holmes Development
during the period from December 15, 2005 through November 30, 2006 with
respect to U.S. Patent # 5,157,489.”
- 35 -
expenses for TLC and Watonga, they still may be entitled to deduct the expenses
under Lohrke v. Commissioner, 48 T.C. 688.
Respondent does not dispute that Mr. Cooper was in the trade or business of
patent commercialization and being an inventor during the years at issue. Mr.
Cooper testified that he had a long-term working relationship with Mr. Holmes.
The Holmes Development invoices, while referencing that the services were
completed with respect to the 489 patent, also list Mr. Cooper as the obligor and
account holder. Thus, it appears Holmes Development understood its client
relationship to be with Mr. Cooper individually and not with Watonga or TLC.38
We find credible Mr. Cooper’s testimony that Holmes Development’s business
relationship was with him personally, Holmes Development trusted Mr. Cooper to
pay for the services completed, and that nonpayment of the Holmes Development
expenses would have adversely affected Mr. Cooper’s business reputation. See,
e.g., Jenkins v. Commissioner, T.C. Memo. 1983-667. Furthermore, Holmes
38
The Holmes Development invoices further support our conclusion that Mr.
Cooper controlled TLC and his portfolio of patents. See supra p. 31. Although
Mr. Cooper purportedly transferred all substantial rights in the 489 patent to TLC
and Watonga, Holmes Development understood its relationship to be with Mr.
Cooper individually. We do not believe that Holmes Development would have
considered its business relationship to be with Mr. Cooper if TLC and Watonga, as
applicable, owned all substantial rights in the 489 patent and TLC and Watonga
functioned as independent corporations.
- 36 -
Development’s work on the 489 patent owned by Watonga had the potential to
directly benefit Mr. Cooper’s trade or business as an inventor because Mr. Cooper
stood to receive 55% of Watonga’s net revenue. Accordingly, we conclude that
Mr. Cooper’s payment of the reverse engineering expenses was for the benefit of
his trade or business as an inventor and his ongoing relationship with Holmes
Development. Therefore, petitioners have satisfied the first part of Lohrke’s two-
part test. See Lohrke v. Commissioner, 48 T.C. 688.
Mr. Cooper further testified that the services performed by Holmes
Development were necessary in his trade or business to keep him apprised of
current developments and current engineering practices for audio and video
technology. He further testified that the services performed by Holmes
Development helped him ascertain whether certain products infringed on any
patents that he had developed and commercialized. We conclude that the reverse
engineering expenses were proximately related to Mr. Cooper’s business as an
inventor and their payment by him was ordinary and necessary. See id. at 689.
Accordingly, we conclude that petitioners have satisfied the second part of the
Lohrke test, see id., and they are entitled to deduct the reverse engineering
expenses.
- 37 -
IV. Bad Debt
Section 166 authorizes a taxpayer to deduct any debt that becomes
worthless within the taxable year. Section 166 distinguishes between business and
nonbusiness bad debts. Nonbusiness bad debts are treated as losses resulting from
the sale or exchange of a short-term capital asset.39 Secs. 166(d)(1), 1211(b),
1212(b). A nonbusiness debt is a debt other than “(A) a debt created or acquired
(as the case may be) in connection with a trade or business of the taxpayer; or (B)
a debt the loss from the worthlessness of which is incurred in the taxpayer's trade
or business.” Sec. 166(d)(2). “To qualify for a deduction for a worthless debt a
taxpayer must show that he and his alleged debtor intended to create a debtor-
creditor relationship, that a genuine debt in fact existed, and that the debt became
worthless within the tax year.” Andrew v. Commissioner, 54 T.C. 239, 244-245
(1970); see also sec. 1.166-1(c), Income Tax Regs. “The year a debt becomes
worthless is fixed by identifiable events that form the basis of reasonable grounds
for abandoning any hope of recovery.” Aston v. Commissioner, 109 T.C. 400, 415
(1997).
39
A business bad debt is deductible as an ordinary loss to the extent of the
taxpayer’s adjusted basis in the debt. Sec. 166(b). Petitioners do not contend that
the loan to Pixel is deductible as a business bad debt.
- 38 -
The question of whether a debt became worthless during a taxable year is
determined on the basis of all the facts and circumstances. See, e.g., Halliburton
Co. v. Commissioner, 93 T.C. 758, 774 (1989), aff’d, 946 F.2d 395 (5th Cir.
1991). “Specifically, * * * [a taxpayer] must prove that the debt had value at the
beginning of the taxable year and that it became worthless during that year.”
Milenbach v. Commissioner, 106 T.C. 184, 204 (1996), aff’d in part, rev’d in part
on other grounds, 318 F.3d 924 (9th Cir. 2003). The taxpayer “must show
sufficient objective facts from which worthlessness could be concluded; mere
belief of worthlessness is not sufficient.” Fincher v. Commissioner, 105 T.C. 126,
138 (1995). Furthermore, legal action is not required to show worthlessness if
surrounding circumstances indicate that a debt is worthless and uncollectible and
that any legal action in all likelihood would be futile because the debtor would not
be able to satisfy a favorable judgment. Sec. 1.166-2(b), Income Tax Regs.
A debt is not worthless for purposes of a section 166 deduction merely
because it might be difficult, or uncomfortable, to collect. See Reading & Bates
Corp. v. United States, 40 Fed. Cl. 737, 757 (1998). A creditor’s determination
that there is no hope of recovery of a debt due and owing must be made in the
exercise of sound business judgment and must be based upon information that is
- 39 -
as complete as is reasonably obtainable regarding the debtor’s financial condition
or ability to satisfy the debt. See Andrew v. Commissioner, 54 T.C. 248.
An analysis regarding the deductibility of a bad debt must examine whether
the debt was truly worthless, and if so, when it became worthless. The
conclusions depend on the particular facts and circumstances of the case, and there
is no bright-line test or formula for determining worthlessness within a given
taxable year. Lucas v. Am. Code Co., 280 U.S. 445, 449 (1930). To be worthless,
a debt must not only be lacking current value and be uncollectible at the time the
taxpayer takes the deduction, but it must also be lacking potential value due to the
likelihood that it will remain uncollectible in the future. Dustin v. Commissioner,
53 T.C. 491, 501 (1969), aff’d, 467 F.2d 47 (9th Cir. 1972); see also Fox v.
Commissioner, 50 T.C. 813, 822 (1968) (“Mere belief that a debt is bad is
insufficient to support a deduction for worthlessness”). The fact that a business is
on the decline, that it has failed to turn a profit, or that its debt obligation may be
difficult to collect does not necessarily justify treating the debt obligation as
worthless. Intergraph Corp. & Subs. v. Commissioner, 106 T.C. 312, 323 (1996),
aff’d without published opinion, 121 F.3d 723 (11th Cir. 1997). This is especially
true where the debtor continues to be a going concern with the potential to earn a
future profit. See Rendall v. Commissioner, 535 F.3d 1221, 1228 (10th Cir. 2008)
- 40 -
(citing Roth Steel Tube Co. v. Commissioner, 620 F.2d 1176, 1182 (6th Cir.
1980), aff’g 68 T.C. 213 (1977)), aff’g T.C. Memo. 2006-174; ABC Beverage
Corp. v. Commissioner, T.C. Memo. 2006-195.
Petitioners contend that the promissory note became worthless in 2008
following the Indian company’s abandonment of the Liptracker program. This
action, according to petitioners, gave rise to the conclusion that there was no hope
of recovering the outstanding amounts under the promissory note. We disagree.
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. The outcome of Pixel’s
arrangement with the Indian company and the failure of the Liptracker program do
not support petitioners’ claim that there was no longer any prospect of recovery of
their loans to Pixel. More importantly, the proper inquiry in this case is not
whether petitioners acted reasonably in their recovery efforts, but whether
sufficient objective facts show that the debt became worthless during the year in
question. Here, the facts do not support such a determination.
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.
- 41 -
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 by the difficulties with
the Liptracker program.40 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.
Mr. Cooper claimed that he consulted with Mr. Mitchell and they
determined that filing a lawsuit against Pixel would be futile. Mr. Cooper then
concluded that the promissory note was worthless. But petitioners failed to
introduce evidence proving what information Mr. Mitchell analyzed to determine
that litigation against Pixel would be futile and failed to introduce evidence
proving the basis on which Mr. Mitchell made his purported conclusion.
Petitioners have failed to satisfy their burden of proving that no prospect of
40
Generally, advances made to an insolvent debtor are not debts for tax
purposes but are characterized as capital contributions or gifts. See Dixie Dairies
Corp. v. Commissioner, 74 T.C. 476, 497 (1980); Davis v. Commissioner, 69 T.C.
814, 835-836 (1978). Furthermore, advances made by an investor to a closely
held or controlled corporation may properly be characterized not as a bona fide
loan but as a capital contribution. See Fin Hay Realty Co. v. United States, 398
F.2d 694, 697 (3d Cir. 1968).
- 42 -
recovery existed in 2008 and failed to prove that the promissory note became
worthless in 2008.41 See Rule 142(a). Accordingly, we sustain respondent’s
disallowance of petitioners’ bad debt deduction for 2008.
V. Accuracy-Related Penalties
A. Introduction
Section 6662 authorizes the imposition of a 20% penalty on the portion of
an underpayment of tax that is attributable to, among other things, (1) negligence
or disregard of rules or regulations or (2) any substantial understatement of income
tax. Sec. 6662(a) and (b)(1) and (2). Only one accuracy-related penalty may be
imposed with respect to any given portion of an underpayment, even if that portion
is attributable to more than one of the reasons identified in section 6662(b). Sec.
1.6662-2(c), Income Tax Regs.
The Commissioner bears the initial burden of production with respect to the
taxpayer’s liability for the section 6662 penalty. Sec. 7491(c). The Commissioner
must introduce sufficient evidence “indicating that it is appropriate to impose the
relevant penalty.” Higbee v. Commissioner, 116 T.C. 446. Once the
Commissioner meets his burden of production, the taxpayer must come forward
41
Pixel’s liabilities to petitioners under the terms of the promissory note
comprised substantially all of Pixel’s liabilities in 2008.
- 43 -
with persuasive evidence that the Commissioner’s determination is incorrect or
that the taxpayer had reasonable cause or substantial authority for the position. Id.
at 446-447.
B. Petitioners’ Liability for the Section 6662 Penalties
1. Substantial Understatement of Income Tax
A substantial understatement of income tax exists if the amount of the
understatement exceeds the greater of 10% of the tax required to be shown on the
return or $5,000. Sec. 6662(d)(1)(A). The term “understatement” means the
excess of the amount of tax required to be shown on the return for the taxable year
over the amount of tax imposed that is shown on the return, reduced by any rebate.
Sec. 6662(d)(2)(A). The amount of the understatement is reduced by that portion
of the understatement that is attributable to (1) the tax treatment of any item if
there is or was substantial authority for such treatment, or (2) any item if the
relevant facts affecting the item’s tax treatment are adequately disclosed in the
return or in a statement attached to the return and there is a reasonable basis for
the taxpayer’s treatment of the item. Sec. 6662(d)(2)(B).
Respondent has introduced sufficient evidence to demonstrate that
petitioners have substantially understated their income tax liability for each of the
years at issue. Petitioners have not alleged nor have they proven that they had
- 44 -
substantial authority for all or any portion of the understatements or that they
adequately disclosed their tax positions on their returns. Accordingly, if the Rule
155 computations confirm a substantial understatement, petitioners are liable for
the section 6662(a) underpayment penalty for a substantial understatement of
income tax.
2. Negligence or Disregard of Rules or Regulations
The term “negligence” includes any failure to make a reasonable attempt to
comply with the provisions of the internal revenue laws, and the term “disregard”
includes any careless, reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-
3(b)(1) and (2), Income Tax Regs. Negligence is strongly indicated where a
taxpayer fails to make a reasonable attempt to ascertain the correctness of a
deduction, credit, or exclusion on a return that would seem to a reasonable and
prudent person to be “too good to be true” under the circumstances. Sec. 1.6662-
3(b)(1)(ii), Income Tax Regs. Disregard of rules or regulations “is ‘careless’ if the
taxpayer does not exercise reasonable diligence to determine the correctness of a
return position” and “is ‘reckless’ if the taxpayer makes little or no effort to
determine whether a rule or regulation exists, under circumstances which
demonstrate a substantial deviation from the standard of conduct that a reasonable
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person would observe.” Sec. 1.6662-3(b)(2), Income Tax Regs.; see also Neely v.
Commissioner, 85 T.C. 934, 947 (1985).
Respondent has met his burden to show that petitioners acted negligently or
with careless disregard of rules and regulations with respect to the royalty
payments Mr. Cooper received from TLC and with respect to the bad debt
deduction for the promissory note. We have found that Mr. Cooper did not
transfer all substantial rights to TLC within the meaning of section 1235 because
Mr. Cooper indirectly controlled TLC. Further, we have found that the promissory
note did not become worthless in 2008 and therefore petitioners were not entitled
to claim a bad debt deduction for the promissory note on their 2008 return.
Petitioners reported the royalty payments from TLC as capital gain without
considering how Mr. Cooper’s involvement with TLC affected their qualification
for capital gain treatment under section 1235. Similarly, petitioners reported the
promissory note as a bad debt on their 2008 return without reasonably attempting
to collect the debt and without identifying specific events that made recovery of
the debt futile in the future. We conclude that petitioners did not make a
reasonable attempt to ascertain the correctness of their bad debt deduction for
2008 or their right to treat the royalty payments received from TLC as capital gain.
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C. Petitioners’ Reasonable Cause/Good Faith Defense
Taxpayers may avoid liability for the section 6662 penalty if they
demonstrate that they had reasonable cause for the underpayment and that they
acted in good faith with respect to the underpayment. Sec. 6664(c)(1).
Reasonable cause and good faith are determined on a case-by-case basis, taking
into account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income
Tax Regs. The most important factor is the extent of the taxpayer’s efforts to
assess his or her proper tax liability. Id. Reliance on professional advice may
constitute reasonable cause and good faith, but “it must be established that the
reliance was reasonable.” Freytag v. Commissioner, 89 T.C. 849, 888 (1987),
aff’d on another issue, 904 F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868 (1991).
We have previously held that the taxpayer must satisfy a three-prong test to be
found to have reasonably relied on professional advice to negate a section 6662(a)
accuracy-related penalty: (1) the adviser was a competent professional who had
sufficient experience to justify the reliance; (2) the taxpayer provided necessary
and accurate information to the adviser; and (3) the taxpayer actually relied in
good faith on the adviser’s judgment. Neonatology Assocs., P.A. v.
Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
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Petitioners contend that they acted with reasonable cause and good faith
based on their reliance on professional advice and therefore no section 6662(a)
accuracy-related penalty is applicable. With regard to the royalty payments Mr.
Cooper received from TLC, petitioners contend they sought the advice of Mr.
Baker, a tax attorney and competent professional. With regard to their bad debt
deduction, petitioners contend they sought and relied on the advice of Mr. Baker
and Mr. Mitchell. Petitioners contend that they provided Mr. Baker and Mr.
Mitchell with all necessary and accurate information, and that they reasonably
relied in good faith on Mr. Baker and Mr. Mitchell’s advice. See Freytag v.
Commissioner, 89 T.C. 888.
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
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6662(a) penalty with respect to their erroneous capital gain treatment of the
royalty payments Mr. Cooper received during the years at issue.
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.
Because respondent has met his initial burden of production under section
7491(c) with respect to the section 6662(a) penalty for each of the years at issue
and petitioners have failed to prove either that they are not liable for the penalties
or that they had reasonable cause and acted in good faith, we conclude that
respondent properly determined that petitioners are liable for the penalties.
Accordingly, if the Rule 155 computations show that the understatement of tax
exceeds the greater of 10% of the tax required to be shown on the return or
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$5,000, see sec. 6662(d)(1)(A), then petitioners are liable for the section 6662(a)
penalty for an underpayment of tax attributable to a substantial understatement of
income tax for each of the years at issue. Alternatively, petitioners are liable for
the section 6662(a) penalty for negligence or disregard of rules and regulations
with respect to the royalty payments and the section 166 bad debt deduction.
We have considered the remaining arguments made by the parties and, to
the extent not discussed above, conclude those arguments are irrelevant, moot, or
without merit.
To reflect the parties’ concessions and the foregoing,
Decision will be entered
under Rule 155.